Bachelor of Commerce

THIRD YEAR
(Semester - 06)

BCOS -62
FINANCIAL MANAGEMENT

School of Management Studies

Tamil Nadu Open University
577, Anna Salai, Saidapet. Chennai-600 015

[Link]
 Name of Programme: [Link]

Course Code with Title: BCOS- 62: Financial Management

Curriculum Design: [Link]

Professor& Director,
School of Management Studies,
Tamil Nadu Open University, Chennai - 600015.
Dr. [Link]
Associate Professor,
School of Management Studies,
Tamil Nadu Open University, Chennai - 600015.
Dr. [Link] Devi
Assistant Professor,
School of Management Studies,
Tamil Nadu Open University, Chennai - 600015.
Dr.S. Archana Bai
Course Writer:
Assistant Professor
Department of Commerce,
Sir Theagaraya College, Chennai – 600021.
Content Editor: Dr. N. Saranya Devi
Assistant Professor,
School of Management Studies,
Tamil Nadu Open University, Chennai - 600015.

Course Coordinator: Dr. N. Saranya Devi

Assistant Professor,
School of Management Studies,
Tamil Nadu Open University,
Chennai-600015.

July, 2023 (First Edition)

ISBN No: 978-93-5753-809-1

@ TNOU, 2023, “Financial Management” is made available under a Creative

Commons Attribution -Share Alike 4.0 License (International).
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Further information on the Tamil Nadu Open University Academic Programmes may be obtained
from the University Office at 577, Anna Salai, Saidapet, Chennai-600 015 [or] [Link]
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 SYLLABUS
Course Title : FINANCIAL MANAGEMENT
Course Code : BCOS - 62
Course Credit :4

COURSE OBJECTIVE

CO1. Introduce the learners with the meaning and the need of Financial
Management in current competitive business environment.
CO2. Measure risk and returns and will be able to analyse various financial
assets based on risk and return through studying Time Value of Money.
CO3. Build an awareness about leverages and capital structure and its theories
of capital structure.
CO4. Tell about dividend policies and various dividend models.
CO5. Provide an insight into various modes and techniques of managing the
working capital, cash and receivable management.

COURSE SYLLABUS

BLOCK I: Introduction to Financial Management

Financial Management – Concept- Definition Finance Goals and Profit Maximization
vs. Wealth maximization - Financial functions – Investment, Financing and Dividend
Decision - Financial Planning - Risk and Return - Sources and Forms of Finance:
Equity Shares, Preference Shares, Bonds, Debentures and Fixed Deposits –
Features – Advantages and Disadvantages
BLOCK II: Time Value of Money
Time value of money: Present value and Compound value - Capitalisation - Bases
of Capitalisation – Cost Theory – Earning Theory – Over Capitalisation – Under
Capitalisation: Symptoms – Causes – Remedies - Cost of capital – Cost of debt –
Cost of preference share capital – Cost of equity – Cost of retained earnings -
Weighted average cost of capital- Calculation of Individual and Composite Cost of
Capital
BLOCK III: Leverage and Capital Structure
Leverage: Introduction, Operating Leverage - Application of Operating Leverage,
Financial Leverage, Combined Leverage - Capital structure –Theories of Capital
Structure (Net Income, Net Operating Income, MM Hypothesis, Traditional
Approach) - Determinants of Capital Structure
BLOCK IV: Dividend Decisions
Dividend Decisions: Introduction - Traditional Approach - Dividend Relevance Model
- Miller and Modigliani Model - Stability of Dividends - Forms of Dividends- Stock
Split
BLOCK V: Working Capital, Cash and Receivable Management
Working Capital Management: Introduction - Components of Current Assets and
Current Liabilities – Concepts, Need and Objective of Working Capital Management
- kinds of working capital - Operating Cycle -Determinants of Working Capital -
Estimation of Working Capital - Inventory Management Techniques - Cash
Management - Meaning and Importance - theories -Receivable Management -
Maintaining Receivables -Credit Policy Variables
REFERENCES:
1. [Link], (2019), Elements of financial management, Sultan Chand &
Sons., New Delhi.
2. [Link] (2022, January 01), Financial Management, Kalyani publishers,
New Delhi.
3. [Link] & [Link], (2019), Financial Management, Sriram
publication, Trichy.
4. [Link], (2017, May 31), Financial Management, Vijay Nicole Publications
, Chennai.
5. Khan & Jain, (2018, August 11), Theory and Problems of Financial
management, McGraw Hill Publication, New Delhi.
6. [Link], (2022, January 01), Financial Management , SahityaBhavan
Publication, New Delhi.
7. Prasanna Chandra, (2011), Financial Management , Tata McGraw-Hill
Education, New Delhi.
8. Dr. A. Murthy, (2013, January 01), Financial Management, Margham
Publications, Chennai.
9. S. K. Sharma, (2018, July 24), Fundamentals of Financial Management , Sultan
Chand & sons, New Delhi.
WEB RESOURCES:
1. [Link]
2. [Link]
[Link]
3. [Link]
4. [Link]
COURSE OUTCOME

On completion of this course, the students will be able to:

CLO1. Develop the skills related to the finance that are required by the finance
manager of a company.
CLO2. Calculate the value of money invested today in different combination of the
rate of interest and time period for taking right decisions to the
capitalisation
CLO3. Calculate the sources of finance for making optimum capital structure and
to find out leverages.
CLO4. Measuring the dividend policies and various dividend models of the
business concern for effective financial decision making to strengthen
wealth of the business.
CLO5. Apply various methods and techniques to calculate working capital, cash
and receivable management for finding the financial position of the
business.

**************
 CONTENT
BLOCK 1 INTRODUCTION TO FINANCIAL MANAGEMENT
UNIT 1 INTRODUCTION TO FINANCIAL MANAGEMENT 2
1.1 Introduction 2
1.2 Scope of Finance 3
1.3 Definitions of Financial Management 3
1.4 Meaning of Financial Management 3
1.5 Profit Maximisation Vs Wealth Maximisation 4
UNIT 2 FINANCIAL FUNCTION 9
2.1 Introduction 9
2.2 Financial Function 10
2.3 Classification of Finance Function 10
UNIT 3 FINANCIAL PLANNING 14
3.1 Meaning of Financial Planning 14
3.2 Definition of Financial Planning 15
3.3 Objectives of Financial Planning 15
3.4 Financial Planning Process 15
3.5 Risk and Return 16
UNIT 4 SOURCES AND FORMS OF FINANCE 20
4.1 Introduction 21
4.2 Types of Finance 21
4.3 Sources of Finance 21
BLOCK 2 TIME VALUE OF MONEY
UNIT 5 TIME VALUE OF MONEY 39
5.1 Introduction 40
5.2 Rationale of time preference of Money 40
5.3 Importance of Time Value of Money 40
5.4 Time Value of Money – Significance in Financial Decision 41
Making
5.5 Reasons for time preference of money 41
5.6 Techniques for estimating time value of money 43
UNIT 6 CAPITALISATION 46
6.1 Meaning of Capitalisation 46
6.2 Bases of Capitalisation 47
6.3 Over Capitalisation - Causes and Remedies 48
6.4 Under Capitalisation - Causes and Remedies 51
UNIT 7 INTRODUCTION TO COST OF CAPITAL 55
7.1 Introduction 56
7.2 Meaning of Cost of Capital 56
7.3 Definitions of Cost of Capital 57
7.4 Significance of Cost of Capital 57
7.5 Factors affecting Cost of Capital 58
7.6 Limitations of Cost of Capital 61
UNIT 8 COST OF CAPITAL AND DEBT 65
8.1 Cost of Capital 66
8.2 Cost of Debt 66
8.3 Cost of Preference Share Capital 69
8.4 Computation of Cost of Equity Share Capital and Retained 70
Earnings
8.5 Calculations of individual and Composite Cost of Capital 76
BLOCK 3 APPOINTMENT OF AUDITOR AND AUDIT REPORT
UNIT 9 INTRODUCTION TO LEVERAGES 88
9.1 Introduction 88
9.2 Meaning of Leverages 89
9.3 Uses of Financial Leverages 89
9.4 Advantages and disadvantages of Leverages 90
9.5 Capital structure definition 91
9.6 Importance of Leverage 91
UNIT 10 TYPES OF LEVERAGES 94
10.1 Types of Leverage 94
10.2 Degree of Operating Leverage 96
10.3 Uses of Operating leverage 96
10.4 Effects of Operating leverage 97
10.5 Financial leverage 97
10.6 Uses of financial leverage 98
10.7 Degree of financial leverage 98
10.8 Combined leverage 99
10.9 Degree of Combined leverage 99
10.10 Importance of Combined leverage 100

UNIT 11 CAPITAL STRUCTURE 107

11.1 Introduction 107
11.2 Definitions of Capital Structure 108
11.3 Importance of Capital Structure 108
11.4 Optimum Capital Structure 108
11.5 Factors determining Capital Structure 109
11.6 Types of Capital Structure 109
UNIT 12 THEORIES OF CAPITAL STRUCTURE 113
12.1 Introduction 114
12.2 Features of Sound Capital Structure 115
12.3 Assumptions of Capital Structure 115
12.4 Pattern of Capital Structure 116
12.5 Theories of Capital Structure 117
12.6 Graded Illustration 120
BLOCK 4 DIVIDEND DECISIONS
UNIT 13 INTRODUCTION TO DIVIDEND DECISIONS 132
13.1 Introduction 132
13.2 Meaning of dividend 133
13.3 Type of dividends 133
13.4 Meaning of dividend policy 134
13.5 Nature of dividend policy 134
13.6 Objectives of dividend policy 135
13.7 Factors affecting dividend policy 136
UNIT 14 MODELS IN DIVIDEND DECISIONS 140
14.1 Introduction 140
14.2 Theories of Dividend 141
14.3 Graded Illustration 146
UNIT 15 FORMS OF DIVIDEND 157
15.1 Dividend meaning 157
15.2 Forms of dividend 158
BLOCK 5 WORKING CAPITAL, CASH AND RECEIVABLE
MANAGEMENT
UNIT 16 INTRODUCTION TO WORKING CAPITAL MANAGEMENT 162
16.1 Introduction 163
16.2 Meaning of Working Capital 163
16.3 Definitions of Working Capital 163
16.4 Concept of Working Capital 164
16.5 Nature of Working Capital 165
16.6 Need for Working Capital 165
16.7 Importance of Working Capital 166
16.8 Elements of Working Capital 166
16.9 Components of Working Capital 167
UNIT 17 KINDS OF WORKING CAPITAL 172
17.1 Methods of working capital calculation 172
17.2 Types of working capital 173
UNIT 18 INVENTORY MANAGEMENT TECHNIQUES 178
18.1 Introduction 179
18.2 Meaning of Inventory Management 179
18.3 Objectives of Inventory Management 180
18.4 Importance of Inventory Management 180
18.5 Types of Inventory Management 181
18.6 Factors Affecting Level of Inventory 182
18.7 Techniques of Inventory Management 182
18.8 Graded Illustration 186
UNIT 19 CASH MANAGEMENT 197
19.1 Nature of Cash 197
19.2 Motive for holding Cash 198
19.3 Objectives of cash management 198
19.4 Cash planning 199
19.5 Factors determining Cash need 199
19.6 Limitations of Cash Management 200
19.7 Graded Illustration 200
UNIT 20 RECEIVABLES MANAGEMENT 205
20.1 Introduction 206
20.2 Meaning of Receivables Management 206
20.3 Objectives of Receivable Management 207
20.4 Costs of Receivables 208
20.5 Benefits of Receivables 209
20.6 Credit Policy in Receivable Management 209
20.7 Setting a Credit Policy 210
Plagiarism Report 217
 BLOCK 1

INTRODUCTION TO FINANCIAL
MANAGEMENT

Unit 1 : Introduction to Financial Management

Unit 2 : Financial Function
Unit 3 : Financial Planning
Unit 4 : Sources and Forms of Finance

1
Unit 1

INTRODUCTION TO FINANCIAL
MANAGEMENT
STRUCTURE
Overview
Learning Objectives
1.1 Introduction
1.2 Scope of Finance
1.3 Definitions of Financial Management
1.4 Meaning of Financial Management
1.5 Profit Maximisation Vs Wealth Maximisation
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Financial management is that managerial activity which is concerned
with planning and control of a firm’s financial resources. It used to be a
branch of economics but now it is a separate discipline form the recent
origin. Finance is the life line for any business and it is essential to
management the funds for smooth running of the business.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• define financial management
• understand the goals of finance
• explain the difference between profit and wealth maximization.
1.1 INTRODUCTION
The Scope of financial management is an integral part of the day-to-day
operations of a business. It involves the analysis, interpretation, and
utilisation of financial information to make informed decisions that will
benefit stakeholders. As such, it requires a comprehensive
understanding of all aspects of finance in order to make informed
decisions.

2
Financial managers must be able to read and interpret financial
statements and understand how their decisions in areas such as
investments, financing, and budgeting can affect the company’s bottom
line. They are often responsible for all or some aspects of finance, so
they must have a piece of thorough knowledge of each function in order
to effectively make decisions in those areas for which they have
authority. Ultimately, the goal is to maximize profits and minimize risks
for stakeholders.
1.2 SCOPE OF FINANCE

The Scope of financial management is an integral part of the day-to-day

operations of a business. It involves the analysis, interpretation, and
utilisation of financial information to make informed decisions that will
benefit stakeholders. As such, it requires a comprehensive
understanding of all aspects of finance in order to make informed
decisions.
Financial managers must be able to read and interpret financial
statements and understand how their decisions in areas such as
investments, financing, and budgeting can affect the company’s bottom
line. They are often responsible for all or some aspects of finance, so
they must have a piece of thorough knowledge of each function in order
to effectively make decisions in those areas for which they have
authority. Ultimately, the goal is to maximize profits and minimize risks
for stakeholders.
1.3 DEFINITIONS OF FINANCIAL MANAGEMENT
“Financial management is the activity concerned with planning, raising,
controlling and administering of funds used in the business” - Guthman
and Douglas

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 searching
goals - J.F. Brandley
1.4 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.

Financial management is the business function that deals with investing

the available financial resources in a way that greater business success

3
and return-on-investment (ROI) is achieved. Financial management
professionals plan, organize and control all transactions in a business.
They focus on sourcing the capital, whether it is from the initial
investment by the entrepreneur, debt financing, venture funding, public
issue, or any other sources. Financial management professionals are
also responsible for fund allocation in an optimised way to ensure
greater financial stability and growth for the organisation.
Financial management definition involves planning, arranging,
managing, and controlling financial activities, such as the acquisition and
use of an organisation's funds. Financial management meaning entails
applying general management ideas to the company's financial
resources. They concentrate on finding the funds, whether they come
from the entrepreneur's initial investment, loan financing, venture capital,
a public offering, or any other source. Professionals in finance
management are also in charge of allocating funds in an efficient
manner to support the organisation's overall financial stability and
expansion.
1.5 PROFIT MAXIMISATION VS WEALTH MAXIMISATION

A firm’s investment and financing decisions are unavoidable and

continuous. In order to make them rationally, the firm must have a goal.
It is generally agreed in theory that the goal of the firm should be
Shareholder Wealth Maximization, as reflected in the market value of the
firm’s shares.
Profit Maximization
Firms, producing goods and services, may function in a market or
government -controlled economy. In a market economy, prices of goods
and services are determined in competitive markets. Firms in the market
economy are expected to produce goods and services desired by the
society as efficiently as possible.
The process of increasing the profit earning capability of the company is
referred to as Profit Maximization. It is mainly a short-term goal and is
primarily restricted to the accounting analysis of the financial year. It
ignores the risk and avoids the time value of money. It primarily
concerns the company’s survival and growth in the existing competitive
business environment.
• Profit Maximization is the ability of the company to operate
efficiently to produce maximum output with limited input or to
produce the same output using much lesser input. So, it
becomes the most crucial goal of the company to survive and

4
 grow in the current cut-throat competitive landscape of the
business environment.
• Given this form of financial management, companies mainly have
a short-term perspective when it comes to earning profits, which
is very much limited to the current financial year.
• If we get into the details, profit is actually what remains out of the
total revenue after paying for all the expenses and taxes for the
financial year. Now to increase profit, companies can either
increase their revenue or minimize their cost structure.

• It may need some analysis of the input-output levels to diagnose

the company’s operating efficiency and identify the key
improvement areas where processes could be tweaked or
changed in their entirety to earn larger profits.
Wealth Maximization
The ability of a company to increase the value of its stock for all the
stakeholders is referred to as Wealth Maximization. It is a long-term goal
and involves multiple external factors like sales, products, services,
market share, etc. It assumes the risk. It recognizes the time value of
money given the business environment of the operating entity. It is
mainly concerned with the company’s long-term growth and hence is
concerned more about fetching the maximum chunk of the market share
to attain a leadership position.
Profit Vs Wealth Maximization
1. Profit maximization is done by increasing the earning capacity of the
company. Whereas, if the company's ability is focused on increasing the
value of stocks for the shareholders and stakeholders, this is known as
Wealth Maximization.
2. While profit maximization is a short-term goal of any business, Wealth
Maximisation is a long-term goal.
3. Risks and uncertainties do not form part of the entire process of profit
maximization. While as Wealth Maximization considers and recognises
the need to assess all possible risks and uncertainties.
4. Profit maximization ensures the survival and growth of the business.
In contrast, Wealth Maximization focuses on a company’s long-term
growth rate by increasing its share in the market.
5. The time value of money is not accounted for in the profit
maximization, whereas wealth maximisation acknowledges it. According

5
to the concept of time value of money, a certain amount of money is
worth more now than it will be in the future. This is so because
investment is the only way to make money grow. An opportunity is lost
when an investment is postponed.
6. Companies with profit maximization as their main goal focus on
efficiency improvement with less cost and maximum profitable output.
While in the case of the companies whose focus is wealth maximization,
they heavily concentrate on increasing and improving the share market
price of the company so that the value of the shareholders is increased.

7. The benefits of profit maximization limit the company's growth to the

current financial year, whereas the benefits of wealth maximization
extend beyond the current year with a huge market share and higher
share price, which ultimately benefits every stakeholder related to the
company.
8. In the case of profit maximization, a company prefers to maximise its
profits. It solely relies on the profits made from the difference between
the total revenue and cost-plus tax expenses of the current financial
year. In contrast, a company with a wealth maximization goal aims to
increase the value of the shareholders' wealth as they are the real
owners of the company. It does so by investing its capital in the market
with uncertain risks but with higher returns.

LET US SUM UP
Finance is the life blood of any business. Finance is the very important
part of the business. Finance is required for smooth running of the
business. To achieve the objective of business finance has to be
managed effectively. The objective of any management is Profit
maximization and wealth maximisation. Both needs to be balanced
based for the continuity of the business.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. Financial management is concerned with the acquisition, financing
and _______ of assets Investment decision making.
a) Monitoring b) Management
c) Supervising d) Selling
2. The objectives of Financial Management is __________.
a) Profit and Wealth Maximization b) Profit Maximisation

c) Capturing the Market d) Financing

6
3. Profit maximization is done by increasing the _______
a) Investment in assets b) Earning capacity of business
c) Sales of the business d) Demand of the Product

4. ___________ includes the analysis of principles and practices related

to management of day-to-day funds of a person.
a) Common Finance b) Personal Finance

c) Public Finance d) Transitional Finance

5. The finance manager is accountable for.
a) Earning capital assets of the company

b) Effective management of a fund

c) Arrangement of financial resources
d) Proper utilisation of funds
GLOSSARY

Finance : money required to start or support any business

Investment. : The act of putting money in a bank, property etc.,

Profit : A financial gain

Decision : a choice of judgement that make after thinking

about various possibilities

Capital : an amount of money that is used to start a

business or to put in a bank

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.

7
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES

1. [Link]
management/[Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

8
Unit 2

FINANCIAL FUNCTION
STRUCTURE
Overview
Learning Objectives
2.1 Introduction
2.2 Financial Function
2.3 Classification of Finance Function
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Finance Function is a very essential for any business undertaking. It is
necessary to set up a sound and efficient organisation for the purpose of
achieving its objectives. The responsibilities of a finance manager are
spread throughout the undertaking. Generally, the finance function is
placed in the hands of top management due to survival a d success or
the growth and development or failure mainly depends on financial
decisions.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• understand what is finance function

• explain Classifications of finance function.

2.1 INTRODUCTION
The scope of finance function is wide because this function affects
almost all the aspects of a firm’s operations. The finance function
includes judgments about whether a company should make more
investment in fixed assets or not.

It is largely concerned with the allocation of a firm’s capital expenditure

over time as also related decisions such as financing investment and
dividend distribution. Most of these decisions taken by the finance
department affect the size and timing of future cash flow or flow of funds.

9
2.2 FINANCIAL FUNCTION
The finance function refers to practices and activities directed to manage
business finances. The functions are oriented toward acquiring and
managing financial resources to generate profit. The financial resources
and information optimized by these functions contribute to the
productivity of other business functions, planning, and decision-making
activities.
Finance is the lifeblood of any business; without proper financial
resources, no business can run smoothly; the finance processes can be
related to planning, execution, control, and maintenance of financial
resources. Moreover, its scope is ever increasing; it widens as the
company grows because larger companies have the resources to
support the increase in functions.
2.3 CLASSIFICATION OF FINANCE FUNCTION
A Firm performs functions simultaneously and continuously ion the
normal course of the business. These functions do not necessarily occur
in a sequence. Finance functions call for skillful planning, control and
execution of a firm’s activities.

Finance Functions are classified as

I. Long term finance functions or decisions
• Long-term asset-mix or investment decisions
• Capital-mix or financing decision
• Profit allocation or dividend decisions
II. Short-term finance functions or decisions
• Short term asset-mix or liquidity decision
I. Long - Term Finance Decisions:
The long-term finance functions or decisions have a longer time horizon,
generally greater than a year. They may affect the firm’s performance
and value in the long run. They also relate to the firm’s strategy and
generally involve senior management in taking the finance decision.
a) Investing Decision: A firm’s investment decision involves capital
expenditure. They are therefore, referred to as capital budgeting
decisions. A capital budgeting decision involve the decisions of
allocation of capital or commitments of funds to long term assets that
would yield benefits (cash flows) in the future. Two important aspects of
investment decisions are the evaluation of the prospective profitability of
new investments and the measurement of a cut-off rate again which the

10
prospective return of new investments could be compared. Future
benefits of investments are difficult to measure and cannot be predicted
with certainty. Risk in investment arises because of the uncertain return.
Investments proposals should, therefore be evaluated in terms of both
expected return and risk. Besides the decisions to commit funds in new
investment proposals. capital budgeting also involves replacement
decisions, that is, decision of committing funds when an asset becomes
less productive or non-profitable.
b) Financing Decision: A financing decision is the is the second
important function to be performed by the financial manager. Broadly the
manager must decide when, where from and how to acquire funds to
meet the firm’s investment needs. The central issue before the manager
is to determine the appropriate proportions of equity and debt. The mix
of debt and equity is known as the firm’s capital structure. The financial
manager must strive to obtain the best financing mix or the optimum
capital structure. For the firm. The firm’s capital structure is considered
optimum when the market value of shares is maximised.
In the absence of debt, the shareholders return is equal to the firm’s
return. The use of debt affects the return and risk of shareholders. It may
increase the return on equity funds but is always increase risk as well.
The change in the shareholders return caused by the change in the
profits is called the financial leverage.
c) Dividend Decision: A dividend decision is the third major financial
decision. The financial manager must decide whether the firm should
distribute all profits, or retain them, or distribute portion and retain the
balance. The proportion of profits distributed as dividends is called the
dividend -payout ratio and the retained portion of profits is known as the
retention ratio. Like the debt policy, the divided policy should be
determined in terms of its impact on the shareholders’ value. The
optimum dividend policy is one of that maximisation that market value of
the firm’s shares. Thus, if shareholders are not indifferent to the firm’s
dividend policy, the financial manager must determine the optimum
dividend payout ratio.
II. Short-Term Finance Decisions
Short -term finance functions or decisions involves a period of less than
one year. These decisions are needed for managing the firm’s day-to-
day fund requirements. Generally, they relate in the management of
current assets and current liabilities, short term borrowings and
investments of surplus cash for short period.

11
a) Liquidity Decision: Investment in current assets affects the firm’s
profitability and liquidity. Management of current assets that affects a
firm’s liquidity is yet another important finance decision. Current assets
should be managed efficiently for safeguarding the firm against the risk
of illiquidity. Lack of liquidity or liquidity in extreme situations can lead in
the firm’s insolvency.

LET US SUM UP
The Finance functions can be divided into three broad categories,
namely investment decisions, financing decisions and dividend decision.
In other words, the firm decides how much to invest in short term and
long-term assets and how to raise the required funds. In making financial
decisions, the financial manager should aim at increasing the value of
the shareholders stake in the firm. Therefore, firms must take certain
decision like long term and short-term decisions for flow of funds and for
the management of funds.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. The finance ___________ refers to practices and activities directed
to manage business finances.
a) Decision b) Planning
c) Function d) policy
2. Investing decisions is a part of ___________decisions.
a) Long-term decisions b) Short-term decisions
c) Medium-term decision d) Overall decisions
3. A decisions regarding purchase of machinery for a business is
___________ decision.
a) Investment b) liquidity
c) financing d) Dividend
4. Short -term finance functions or decisions involves a period of less
than ___________ year.
a) two b) One
c) three d) none of the above
5. ___________ is the second import decision of a finance manager.
a) Investment b) liquidity
c) financing d) Dividend
GLOSSARY
Investment : The act of putting money in a bank, business
property etc.,

12
Financing : To provide the money to pay for something
Liquidity : the state of owning things of value that can
be exchange for cash.
Dividend Decision : There has to be an appropriate, well thought
dividend policy for a firm in case it wants to
maximize on its wealth.
Working Capital These decisions relate to working capital
Decision needs of the firm i.e., current assets and
current liabilities of the unit.
SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
[Link]
2. [Link]
3. [Link]
TfTAQ3YxCS35iKyMphNcXSr
ANSWERS TO CHECK YOUR PROGRESS
1. c) 2. a) 3. a) 3. b) 5. c)

13
Unit 3

FINANCIAL PLANNING
STRUCTURE
Overview
Learning Objectives
3.1 Meaning of Financial Planning
3.2 Definition of Financial Planning
3.3 Objectives of Financial Planning
3.4 Financial Planning Process
3.5 Risk and Return
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Planning is one of the principles of management and the financial
planning means deciding in advance what is to be done. The financial
planning is primarily concerned with procurement and efficient use of
funds. Financial plan is the systematic approach to attain economic
Procurement and utilisation of funds.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• understand what is financial planning
• explain the objectives of financial planning
• explain the process of financial planning
• meaning of risk and return.
3.1 MEANING OF FINANCIAL PLANNING
Financial Plan is a plan which properly estimates the amount of funds
required, proportion of debt-equity, and the policies for administration of
financial plan.
Financial plan is the statement estimating the amount of capital required,
determination of finance mix and formulation of policies for effective
administration of financial plan. Financial plan states the amount of

14
capital required to be raised, the proportion of debt in total capital and its
form and policies bearing on the administration of capital.
3.2 DEFINITION OF FINANCIAL PLANNING

‘The Financial plan of a corporation has two-fold aspects, it refers not to

the capital structure of the corporation, but also to the financial policies
which the corporation has adopted or intends to adopt’ - Bourneville, J.H

‘Financial planning pertains only to the function of finance and includes

the determination of the firm’s financial objectives formulating and
promulgating financial policies and developing financial procedures’ -
Walker and Boughn.
3.3 OBJECTIVES OF FINANCIAL PLANNING
(i) Ensure the availability of sufficient funds: It ensures availability of
sufficient funds to invest in feasible projects, there by achieving
company goals.
(ii) Balance of Risk and Costs: While raising the required funds there
is a need to balance risks and costs to protect the inventor.
• Simplicity: Simplicity means firm should issue few securities,
since issue of variety of securities complicate
• Flexibility: Flexibility means the plan should allow to adjust
according to the changing conditions.
• Liquidity: Liquidity means the ability of an enterprise to honour
the currently maturing obligation. Hence, the financial plan hold
be able to provide funds only when it is running under profits, but
also in the periods of depression or abnormal business period.
• Optimum use: Financial Plan should ensure sufficient funds only
for genuine needs, plan should not allow the firm to suffer
shortage of cash or should have excess of funds than need,
which will be a waste. Put it simple the funds should be raised
according to the needs and should be utilised wisely.
• Economy: The main objective of financial manager is to raise
funds at least cost, the same is the case in financial plan. Plan
should help the firm to raise funds at minimum cost. It should not
impose disproportionate burden on the firm, which means the
plan should ensure optimum debt-equity mix.
3.4 FINANCIAL PLANNING PROCESS
The financial planning process involves six steps:

1. Projection of financial statements: Financial statements are profit

and loss account and balance sheet. Projection of financial statement

15
helps to analyse the effects of the operating plan on projected profits
and various financial plans. The same projects can also ensure the
proper monitoring of the implemented financial plan. Success of the firm
depends on the ability to identify the deviations from financial plan.
2. Determinations of funds needed: Anticipation of funds needed to
invest on fixed assets as well as current assets for research and
development programmes and for major promotional campaigns.
3. Forecast the availability of funds: The required funds may be
generated from two sources, internal and external sources. This step
involves estimation of funds to be generated internally, which
automatically identifies the amount of funds to be raised from outside.
4. Establish and maintain system of controls: Planning and control
are the requisites of management. Control system is necessary to see
the proper and effective utilisation of funds within the firm. It makes that
the basic plan is carried out properly.
5. Develop procedures: Developing procedures ensure consistency of
action. Procedures should be developed for adjusting the basic plan if
the economic forecasts upon which the plan was based do not
materialise.
6. Establish performance-based management compensation
system: It is important to reward the managers for doing what
stakeholders want them to do. Based on the performance, an evaluation
process must be done in order to reward the manager based on the
output of the business.
3.5 RISK AND RETURN
Risk and return in financial management are the risk associated with a
certain investment and its returns. Usually, high-risk investments yield
better financial returns, and low-risk investments yield lower returns.
That is, the risk of a particular investment is directly related to the returns
earn
The risk and return analysis aim to help investors find the best
investments. Hence, investors use many methods to analyze and
evaluate the market, industry, and company. Diversification of the
portfolio, i.e., choosing an optimal mix of different investment options,
can reduce the risk and amplify returns
Risk and return in investing are perhaps the most crucial parameters
considered by investors while choosing an investment option. Individuals
who invest on a large scale analyze the risks involved in a particular

16
investment and the returns it can yield. Let’s take a step-by-step
approach to understand the concept.
First, let’s begin with risk. A risk can be defined as the uncertainty
related to the investment, market, or company. Investors want profits,
and the risks can potentially reduce the profits, sometimes even making
a loss for them.

Many types of risk are involved in investments – market-specific,

speculative, industrial, volatility, inflation, etc. However, studying the
market thoroughly can help investors make the right decisions. They can
analyze the trends and forecast the situation.
Now, let’s understand return on investment, or ROI. It can be explained
as the financial gains from investing in a certain investment. Ideally,
individuals prefer investments that give them higher returns, like stocks
of Google, Amazon, etc.
LET US SUM UP
The Finance planning leads to the effective e management of the
business. Financial planning includes estimating the funds required,
proportion of debt equity and the policies for administration. Financial
planning helps in understanding the requirements of the business with
respect to funds, procurement, utilisation etc.,
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Financial Plan is a statement estimating the amount of capital
required, estimation of ____________ mix.
a) Decision b) Planning
c) Finance d) policy
2. Financial planning begins with ____________ financial plans that in
turn guide in the formulation of operating plans and budgets
a) Long-term or strategic b) Short-term or dynamic
c) Medium-term or Strategic d) all of the above
3. Planning and controlling are the _______ of management.
a) requisites b) sources
c) factors d) policies

4. Flexibility is the main ______ of sound financial plan.

a) Objective b) Process

17
c) stages d) method
5. There are ______ types of financial plan.
a) five b) two

c) three d) four
GLOSSARY

Planning : the process of making plans for something.

Strategy : a plan of action designed to achieve a long-

term or overall aim.

Policy : a course or principle of action adopted or

proposed by an organisation or individual.

Forecast : financial projections performed to facilitate

any decision-making relevant for determining
future business performance.

Investment Decision : A prospective investment to be made by any

business unit must be evaluated in terms of
risk involved, cost of capital involved and
expected benefits from it.

SUGGESTED READINGS

1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of

Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.

18
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.

WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

19
Unit 4

SOURCES AND FORMS OF FINANCE

STRUCTURE
Overview
Learning Objectives
4.1 Introduction
4.2 Types of Finance
4.3 Sources of Finance
4.3.1 Based on the Period
4.3.2 Based on Ownership
4.3.3 Based on Sources of Generation
4.3.4. Based in Mode of Finance
4.3.5 Security Finance
4.3.6 Types of Security Finance
4.3.7 Internal Finance
4.3.8 Loan Financing
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
This unit provides an overview of the various sources from where funds
can be procured for starting as also for running a business. It also
discusses the advantages and limitations of various sources and points
out the factors that determine the choice of a suitable source of business
finance. It is important for any person who wants to start a business to
know about the different sources from where money can be raised. It is
also important to know the relative merits and demerits of different
sources so that choice of an appropriate source can be made.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• explain the types of finance
• describe the sources of finance
• difference between internal and external funds

20
 • differentiate between long term and short-term finance.
4.1 INTRODUCTION
Finance is the lifeblood of business concern, because it is interlinked
with all activities performed by the business concern. In a human body, if
blood circulation is not proper, body function will stop. Similarly, if the
finance not being properly arranged, the business system will stop.
Arrangement of the required finance to each department of business
concern is highly a complex one and it needs careful decision. Quantum
of finance may be depending upon the nature and situation of the
business concern. But, the requirement of the finance may be broadly
classified into two parts.

4.2 TYPES OF FINANCE

i) Long-term Financial Requirements or Fixed Capital Requirement
Financial requirement of the business differs from firm to firm and the
nature of the requirements on the basis of terms or period of financial
requirement, it may be long term and short-term financial requirements.
Long-term financial requirement means the finance needed to acquire
land and building for business concern, purchase of plant and machinery
and other fixed expenditure. Long- term financial requirement is also
called as fixed capital requirements. Fixed capital is the capital, which is
used to purchase the fixed assets of the firms such as land and building,
furniture and fittings, plant and machinery, etc. Hence, it is also called a
capital expenditure.

ii) Short-term Financial Requirements or Working Capital

Requirement
Apart from the capital expenditure of the firms, the firms should need
certain expenditure like procurement of raw materials, payment of
wages, day-to-day expenditures, etc. This kind of expenditure is to meet
with the help of short-term financial requirements which will meet the
operational expenditure of the firms. Short-term financial requirements
are popularly known as working capital.
4.3 SOURCES OF FINANCE
Sources of finance mean the ways for mobilizing various terms of
finance to the industrial concern. Sources of finance state that, how the
companies are mobilizing finance for their requirements. The companies
belong to the existing or the new which need sum amount of finance to
meet the long-term and short-term requirements such as purchasing of

21
fixed assets, construction of office building, purchase of raw materials
and day-to-day expenses.
Sources of finance may be classified under various categories
according to the following important heads:
4.3.1 Based on the Period
Sources of Finance may be classified under various categories
based on the period. Long-term sources: Finance may be mobilized by
long-term or short-term. When the finance mobilized with large amount
and the repayable over the period will

be more than five years, it may be considered as long-term sources.

Share capital, issue of debenture, long-term loans from financial
institutions and commercial banks come under this kind of source of
finance. Long-term source of finance needs to meet the capital
expenditure of the firms such as purchase of fixed assets, land and
buildings, etc.
Long-term sources of finance include:
• Equity Shares
• Preference Shares
• Debenture
• Long-term Loans
• Fixed Deposits

Short-term sources: Apart from the long-term source of finance, firms

can generate finance with the help of short-term sources like loans and
advances from commercial banks, moneylenders, etc. Short-term source
of finance needs to meet the operational expenditure of the business
concern.
Short-term source of finance include:
• Bank Credit
• Customer Advances
• Trade Credit
• Factoring
• Public Deposits
• Money Market Instruments
4.3.2 Based on Ownership
Sources of Finance may be classified under various categories based on
the period:

22
An ownership source of finance includes
• Shares capital, earnings
• Retained earnings
• Surplus and Profits
Borrowed capital include
• Debenture
• Bonds
• Public deposits
• Loans from Bank and Financial Institutions.

4.3.3 Based on Sources of Generation

Sources of Finance may be classified into various categories based
on the period.

Internal source of finance includes

• Retained earnings
• Depreciation funds
• Surplus
• External sources of finance may be included
• Share capital
• Debenture
• Public deposits
• Loans from Banks and financial institutions

4.3.4 Based in Mode of Finance

Security finance may be include
• Shares capital
• Debenture
• Retained earnings may include
• Loan finance may include
• Long-term loans from Financial Institutions
• Short-term loans from Commercial banks.
The above classifications are based on the nature and how the finance
is mobilized from various sources. But the above sources of finance can
be divided into three major classifications:
i) Security Finance
ii) Internal Finance
iii) Loans Finance

23
4.3.5 Security Finance
If the finance is mobilized through issue of securities such as shares and
debenture, it is called as security finance. It is also called as corporate
securities. This type of finance plays a major role in the field of deciding
the capital structure of the company.
Characters of Security Finance

Security finance consists of the following important characters:

1. Long-term sources of finance.
2. It is also called as corporate securities.

3. Security finance includes both shares and debentures.

4. It plays a major role in deciding the capital structure of the company.
5. Repayment of finance is very limited.

6. It is a major part of the company’s total capitalization.

4.3.6 Types of Security Finance
Security finance may be divided into two major types:

1. Ownership securities or capital stock.

2. Creditorship securities or debt capital.
Ownership Securities

The ownership securities also called as capital stock, is commonly called

as shares. Shares are the most Universal method of raising finance for
the business concern. Ownership capital consists of the following types
of securities.
I. Equity Shares
II. Preference Shares
III. No par stocks
IV. Deferred Shares
I. EQUITY SHARES
Equity Shares also known as ordinary shares, which means, other than
preference shares. Equity shareholders are the real owners of the
company. They have a control over the management of the company.
Equity shareholders are eligible to get dividend if the company earns
profit. Equity share capital cannot be redeemed during the lifetime of the
company. The liability of the equity shareholders is the value of unpaid
value of shares.

24
Features of Equity Shares
Equity shares consist of the following important features:
1. Maturity of the shares: Equity shares have permanent nature of
capital, which has no maturity period. It cannot be redeemed during the
lifetime of the company.
2. Residual claim on income: Equity shareholders have the right to get
income left after paying fixed rate of dividend to preference shareholder.
The earnings or the income available to the shareholders is equal to the
profit after tax minus preference dividend.

3. Residual claims on assets: If the company wound up, the ordinary

or equity shareholders have the right to get the claims on assets. These
rights are only available to the equity shareholders.

4. Right to control: Equity shareholders are the real owners of the

company. Hence, they have power to control the management of the
company and they have power to take any decision regarding the
business operation.
5. Voting rights: Equity shareholders have voting rights in the meeting
of the company with the help of voting right power; they can change or
remove any decision of the business concern. Equity shareholders only
have voting rights in the company meeting and also, they can nominate
proxy to participate and vote in the meeting instead of the shareholder.

6. Pre-emptive right: Equity shareholder pre-emptive rights. The pre-

emptive right is the legal right of the existing shareholders. It is attested
by the company in the first opportunity to purchase additional equity
shares in proportion to their current holding capacity.
7. Limited liability: Equity shareholders are having only limited liability
to the value of shares they have purchased. If the shareholders are
having fully paid-up shares, they have no liability. For example: If the
shareholder purchased 100 shares with the face value of Rs. 10 each.
He paid only Rs. 900. His liability is only Rs. 100.
Total number of shares 100
Face value of shares Rs. 10
Total value of shares- 100 × 10 = 1,000
Paid up value of shares 900
Unpaid value/liability 100

25
Liability of the shareholders is only unpaid value of the share (that is Rs.
100).
Advantages of Equity Shares

Equity shares are the most common and universally used shares to
mobilize finance for the company. It consists of the following
advantages.

1. Permanent sources of finance: Equity share capital is belonging to

long-term permanent nature of sources of finance; hence, it can be used
for long-term or fixed capital requirement of the business concern.

2. Voting rights: Equity shareholders are the real owners of the

company who have voting rights. This type of advantage is available
only to the equity shareholders.

3. No fixed dividend: Equity shares do not create any obligation to pay

a fixed rate of dividend. If the company earns profit, equity shareholders
are eligible for profit, they are eligible to get dividend otherwise, and they
cannot claim any dividend from the company.
4. Less cost of capital: Cost of capital is the major factor, which affects
the value of the company. If the company wants to increase the value of
the company, they have to use more share capital because, it consists
of less cost of capital (Ke) while compared to other sources of finance.
5. Retained earnings: When the company have more share capital, it
will be suitable for retained earnings which is the less cost sources of
finance while compared to other sources of finance.
Disadvantages of Equity Shares
1. Irredeemable: Equity shares cannot be redeemed during the lifetime
of the business concern. It is the most dangerous thing of over
capitalization.
2. Obstacles in management: Equity shareholder can put obstacles in
management by manipulation and organizing themselves. Because, they
have power to contrast any decision which are against the wealth of the
shareholders.
3. Leads to speculation: Equity shares dealings in share market led to
secularism during prosperous periods.
4. Limited income to investor: The Investors who desire to invest in
safe securities with a fixed income have no attraction for equity shares.
5. No trading on equity: When the company raises capital only with the
help of equity, the company cannot take the advantage of trading on

26
equity.
II. PREFERENCE SHARES
The parts of corporate securities are called as preference shares. It is
the shares, which have preferential right to get dividend and get back the
initial investment at the time of winding up of the company. Preference
shareholders are eligible to get fixed rate of dividend and they do not
have voting rights.
Preference shares may be classified into the following major types:
1. Cumulative preference shares: Cumulative preference shares have
right to claim dividends for those years which have no profits. If the
company is unable to earn profit in any one or more years, C.P. Shares
are unable to get any dividend but they have right to get the comparative
dividend for the previous years if the company earned profit.
2. Non-cumulative preference shares: non-cumulative preference
shares have no right to enjoy the above benefits. They are eligible to get
only dividend if the company earns profit during the years. Otherwise,
they cannot claim any dividend
3. Redeemable preference shares: When, the preference shares have
a fixed maturity period it becomes redeemable preference shares. It can
be redeemable during the lifetime of the company. The Company Act
has provided certain restrictions on the return of the redeemable
preference shares.
4. Irredeemable Preference Shares: Irredeemable preference shares
can be redeemed only when the company goes for liquidator. There is
no fixed maturity period for such kind of preference shares.
[Link] Preference Shares: Participating preference shares
holders have right to participate extra profits after distributing the equity
shareholders.
[Link]-Participating Preference Shares: Non-participating preference
shares holders are not having any right to participate extra profits after
distributing to the equity shareholders. Fixed rate of dividend is payable
to the type of shareholders.
7. Convertible Preference Shares: Convertible preference shares
holders have right to convert their holding into equity shares after a
specific period. The articles of association must authorize the right of
conversion.

27
8. Non-convertible Preference Shares: There shares, cannot be
converted into equity shares from preference shares.
Features of Preference Shares

The following are the important features of the preference shares:

1. Maturity period: Normally preference shares have no fixed maturity
period except in the case of redeemable preference shares. Preference
shares can be redeemable only at the time of the company liquidation.
2. Residual claims on income: Preferential shares holders have a
residual claim on income. Fixed rate of dividend is payable to the
preference shareholders.
3. Residual claims on assets: The first preference is given to the
preference shareholders at the time of liquidation. If any extra Assets are
available that should be distributed to equity shareholder.
4. Control of Management: Preference shareholder does not have any
voting rights. Hence, they cannot have control over the management of
the company.
Advantages of Preference Shares
Preference shares have the following important advantages

1. Fixed dividend: The dividend rate is fixed in the case of preference

shares. It is called as fixed income security because it provides a
constant rate of income to the investors.

2. Cumulative dividends: Preference shares have another advantage

which is called cumulative dividends. If the company does not earn any
profit in any previous years, it can be cumulative with future period
dividend.
3. Redemption: Preference Shares can be redeemable after a specific
period except in the case of irredeemable preference shares. There is a
fixed maturity period for repayment of the initial investment.
4. Participation: Participative preference shares holders can participate
in the surplus profit after distribution to the equity shareholders.
5. Convertibility: Convertibility preference shares can be converted into
equity shares when the articles of association provide such conversion.
Disadvantages of Preference Shares

1. Expensive sources of finance: Preference shares have high

expensive source of finance while compared to equity shares.

28
2. No voting right: Generally, preference shares holders do not have
any voting rights. Hence, they cannot have the control over the
management of the company.

3. Fixed dividend only: Preference shares can get only fixed rate of
dividend. They may not enjoy more profits of the company.
4. Permanent burden: Cumulative preference shares become a
permanent burden so far as the payment of dividend is concerned.
Because the company must pay the dividend for the unprofitable periods
also.

5. Taxation: In the taxation point of view, preference shares dividend is

not a deductible expense while calculating tax. But interest is a
deductible expense. Hence, it has disadvantage on the tax deduction
point of view.
III. NO PAR SHARES
When the shares are having no face value, it is said to be no par shares.
The company issues this kind of shares which is divided into a number
of specific shares without any specific denomination. The value of
shares can be measured by dividing the real net worth of the company
with the total number of shares.
IV. DEFERRED SHARES
Deferred shares also called as founder shares because these shares
were normally issued to founders. The shareholders have a preferential
right to get dividend before the preference shares and equity shares.
According to Companies Act 1956 no public limited company or which is
a subsidiary of a public company can issue deferred shares.
These shares were issued to the founder at small denomination to
control over the management by the virtue of their voting rights.
Creditorship Securities
Creditorship Securities also known as debt finance which means the
finance is mobilized from the creditors. Debenture and Bonds are the
two major parts of the Creditorship Securities.
Debentures
A Debenture is a document issued by the company. It is a certificate
issued by the company under its seal acknowledging a debt.
According to the Companies Act 1956, “debenture includes debenture
stock, bonds and any other securities of a company whether constituting
a charge of the assets of the company or not.”

29
Types of Debentures
Debentures may be divided into the following major types:
1. Unsecured debentures: Unsecured debentures are not given any
security on assets of the company. It is also called simple or naked
debentures. This type of debentures is treading as unsecured creditors
at the time of winding up of the company.

2. Secured debentures: Secured debentures are given security on

assets of the company. It is also called as mortgaged debentures
because these debentures are given against any mortgage of the assets
of the company.
3. Redeemable debentures: These debentures are to be redeemed on
the expiry of a certain period. The interest is paid periodically and the
initial investment is returned after the fixed maturity period.
4. Irredeemable debentures: These kinds of debentures cannot be
redeemable during the life time of the business concern.
5. Convertible debentures: Convertible debentures are the debentures
whose holders have the option to get them converted wholly or partly
into shares. These debentures are usually converted into equity shares.
Conversion of the debentures may be:
6. Other types: Debentures can also be classified into the following
types. Some of the common types of the debentures are as follows:

• Collateral Debenture
• Guaranteed Debenture
• First Debenture
• Zero Coupon Bond
• Zero Interest Bond/Debenture
Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity
period. Normally, debentures consist of 10–20 years maturity period and
are repayable with the principle investment at the end of the maturity
period.
2. Residual claims in income: Debenture holders are eligible to get
fixed rate of interest at every end of the accounting period. Debenture
holders have priority of claim in income of the company over equity and
preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims
on Assets of the company over equity and preference shareholders. The

30
Debenture holders may have either specific change on the Assets or
floating change of the assets of the company. Specific change of
Debenture holders is treated as secured creditors and floating change of
Debenture holders are treated as unsecured creditors.
4. No voting rights: Debenture holders are considered as creditors of
the company. Hence, they have no voting rights. Debenture holders
cannot have the control over the performance of the business concern.
5. Fixed rate of interest: Debentures yield fixed rate of interest till the
maturity period. Hence the business will not affect the yield of the
debenture.
Advantages of Debenture
Debenture is one of the major parts of the long-term sources of
finance which of consists the following important advantages:
1. Long-term sources: Debenture is one of the long-term sources of
finance to the company. Normally the maturity period is longer than the
other sources of finance.
2. Fixed rate of interest: Fixed rate of interest is payable to debenture
holders; hence it is most suitable of the companies earn higher profit.
Generally, the rate of interest is lower than the other sources of long-
term finance.
3. Trade on equity: A company can trade on equity by mixing
debentures in its capital structure and thereby increase its earning per
share. When the company apply the trade on equity concept, cost of
capital will reduce and value of the company will increase.
4. Income tax deduction: Interest payable to debentures can be
deducted from the total profit of the company. So it helps to reduce the
tax burden of the company.
5. Protection: Various provisions of the debenture trust deed and the
guidelines issued by the SEB1 protect the interest of debenture holders.
Disadvantages of Debenture
Debenture finance consists of the following major disadvantages:
1. Fixed rate of interest: Debenture consists of fixed rate of interest
payable to securities. Even though the company is unable to earn profit,
they have to pay the fixed rate of interest to debenture holders, hence, it
is not suitable to those company earnings which fluctuate considerably.
2. No voting rights: Debenture holders do not have any voting rights.
Hence, they cannot have the control over the management of the

31
company.
3. Creditors of the company: Debenture holders are merely creditors
and not the owners of the company. They do not have any claim in the
surplus profits of the company.
4. High risk: Every additional issue of debentures becomes more risky
and costly on account of higher expectation of debenture holders. This
enhanced financial risk increases the cost of equity capital and the cost
of raising finance through debentures which is also high because of high
stamp duty.

5. Restrictions of further issues: The company cannot raise further

finance through debentures as the debentures are under the part of
security of the assets already mortgaged to debenture holders.

4.3.7 Internal Finance

A company can mobilize finance through external and internal sources.
A new company may not raise internal sources of finance and they can
raise finance only external sources such as shares, debentures and
loans but an existing company can raise both internal and external
sources of finance for their financial requirements. Internal finance is
also one of the important sources of finance and it consists of cost of
capital while compared to other sources of finance.
Internal source of finance may be broadly classified into two
categories:
I. Depreciation Funds
II. Retained earnings
I. Depreciation Funds
Depreciation funds are the major part of internal sources of finance,
which is used to meet the working capital requirements of the business
concern. Depreciation means decrease in the value of asset due to wear
and tear, lapse of time, obsolescence, exhaustion and accident.
Generally, depreciation is changed against fixed assets of the company
at fixed rate for every year. The purpose of depreciation is replacement
of the assets after the expired period. It is one kind of provision of fund,
which is needed to reduce the tax burden and overall profitability of the
company.
II. Retained Earnings
Retained earnings are another method of internal sources of finance.
Actually, is not a method of raising finance, but it is called as

32
accumulation of profits by a company for its expansion and
diversification activities.
Retained earnings are called under different names such as; self-
finance, inter finance, and plugging back of profits. According to the
Companies Act 1956 certain percentage, as prescribed by the central
government (not exceeding 10%) of the net profits after tax of a financial
year have to be compulsorily transferred to reserve by a company before
declaring dividends for the year.
Under the retained earnings sources of finance, a part of the total profits
is transferred to various reserves such as general reserve, replacement
fund, reserve for repairs and renewals, reserve funds and secrete
reserves, etc.

Advantages of Retained Earnings

Retained earnings consist of the following important advantages:
1. Useful for expansion and diversification: Retained earnings are
most useful to expansion and diversification of the business activities.
2. Economical sources of finance: Retained earnings are one of the
least costly sources of finance since it does not involve any floatation
cost as in the case of raising of funds by issuing different types of
securities.
3. No fixed obligation: If the companies use equity finance, they have
to pay dividend and if the companies use debt finance, they have to pay
interest. But if the company uses retained earnings as sources of
finance, they need not pay any fixed obligation regarding the payment of
dividend or interest.
4. Flexible sources: Retained earnings allow the financial structure to
remain completely flexible. The company need not raise loans for further
requirements, if it has retained earnings.
5. Increase the share value: When the company uses the retained
earnings as the sources of finance for their financial requirements, the
cost of capital is very cheaper than the other sources of finance; Hence
the value of the share will increase.
6. Avoid excessive tax: Retained earnings provide opportunities for
evasion of excessive tax in a company when it has small number of
shareholders.
7. Increase earning capacity: Retained earnings consist of least cost of
capital and also it is most suitable to those companies which go for

33
diversification and expansion.
Disadvantages of Retained Earnings
Retained earnings also have certain disadvantages:

1. Misuses: The management by manipulating the value of the shares

in the stock market can misuse the retained earnings.
2. Leads to monopolies: Excessive use of retained earnings leads to
monopolistic attitude of the company.
3. Over capitalization: Retained earnings lead to over capitalization,
because if the company uses more and more retained earnings, it leads
to insufficient source of finance.
4. Tax evasion: Retained earnings lead to tax evasion. Since, the
company reduces tax burden through the retained earnings.

5. Dissatisfaction: If the company uses retained earnings as sources of

finance, the shareholder can’t get more dividends. So, the shareholder
does not like to use the retained earnings as source of finance in all
situations.
4.3.8 Loan Financing
Loan financing is the important mode of finance raised by the
company. Loan finance may be divided into two types:
I. Long-Term Sources
II. Short-Term Sources

Loan finance can be raised through the following important

institutions.

Figure 4.1 Loan Financing Institutions

34
Loan Financing
With the effect of the industrial revaluation, the government established
nationwide and state wise financial industries to provide long-term
financial assistance to industrial concerns in the country. Financial
institutions play a key role in the field of industrial development and they
are meeting the financial requirements of the business concern. IFCI,
ICICI, IDBI, SFC, EXIM Bank, ECGC are the famous financial
institutions in the country.
Commercial Banks

Commercial Banks normally provide short-term finance which is

repayable within a year. The major finance of commercial banks is as
follows:

Short-term advance: Commercial banks provide advance to their

customers with or without securities. It is one of the most common and
widely used short-term sources of finance, which are needed to meet the
working capital requirement of the company.
It is a cheap source of finance, which is in the form of pledge, mortgage,
hypothecation and bills discounted and rediscounted.

Short-term Loans
Commercial banks also provide loans to the business concern to meet
the short-term financial requirements. When a bank makes an advance
in lump sum against some security it is termed as loan. Loan may be in
the following form:
a. Cash credit: A cash credit is an arrangement by which a bank allows
his customer to borrow money up to certain limit against the security of
the commodity.
b. Overdraft: Overdraft is an arrangement with a bank by which a
current account holder is allowed to withdraw more than the balance to
his credit up to a certain limit without any securities.
Development Banks
Development banks were established mainly for the purpose of
promotion and development the industrial sector in the country.
Presently, large number of development banks are functioning with
multidimensional activities. Development banks are also called as
financial institutions or statutory financial institutions or statutory non-
banking institutions. Development banks provide two important types of
finance:

35
(a) Direct Finance
(b) Indirect Finance/Refinance
Presently the commercial banks are providing all kinds of financial
services including development-banking services. And also, nowadays
development banks and specialized financial institutions are providing all
kinds of financial services including commercial banking services.
Diversified and global financial services are unavoidable to the present-
day economics. Hence, we can classify the financial institutions only by
the structure and set up and not by the services provided by them.

LET US SUM UP
In the Process of managing the finance, the first step involved is to
source the funds based on various feasibility. The funds are of different
types namely short term and long term, Internal and external funds. It
can also be classified on various basis.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. Equity shares are known as ____________.
a) Debt securities b) Ownership securities

c) Both d) None of the above

2. ____________ market provide finance for short term purpose
a) Money market b) Capital Market

c) Derivative Market d) Share market

3. Arrear dividend is paid to the Preference share otherwise known as
____________.

a) Participate Preference Share

b) Cumulative Preference shares
c) Non-Cumulative Preference Shares
d) None of these
4. Bank loan with security is ____________.
a) Short term loan b) Long term loan
c) Temporary Loan d) Overdraft facility
5. Debentures are a form of _______
a) Short term loan b) Long term loan

36
c) Temporary Loan d) Internal short-term loan
GLOSSARY

Funds : A sum of money saved or made available for a

particular purpose.

Sources : Something which is obtained from a place or a thing.

Policy : A principle of action adopted.

Loans : A Sum of money borrowed.

Credit : Obtaining something on later payment terms.

SUGGESTED READINGS

1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of

Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
studies/financial-performance/sources-of-finance/
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

37
 BLOCK 2

TIME VALUE OF MONEY

Unit 5 : Time Value of Money

Unit 6 : Capitalisation
Unit 7 : Introduction to Cost of Capital
Unit 8 : Cost of Capital and Debt

38
Unit 5

TIME VALUE OF MONEY

STRUCTURE
Overview
Learning Objectives
5.1 Introduction - Time Value of Money
5.2 Rationale of time preference of Money
5.3 Importance of Time Value of Money
5.4 Time Value of Money – Significance in Financial Decision
Making
5.5 Reasons for time preference of money
5.6 Techniques for estimating time value of moneyLet Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
One of the limitations of Profit maximisation is ignoring time value of
money. At the same time, it does not consider the magnitude and timing
of earnings. There is no difference between the earnings that occur in
different year. To overcome the limitations of profit maximisation, firms
consider the objective of wealth maximisation. Most of the financial
decisions such as investment decision, financing decision and dividend
decision involve cash flows (inflow and outflow) occurring in different
time periods. Firm can maximise the wealth only when it is able to
recognize the time value of money and risk. Hence there is a need to
understand the tools of compounding and discounting, which require in
most of the financial decisions.
LEARNING OBJECTIVES

After learning this unit, you will be able to;

• define Financial Management
• understand the goals of finance

• explain the difference between Profit and wealth Maximisation.

39
5.1 INTRODUCTION - TIME VALUE OF MONEY
A rupee which is received today, is more valuable than a rupee
receivable in future. One of the limitations of Profit maximisation is, it
does not consider the time value and importance of early profits. The
amount that is received earlier period can be reinvested and it can earn
an additional amount. For example, a rupee received today can be
reinvested and it can earn some interest., but the rupee receivable in
future cannot be reinvested. Hence, people to receive the rupee that is
receivable at the earliest.

Time value of money is defined as “the value derived from the use of
money over time as a result of investment and reinvestment”. Time
value of money means that “worth of a rupee received today is different
from the worth of rupee to be received in future”. The preference for
money now, as compared to future money is known as time preference
of money.
The whole set of financial decisions (whether financing decision or
investment decision) hinges on the fact that the value of one rupee today
is not equal to the value of one rupee at the end of one year or at the
end of second year. In other words, we cannot assume that the value of
rupee. remains the same. This is known as ‘Time Value of Money’.
5.2 RATIONALE OF TIME PREFERENCE OF MONEY

Time value of money is defined as “the value derived from the use of
money over time as a result of investment and reinvestment”. Time
value of money means that “worth of a rupee received today is different
from the worth of rupee to be received in future”. The preference for
money now, as compared to future money is known as time preference
of money.

The whole set of financial decisions (whether financing decision or

investment decision) hinges on the fact that the value of one rupee today
is not equal to the value of one rupee at the end of one year or at the
end of second year. In other words, we cannot assume that the value of
rupee remains the same. This is known as ‘Time Value of Money’.
5.3 IMPORTANCE OF TIME VALUE OF MONEY
In the financial decisions, the time value of money holds great
importance. It is now the most significant principle in finance and
economics. There are certain valid reasons for this state of affairs.

i) Inflation: Because of inflationary conditions, the rupee today has a

higher purchasing power than rupee in future. As a result, those who

40
have to receive the money prefer to receive the same as early as
possible, while those who have to pay the money try to delay the
payment.

ii) Uncertainty: Since the future is characterized by uncertainty,

individuals/business concerns prefer to have current income rather than
having the same payment at a later date. They have an apprehension
that the party making the payment may default due to insolvency or
other reasons.
iii) Preference for Present Consumption: Both due to uncertainty and
inflationary conditions, individuals prefer the consumption to future
consumption. They do not wish to save for the future by curtailing
current consumption.

iv) Opportunities for reinvestment: Money can be employed to

generate real returns. Individual’s business concerns reinvest the money
at a certain rate so as to have some yield on it. As such a financial
manager of any business concern cannot ignore the concept of time
value of money while making any financial decisions, otherwise his
decisions will be invalid and incorrect also.

5.4 TIME VALUE OF MONEY – SIGNIFICANCE IN FINANCIAL

DECISION MAKING
The recognition of the time value of money is extremely significant in
financial decision making because, most of financial decisions such as
the acquisition of assets or procurement of funds, affect firm’s cash flows
in different time periods, for example, if a fixed asset is purchased, it will
require an immediate cash outlay and will affect cash flows during many
future periods.
Similarly, if the firm borrows funds from a bank or from any other
sources, it receives cash now and commits an obligation to pay interest
and return principal sum in future. While taking decisions on these
matters, the financial management must keep the time factor in
mind.
If the timing of cash flows is not considered, the firm may make
decisions which may falter its objective of maximising the owner’s
welfare.
5.5 REASONS FOR TIME PREFERENCE OF MONEY
i) Availability of better investment opportunities.

ii) Due to Risk and uncertainty of Cash flows.

41
 iii) Due to Inflationary Conditions.
iv) Preference for Present Consumption of goods, commodities and
services.

v) Due to Urgency or Emergency.

i) Availability of Better Investment Opportunities:
There are investment opportunities, where people can invest their cash
and earn some interest or return through lending or investment. A rupee
invested today is more valuable than a rupee invested tomorrow, so they
prefer to receive money today than to receive the same tomorrow

ii) Due to Risk and Uncertainty of Cash Flows:

Future is uncertain with plenty of risks. In this environment cash outflows
(i.e., investment made at ‘0’ period) are in investors control but the cash
inflows (i.e., incomes earned from investments) return on investment
and recovery of investments are not in investor’s control. The receipt
from outsiders is uncertain. Hence, the investors prefer to receive
cash now rather than receiving the same in future.
iii) Due to Inflationary Conditions:
In the inflationary condition the purchasing power of money is
decreasing. In this condition a rupee today has more purchasing power
than a rupee tomorrow. So, people prefer to receive cash now rather
than tomorrow.

iv) Preference for Present Consumption:

It is human tendency to prefer present consumption of goods,
commodities and services; than to postpone their consumption to future
periods. Hence people prefer to possess cash for current consumption,
rather to postpone or cancel.
v) Due to Urgency / Emergency:
People prefer to receive cash today than in some future date, to meet
some urgent needs or to meet emergency requirements. So as to
maximize the firm’s value, it must choose the best combination of
decisions in respect of investment, financing and dividends. These
decisions have return-risk complexions which, in turn, affect the value of
the firm. More specifically, the question of valuation arises in a large
number of situations.
Thus, the principle of valuation is closer to determining when the
management is contemplating whether to acquire an enterprise or
merger issue is under consideration, it needs to employ relevant

42
concepts and techniques of valuation to assess new investment
opportunities and to determine the value of an entire firm involved in a
merger. Likewise, feasibility of a re organisation plan can be studied by
determining the value of the enterprise.
A finance manager plaguing the problem of recapitalization makes
extensive use of principles of valuation. In the same vein, principles of
valuation are useful to the management who is interested to know the
realisable value of the enterprise being terminated either due to
bankruptcy or voluntary liquidation. In analysing utility of leases, a
finance manager employs very frequently the principles of valuation.
In addition, a firm considering a public offering of its own stock to raise
equity capital is faced with the need to establish a price for the issue.
The question of value to be placed on a going business either as a
whole or on a fraction thereof also comes upon in the purchase, sale,
taxation and pledge of existing securities.
Thus, concepts and principles of valuation constitute vital cornerstones
of financial management, thorough understanding of which is imperative
for reaching prudent decision making.

Three major aspects of valuation that pervade financial decision areas

are time value of time, valuation of long-term securities and risk and
return.

5.6 TECHNIQUES FOR ESTIMATING TIME VALUE OF MONEY

1. Discounting Technique or the Present Value Method
2. Compounding Technique or the Future Value Method
1. Discounting or Present Value Method:
The current value of an expected amount of money to be received at a
future date is known as Present Value. If we expect a certain sum of
money after some years at a specific interest rate, then by discounting
the Future Value we can calculate the amount to be invested today, i.e.,
the current or Present Value.
Hence, Discounting Technique is the method that converts Future Value
into Present Value. The amount calculated by Discounting Technique is
the Present Value and the rate of interest is the discount rate.
2. Compounding or Future Value Method:
Compounding is just the opposite of discounting. The process of
converting Present Value into Future Value is known as compounding.

43
Future Value of a sum of money is the expected value of that sum of
money invested after n number of years at a specific compound rate of
interest.

LET US SUM UP
Time value of money is the most important component to be considered
in wealth maximisation. There for any future decisions to be taken time
value of money interns of present and future value of money is to be
determined. The unit focuses on the importance of such values.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. Time value of money indicates that __________.
a) A unit of money obtained today is worth more than a unit of money
obtained future
b) A unit of money obtained today is worth more less than a unit of
money obtained future
c) There is no difference in the value of money obtained today and future
d) None of the above
2. Time value of money supports the comparison of cash flows recorded
at different time periods by __________.
a) Discounting all cash flows to a common point of time
b) Compounding all cash flows to a common point of time
c) Using either (a) or (b)
d) None of the above
3. In time value of money, nominal rate is __________.
a) Not shown on timeline b) Shown on timeline
c) Multiplied on timeline d) Divided on timeline
4. In calculation of time value of money, PMT represents
a) Present money tracking b) Payment
c) Payment money tracking d) Future money payment
5. Discounted cash flow analysis is also classified as

a) Time value of stock b) Time value of money

c) Time value of bonds d) Time value of treasury bonds

44
GLOSSARY

Time Value : An amount an investor is willing to pay for an

option above its intrinsic Value

Money : A medium of exchange.

Discounting : A process of converting a value received in a

future time period to an Equivalent value
received immediately.

Decisions : A choice or a judgement after thinking

various possibilities.

Uncertainty : The future is characterized by uncertainty,

individuals/business concerns prefer to have
current income rather than having the same
payment at a later date.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

45
Unit 6

CAPITALISATION
STRUCTURE

Overview
Learning Objectives
6.1 Meaning of Capitalisation

6.2 Bases of Capitalisation

6.3 Over Capitalisation - Causes and Remedies
6.4 Under Capitalisation - Causes and Remedies
Let Us Sum Up
Check Your Progress
Glossary

Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Capitalisation is an important constituent of financial plan. ln common
parlance, the phrase ‘Capitalisation’ refers to total amount of capital
employed in a business. However, scholars are not unanimous in so far
as capitalisation is concerned. The term capitalisation connotes the
process of determining the quantum of funds that a firm would require to
run its business.
LEARNING OBJECTIVES
After learning this unit, you will be able to;

• explain the meaning of capitalisation

• explain the bases of Capitalisation
• differentiate over and under Capitalisation.

6.1 MEANING OF CAPITALISATION

The term capital refers to the total investment of a company in money,
tangible assets like goodwill. It is in a way the total wealth of a company.
When used in the sense of net capital, it indicates the excess of total
assets over liabilities. Here, then, it includes “the gains or profits from the

46
use and investment of the capital that has not been distributed to the
stockholders” and excludes losses that have resulted from the use of
capital. Capitalisation, on the other hand, refers only to the par value
(i.e., face value indicated on the security itself) of the long-term
securities (shares and debentures) plus by any reserves which are
meant to be used for meting long-term and permanent needs of a
company. Thus, capital includes all the loans and reserves of the
concern but Capitalisation includes only long-term loans and retained
profits besides the capital.

6.2 BASES OF CAPITALISATION

The bases for Capitalisation are;
1. Cost Theory of Capitalisation
According to this theory capitalisation of a firm is regarded as the sun of
cost actually incurred in setting of the business. A film needs funds to
acquire fixed assets, to defray promotional and organizational expenses
and to meet current asset requirements of the enterprise sum of the
costs of the above asset gives the amount of capitalisation of the firm,
acquiring fixed assets and to provide with necessary working capital and
to cover possible initial losses, it will capitalised under this method more
emphasis is laid on current investments. They are static in nature and do
not have any direct relationship with the future earning capacity. This
approach givens as the value of capital only at a particular point of time
which would not reflect the future changes.
2. Earning Theory of Capitalisation
According to this theory, firm should be capitalised on the basis of its
expected earning A firm is profit is seeking entity and hence its value is
determiner according to What it earns. The probable earning is forecast
and them they are capitalised at a normal representative rate of return.
Capitalisation of a company as per the earning theory can thus be
determined with help following formula.
Capitalisation = Annual Net Earnings X Capitalisation Rate
Thus, for the purpose of determining amount of Capitalisation in an
enterprise the financial manager has to fist estimate of annual net
earnings of the enterprise where after he will have to determine the
capitalisation rate. The future earning cannot be forecast exactly and
depend to a large extent on such external factors which are beyond
control management.

(i) Estimating Annual Earnings: In capitalisation of earning only future

annual net earnings is used. The task of estimating future returns is
difficult one. In the case of an existing concern, future earning can be
based on the past earnings since the latter givens a partial evidence of

47
what future earnings will be in computing these historical figures care
is taken to remove non-recurring gains such as gain realized on the sale
of building. Usually only the earnings attributable to operations of the
enterprise are included to the future that is to be capitalised. Also,
income tax is deducted from the earnings figures. The earning figures is
further adjusted for any other factors that would make the adjusted
amount more representative of the expected future earnings. The long
run prospects of the company should also be taken into consideration.
These estimates are then compared with the actual figures of firms
engaged in the same business. Allowance of course, must be made for
differences in size, age, location, managerial experience, growth rate
and the like factors in such comparison. The earnings so estimated are
used for capitalisation purpose.
(ii) Determining Capitalisation Rate: Capitalisation rate is investor’s
expected rate of return. More specifically capitalisation rate is same as
to cost of capital. Capitalisation rate can at best be determined by
studying the rate of earnings of the similarly situated companies in the
same industry and the rate at which market is capitalising the earnings.
Such a study involves as analysis of the return on stocks and bonds.
Thus, capitalisation rate must reflect return on the invested capital that
would adequately compensate the investors for the use of his funds and
the risk undertakes. In actual practice, average price earnings ratio of
companies engaged in a particular industrial activity is taken as
capitalisation rate of the company. In actual practice business
enterprises rely on different sources of financing for their capital needs
and share capital constitutes only a part of the total funds. Under
such a situation capitalisation rate arrived at on the basis of price
earnings ratio will not be a representative one.
6.3 OVER CAPITALISATION - CAUSES AND REMEDIES
According to Beacham, over capitalization refers to “when securities in
the company are issued in excess of its capitalized earning power”.
“According to Bonneville, Dewey and Kelly, over capitalization means,
“when a business is unable to earn a fair rate on its outstanding
securities”.
In the words of Hoagland, “whenever the aggregate of the par values of
stocks and bonds outstanding exceed the true value of fixed assets of
the corporation, it is said to be over capitalized”.
It is quite clear that when any business concern continuously fails to
earn as much. Income on the capital employed as not sufficient to give
dividend at a reasonable rate to its shareholders, this is constantly a

48
case of over capitalisation. According to Bonneville, Dewey and Kelly,
“When a business is unable to earn a fair rate of return on its
outstanding securities, it is over capitalised.”
In this connection, Gerstenberg opines that a “corporation is over-
capitalised when its earnings are not large enough to yield a fair return
on the number of stocks and bonds that have been issued.” Hogland has
to say on this point “Whenever the aggregate of par values of stocks or
bonds outstanding exceeded the true value of fixed assets, the
corporation was said to be over-capitalised.”
It must be clear that a company is said to be over-capitalised only when
it has not been able to earn fair income over a long period of time. In
such a situation, the real values of a company’s total assets would be
less than their book values. As a result, market value of equity shares
declines.

Causes For Over Capitalisation

1. Excess Issue of Capital: Many times, the company issues more
capital than actually required. The excess capital may lead to over-
capitalisation. The excess issue of capital cannot be profitably employed
in the business. So, it is unnecessary burden on the business.
2. Borrowed Capital: When a company borrows a large amount of
money which is having a higher rate of interest then its rate of earnings
will be treated as over-capitalisation. The company has to pay a large
part of their earnings by way of interest and there is no more scope to
pay the higher dividends to shareholders.
3. Purchase of Properties of Inflated Price: Many times, the company
purchases the assets which are created at the time of incorporation. In
such situations, there is a possibility of charging inflated prices rather
than real value of assets.
4. Heavy Capital Expenditure: If the heavy expenses are incurred at
the promoting stage, it may lead to over- capitalisation. The company
might have spent huge amounts during its formation stage or might have
spent huge amounts for the purchase of intangible assets like goodwill,
patents, trademarks, etc. As a result, the earning capacity of the
company may be adversely affected.
5. Inadequate Provision for Depreciation: Because of inadequate
provision for depreciation, replacement or obsolescence of assets may
lead to over-capitalisation. Inadequate provision causes inefficiency
which results in its reduced earning capacity.

49
6. Liberal Dividend Policy: Many times, a company declares higher
rate of dividends to attract the shareholders. For doing so, the company
manipulates the accounts so that in the long run, the real value of the
shares comes down.
7. Tax Saving Policy: In order to avoid heavy tax liability, many
companies manipulate their accounts in such a way that there will be
less income for dividend distribution. Ultimately, it adversely effects on
company's operating efficiency and company suffers from over-
capitalisation.

8. Absence of Adequate Reserves: Many times, entire profit is

distributed in the form of dividend and do not make adequate provisions
for reserves. It discloses excessive profit which is treated as over-
capitalisation.
9. Wrong Capitalisation Rate: According to the theory of capitalisation,
the capitalisation is the amount of earnings capitalised at a
representative rate of return. As such, if capitalisation rate is wrong, the
amount of capitalisation will be wrong in such a way that lower the rate
of capitalisation, higher will be the amount of capitalisation.

Remedies of Over-Capitalisation
It is evident from the foregoing discussion that the effects of over-
capitalisation are very serious. Various remedial measures to correct the
situation caused by over-capitalisation are as under: -
1. Reduction in Funded Debt: In order to control the situation of over-
capitalisation, the company should reduce the number of funded debts
through outright re-organisation. The debentures should be immediately
redeemed out of accumulated earnings or new and bonds issues.
2. Reduction of Interest Rate on Debentures: In order to increase
earnings, an over -capitalised company should try to reduce its fixed
obligation with regard to payment of interest on debts. The company
may persuade the existing debenture holders to accept new debentures
carrying lower rates of interest. The debenture holders may be attracted
by offering some premium in this regard.
3. Redemption of Preference Shares: The amount of capitalisation
may also be reduced by redeeming the preference shares carrying high
rate of dividend. But the raising of necessary funds for redeeming the
high dividend preference shares may further aggravate the situation.

4. Reduction of Par Value of Shares: The situation of over-

capitalisation may also be corrected by persuading the existing

50
shareholders to agree to accept new shares with reduced par value.
Obviously, this would reduce the amount of capitalisation and improve
the earning capacity of the company. However, it is very difficult to
shareholders in this regard as they take it as a convince the trick to
deceive them. If the management is able to management convince the
existing shareholders that reduction in par value of share is the situation
of in their interest, then it is possible to correct over-capitalisation by
following this measure.
5. Reduction in Number of Shares: With the consent of its existing
shareholders, the company may also reduce the number of shares to
correct the situation caused by over-capitalisation. This may be done
through consolidation of shares or reverse share split. The shareholders
may be given one share of the same amount in exchange of several
shares. This will not affect the amount of capitalisation, but earnings per
share will go up. It will help the company in raising the necessary funds
for future developments. In fact, this is purely psychological approach.
6.4 UNDER CAPITALISATION - CAUSES AND REMEDIES
According to Beacham, over capitalization refers to “when securities in
the company are issued in excess of its capitalized earning power”.
“According to Bonneville, Dewey and Kelly, over capitalization means,
“when a business is unable to earn a fair rate on its outstanding
securities”.
In the words of Hoagland, “whenever the aggregate of the par values of
stocks and bonds outstanding exceed the true value of fixed assets of
the corporation, it is said to be over capitalized”.
Under-capitalisation is just the reverse of over-capitalisation but it should
never be taken to indicate deficiency or inadequacy of capital. The stage
of under-capitalisation arises when the concern starts earning at a rate
higher than current rate. In fact, it is an index of proper and effective
utilisation of capital employed in the concern.
In the words of Gestenberg, “A Corporation is under capitalised when
the rate of profits, it is making on the total capital is exceptionally high in
relation to the return enjoyed by similar companies in the same industry
or when it has too little capital with which to conduct its business.”
On the other hand, Hogland is of the opinion that under-capitalisation
means excess of assets when compared with total share capital
invested in the business. In fact, under-capitalisation is indicative of
sound financial position and good management of the company.

51
Causes of Under-Capitalisation:
There are at least five causes of under-capitalisation:
1. Accident: Under estimation of future earnings due to some future
occurrence
2. Business cycles: Unexpected increase in earnings during prosperity
in case of companies floated in recession. This means that the business
cycle movements can cause under-capitalisation.
3. Assets appreciation: Appreciation of assets seems to be the third
cause of under-capitalisation. This is attributable to conservative
dividend policy adopted by management which makes not only liberal
depreciation provision but retains a huge portion of profit (without
distributing it among shareholders) and lays stress on self-financing of
growth (i.e., ploughing back of profits).
4. Excess reserves: Build-up of excess (huge) reserves also accounts
for under capitalisation.
5. Modernisation: The adoption of latest production processes and
techniques such as rationalization, scientific management, financing
investing from past savings as also increase in profits due to productivity
rise and improvement in operational efficiency conjointly contribute to
under-capitalisation.
Remedies of Under-Capitalisation

The following remedies are available to correct the situation caused by

under- capitalisation: -
1. Splitting-up of Shares: The shares of an under-capitalised company
may be splitted into shares of small denomination. This would lead to
bring down the amount of dividend per share without affecting the total
earnings and the amount of capital of the company.
2. Issue of Bonus Shares: The most effective way to remedy under-
capitalisation is to capitalise the retained earnings of the company by
issuing bonus shares. This will increase the share capital as well as the
number of shares of the company. Consequently, the rate of dividend
per share will come down.
3. Issue of Shares and Debentures: Where a company is under-
capitalised due to inadequacy of capital, it may raise more capital by
issuing shares and debentures. This measure will increase the share
capital and number of shares of the company resulting in decline in the
rate of dividend.

52
LET US SUM UP
Capitalisation is the total investment of the Company. For managing the
funds and for smooth flow of funds, the company must plan the
proportion of investment based on the various investment avenues in the
market. An organisation can adapt a wise policy of investing in both
financial and non-financial assets based on the market conditions.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. According to this theory capitalisation of a firm is regarded as the sun
of cost actually incurred in setting of the business ____________.
a) Cost theory b) Equity theory
c) securities theory d) Earning theory
2. Splitting up of shares is one of the remedies for ____________.
a) inflation b) deflation
c) bankruptcy d) merger
3. Asset appreciation is one of the causes for ____________.
a) inflation b) depreciation
c) wealth accumulation d) interest rate reduction
4. ____________ is a part of Cost theory.
a) Investment in fixed assets b) Earning per share
c) Interest on investment d) Purchase of goods
5. Wrong Capitalization rate is one of the causes of ____________.
a) profit margin increases b) real estate growth
c) investment success d) incorrect property valuation
GLOSSARY

Finance : Money required to start or support any business.

Investment : The act of putting money in a bank, property etc.,

Profit : A financial gain.

Decision : A choice of judgement that make after thinking

about various possibilities.

Capital : An amount of money that is used to start a

business or to put in a bank.

53
SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES

1. [Link]
2. [Link]
3. [Link]

ANSWERS TO CHECK YOUR PROGRESS

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

54
Unit 7

INTRODUCTION TO COST OF CAPITAL

STRUCTURE
Overview
Learning Objectives
7.1 Introduction
7.2 Meaning of Cost of Capital
7.3 Definitions of Cost of Capital
7.4 Significance of Cost of Capital
7.5 Factors affecting Cost of Capital
7.5.1 Fundamental factors affecting Cost of Capital
7.5.2 Economic and other factors affecting Cost of Capital
7.5.3 Individual Company factors affecting Cost of Capital
7.6 Limitations of Cost of Capital
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Cost of capital can be pre-tax or post-tax cost. Debenture interest is
deducted while computing income for tax purposes. So, debentures’
post-tax cost is lower than pre-tax cost. Accordingly, overall cost of
capital also can be classified into pre-tax and post-tax overall cost of
capital. Cost of capital may be explicit or implicit cost. Explicit cost o
capital is similar to out-of-pocket cost It is an accounting cost. Implicit
cost hidden and it may not involve actual payment and hence may not
be directly accounted for. Cost of capital may be classified into past and
future costs. Post cost is irrelevant for decision making, while future cost
is relevant. For funds raised already the floatation cost is a past cost,
whereas future interest/ dividend commitments are future cost. Let us
discuss meaning and definitions of Cost of Capital, Factors affecting
Cost of Capital and Limitations of Cost of Capital.

LEARNING OBJECTIVES
After learning this unit, you will be able to;

55
 • define the Cost of Capital and understand the meaning of Cost of
Capital
• state the various factors affecting Cost of Capital
• list out the Limitations of Cost of Capital.
7.1 INTRODUCTION
The cost of capital of an investor in financial management is equal to the
return an investor can fetch from the next best alternative investment. In
simple words, it is the opportunity cost of investing the same money in a
different investment having similar risks and other characteristics. From
a financing angle, it is simply the cost paid for using the capital.
Alternatively, a percentage return on investment that convinces an
investor to invest in a particular project or company is the appropriate
cost of capital for that investor. There are several concepts of cost of
capital Cost of capital is the minimum return expected by investors in
financial investments. The minimum return expected by debenture
holders is the cost of debt, by the shareholders is the cost of equity and
so on. The firm must provide this minimum return in order to enthuse the
public to subscribe to the debentures or shares, as the case may be.
Cost of capital is the minimum return that should be earned by a
business (so as to be in a position to satisfy the providers of capital). If
16% return is expected by investors in bonds of a company, the
company must earn at least 16%on the funds mobilized through issue of
bonds. Hence minimum return expected by investors and minimum
return to be earned by a company both mean one and the same.

7.2 MEANING OF 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 fulfill 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

56
weighted average of the different costs of raising different sources of
capital.
7.3 DEFINITIONS OF COST OF CAPITAL

Ezra Solomon defines “Cost of capital is the minimum required rate of

earnings or cutoff rate of capital expenditure”.
According to Mittal and Agarwal “the cost of capital is the minimum
rate of return which a company is expected to earn from a proposed
project so as to make no reduction in the earning per share to equity
shareholders and its market price”.

According to Khan and Jain, cost of capital means “the minimum

rate of return that a firm must earn on its investment for the market value
of the firm to remain unchanged”.

7.4 SIGNIFICANCE OF 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.

The significance or 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.
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.

57
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 actual profitability of the investment
project undertaken by the firm with the overall cost of capital.
7.5 FACTORS AFFECTING COST OF CAPITAL
Cost of capital is the cost for a business but the return for an investor.
There are various factors that can affect the cost of capital. Broadly,
factors can be classified as fundamental, economic, and other factors.
Fundamental factors are market opportunities, capital provider
preference, risk, and inflation. Other factors include Federal Reserve
policy, federal surplus and deficit, trade activity, foreign trade surpluses
and deficits, country risk, and exchange rate risk.
7.5.1 FUNDAMENTAL FACTORS AFFECTING COST OF CAPITAL
i) Market Opportunity: Unquestionably, the most fundamental price
deciding factor for anything in this world is the law of demand-supply.
The cost of capital is also not away from this fundamental law. When the
demand for capital increases, the cost of capital also increases and vice
versa. The demand is influenced greatly by the available market
opportunities. If there are a lot of production opportunities in the market,

58
more and more entrepreneurs will explore those opportunities to create
profitable ventures. Entrepreneurs, then, would require capital to
implement their business ideas. So, the cost of capital is directly related
to the market opportunities available in the market.
ii) Capital Provider’s Preferences: An individual with some additional
funds has two straight choices – save money or consume it. It is
completely a personal choice, but to a great extent, the culture of society
impacts it. For example, Japanese people are more bent on saving than
the US. Another important factor determining the utility of capital is the
interest rate or returns available to their funds. Naturally, higher returns
would enforce higher savings.
iii) Risk: The “High-risk, high-return” principle works here too. If the
venture where investment is required has a high level of risk, the return
required by the investor would also be very high to compensate for the
risk. On the other hand, the businessman taking up the venture may not
opt for a too high cost of capital because it may put the viability of the
overall project at stake. So, this is how risk plays a key role in deciding
the capital transactions in the market.

iv) Inflation: All capital providers try to invest in a manner that

maximizes returns. The lower benchmark for investing has always
been inflation. At the minimum, an investment should beat inflation, and
there should be some real income. Real income is nothing but the actual
return less inflation. In simple words, you invested money that could buy
you a particular basket of things a year ago. After a year, when your
investment is matured, and you receive money, you would at least
expect that money should be able to buy that same basket of things. If
the matured money falls short of buying you the same basket, you have
diminished the value of your money in the last year. If the money is more
than just buying that basket, you have earned real income on your
investment.
7.5.2 ECONOMIC AND OTHER FACTORS AFFECTING COST OF
CAPITAL
i) Federal Reserve Policy: All federal banks have got the power to
influence the economy. US Federal Reserve Board purchases the
treasury securities, normally held by banks, to boost the economy. Let’s
understand how it works. When the ‘Federal Reserve Board’ buys
treasury securities from the banks, the banks accumulate a lot of
loanable funds with it. Now, the banks with a higher supply of funds
would start offering loans at lower interest rates. This reduction in
interest rates will encourage industrialists to start more and more

59
ventures, which will create job opportunities, overall demand in the
market, etc. Although, there is a flip side of this policy that will increase
inflation in the longer run. This is how federal policies greatly impact the
cost of capital.
ii) Federal Budget Deficit or Surplus: Federal budget deficit and
surplus also have a role to play in deciding the cost of capital in the
market. In a surplus situation, Fed would buy Treasury securities from
the market, and that will reduce the interest rates. On the contrary, in a
deficit situation, Fed would sell Treasury securities or mint money.
Minting money would increase the money supply in the market and an
expectation of higher inflation, leading to increasing the cost of money.
Similarly, selling Treasury securities to banks will reduce the loanable
funds with banks and increase the cost of funds.
iii) Trade Activity: Economic boom and recession also play a very
important role in determining the cost of capital by impacting the interest
rates in the market.
iv) Foreign Trade Surpluses or Deficits: A foreign trade deficit creates
a need for borrowing from other countries. Borrower countries will have
their own opportunity cost of capital based on the interest rates available
with other countries. The higher the borrowings and higher will be the
interest rates. That will impact the capital market.

v) Country Risk: Country risk is the risk associated with the political,
social, and economic environment of a country. To understand with an
example, assume a country has trends of suddenly changing the tax
rates, regulations relating to trade and commerce, etc. An international
investor would resist investing in that country because their policy can
suddenly put any business at stake. This will reduce the flow of
international capital in the country and thereby increase the cost of
capital.
vi) Exchange Rate Risk: Investment in countries other than the home
country has a bearing on their exchange rate risk. The real return of an
investor depends on two factors.
1. The performance of the investment in the foreign country and
2. The performance of the currency of that country in comparison to
the home currency. At the time of maturity of the investment, if
the home currency weakens, the net realization in home currency
would also be reduced. That can affect an investor’s decision to
invest in other countries, especially those whose currency rates
fluctuate a lot.

60
7.5.3 INDIVIDUAL COMPANY FACTORS AFFECTING COST OF
CAPITAL
i) Capital Structure Policy: All companies try to optimize their capital
structure with a policy that suits their individual situations. New
acquisition of capital will depend a lot on the capital structure policy.
Therefore, the capital structure policy of the said company will have a
bearing on its cost of capital.
ii) Dividend Policy: A dividend policy of a corporation decides how
much percentage of profits it will retain and how much will be distributed
as dividends. If a company retains a higher percentage of profits in the
business, it effectively adds capital at the cost of equity. Accordingly, the
overall cost of capital will be impacted.

iii) Investment Policy: A company is nothing but a set of different

projects it takes up. It is very important to note that different projects
would have different risk profiles. If a company is adding a project with a
higher risk than the organization’s overall risk level, it is effectively
increasing the organization’s risk. With this increase in risk, the required
rate of return will also increase. This is how investment policy impacts
the cost of capital.
7.6 LIMITATIONS OF COST OF CAPITAL
1. For ascertaining cost capital, use of mathematical calculations and
their results cannot be accurate for practical use.
2. The decision maker should not put too much dependence or reliance
on these financial calculations.
3. From the calculations indicates that debt capital is cheaper than
preference and equity shares capital in case most of the enterprises.
LET US SUM UP
The cost of capital of an investor in financial management is equal to the
return an investor can fetch from the next best alternative investment. In
simple words, it is the opportunity cost of investing the same money in a
different investment having similar risks and other characteristics. From
a financing angle, it is simply the cost paid for using the capital.
Alternatively, a percentage return on investment that convinces an
investor to invest in a particular project or company is the appropriate
cost of capital for that investor. There are several concepts of cost of
capital Cost of capital is the minimum return expected by investors in
financial investments.

61
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. _________ is the opportunity cost of investing the same money in a
different investment having similar risks and other characteristics.
a) Cost of Capital b) Cost of Margin
c) Analysis of Profit d) Analysis of Revenue

2. The cost of capital is the_________ rate of return.

a) Maximum b) Average
c) Minimum d) High

3. _________ is known as fundamental factors affecting Cost of Capital.

a) Market Risk b) Market Opportunity
c) Financial Risk d) Financial Opportunity
4. _________ risk is the risk associated with the political, social, and
economic environment of a country.
a) Firm b) Individual

c) Country d) Exchange Rate

5. A _________ of a corporation decides how much percentage of
profits it will retain and how much will be distributed as dividends.

a) Capital Structure b) Cost of Capital

c) Criterion d) Dividend Policy
GLOSSARY

Cost of Capital : The cost of capital of an investor in financial

management is equal to the return an investor
can fetch from the next best alternative
investment. In simple words, it is the opportunity
cost of investing the same money in a different
investment having similar risks and other
characteristics.

Inflation : All capital providers try to invest in a manner

that maximizes returns. The lower benchmark
for investing has always been inflation. At the
minimum, an investment should beat inflation,
and there should be some real income.

62
Federal Reserve : All federal banks have got the power to
Policy influence the economy. US Federal Reserve
Board purchases the treasury securities,
normally held by banks, to boost the economy.
Let’s understand how it works. When the
‘Federal Reserve Board’ buys treasury
securities from the banks, the banks
accumulate a lot of loanable funds with it.

Country Risk : Country risk is the risk associated with the

political, social, and economic environment of a
country. To understand with an example,
assume a country has trends of suddenly
changing the tax rates, regulations relating to
trade and commerce, etc. An international
investor would resist investing in that country
because their policy can suddenly put any
business at stake.

Investment Policy : A company is nothing but a set of different

projects it takes up. It is very important to note
that different projects would have different risk
profiles. If a company is adding a project with a
higher risk than the organization’s overall risk
level, it is effectively increasing the
organization’s risk. With this increase in risk, the
required rate of return will also increase. This is
how investment policy impacts the cost of
capital.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.

63
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

64
Unit 8

COST OF CAPITAL AND DEBT

STRUCTURE
Overview
Learning Objectives
8.1 Cost of Capital
8.2 Cost of Debt
8.3 Cost of Preference Share Capital
8.4 Computation of Cost of Equity Share Capital and Retained
Earnings
8.4.1 Cost of Equity Capital
8.4.2 Cost of Retained Earnings
8.4.3 Cost of Weighted Average Cost of Capital
8.5 Calculations of individual and Composite Cost of Capital
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
The Cost of Capital for a project is the discount rate for calculating the
present value of cash flows. The project Cost of capital is the minimum
rate of return on funds committed to the project, which depends on the
riskiness of its Cash flows. Since the investment projects undertaken by
a firm may differ in risk, each one of them will have its own unique Cost
of Capital. It should be clear at the outset that the Cost of Capital for a
project is defined by the risk rather than the characteristics of the firm
undertaking the project.
LEARNING OBJECTIVES
After learning this unit, you will be able to;

• apply the elements of cost of capital

• explain Cost of debt
• explain the practical calculations related to Cost of Capital and
Debt.

65
8.1 COST OF CAPITAL
The cost of capital is a term used in the field of financial investment to
refer to the cost of a company’s funds (both debt and equity), or, from an
investor’s point of view “the shareholder’s required return on a portfolio
of all the company’s existing securities”. It is used to evaluate new
projects of a company as it is the minimum return that investors expect
for providing capital to the company, thus setting a benchmark that a
new project has to meet.
For an investment to be worthwhile, the expected return on capital must
be greater than the cost of capital. The cost of capital is the rate of return
that capital could be expected to earn in an alternative investment of
equivalent risk. If a project is of similar risk to a company’s average
business activities it is reasonable to use the company’s average cost of
capital as a basis for the evaluation. A company’s securities typically
include both debt and equity; one must therefore calculate both the cost
of debt and the cost of equity to determine a company’s cost of capital.
However, a rate of return larger than the cost of capital is usually
required.

Cost of Capital is the minimum rate of return that must be earned on

investments, in order to meet the rate of return required by the investors.
It is the discount rate applied to evaluate the firm’s capital projects.
According to Professor [Link] “Cost of Capital is the discount rate
used in evaluating the desirability of the investment project”. The cost of
capital is the minimum rate of return required for investment project. The
cost of capital is the minimum rate of return which will maintain the
market value per share at its current level.
8.2 COST OF DEBT

The debts may be either short term debts or long-term debts. Very
naturally, the cost of capital in the form of debt is the interest which the
company has to pay. But this is not the real cost attached with debt
capital. The real cost is something less than the rate of interest which
the company has to pay. This is due to the fact that the interest on debt
is tax deductible expenditure. If the amount of interest is considered as a
part of expenses, the tax liability of the company reduces proportionally.
As such, while computing the cost of debt, adjustments are required to
be made for its tax impact.

Cost of debt may be defined as the returns expected by the potential

investors of debt securities of a firm. It measures the current cost to the

66
firm of borrowing funds to finance the projects. It is generally determined
by the following variables:
(i) The current level of interest rates: As the level of interest rates
increases, the cost of debt will also increase.
(ii) The default risk of the form: As the default risk of the firm
increases, the cost of debt will also increase. One way of measuring the
default risk is to use the bond rating for the firm; higher credit rating
leads to higher interest rates.
(iii) The tax advantages associated with the debt: Since the interest
is tax deductible, the after-tax cost of debt is a function of tax-rate. The
tax benefit that accrues from paying interest makes the after-tax cost of
debt lower than the pretax cost.

Types of Cost of Debt and Its Computation

The cost of debt is of two types i.e., cost of irredeemable debt and cost
of redeemable debt.
1. Cost of Irredeemable Debt: Irredeemable debt also known as
perpetual debt refers to the debt which is not redeemable during the
life time of the firm. Interest payable on such debt is called cost of
irredeemable debt, it is calculated by using the following formula:
A. Cost of debt before tax (kdb)
Interest
𝑘𝑑𝑏 = Net procrrds (NP)
(a) Interest on debt should be calculated only on the face value of
debt irrespective of the issue price.
(b) Net proceeds (NP) are to be ascertained as given below;
(i) Debt issued at par;
NP = Face value – Issue expenses
(ii) Debt issued at premium;
NP = Face value + Securities premium – Issue expenses
(iii) Debt issued at discount;
NP = Face value – Discount – Issue expenses.
B. Cost of debt after tax (kdb): As the interest on debt is tax
deductible, the firm gets a saving in its tax liability. The interest
works as a tax shield and the tax liability of the firm is reduced.
Thus, the effective cost of debt is lower than the interest paid to
debt investors. The cost of debt is determined as given below:
Interest−Tax savings
Cost of debt after tax (kdb) =
Net proceeds

The after-tax cost of debt may also be determined by applying the

formula given below:

67
 kdb = kdb (1-Tax rate)
2. Cost of Redeemable Debt: Redeemable debt refers to the debt
which is repayable after a stipulated period, say 5 or 7 or 10 years.
The cost of this debt is determined as given below:
(A) Cost of debt before tax (kdb)
Annual cost before tax
Kdb =
Average value of debt
(a) Computation of Annual cost before tax
Rs.
Interest on debt p.a. xx
Add: Issue expenses, amortised p.a xx
Add: Discount on issue, amortised p.a xx
Add: Premium on redemption of debt, amortised p.a xx
(In case of redemption at premium)
xx
Less: Premium on issue of debt, amortised p.a
xx
(In case of issue at premium)

Annual cost before tax xx

xx

Note: (i) While calculating annual cost, the issue expenses, discount on
issue, premium on redemption and premium on issue are mortised over
the tenure of debt
(ii) Issue expenses (floatation costs) are to be calculated at face value or
the issue prices whichever is higher.
(b) Computation of average value of debt (AV): The average
value of debt is the average of net proceeds (NP) and
redemption value (RV) of debt.
Np + RV
𝐴𝑉 = 2

(B) Cost of debt after tax (kdb)

The cost of redeemable debt after tax is calculated as given
below:
Annual cost−Tax saving
𝑘𝑑𝑏 =
Average value of debt

The cost of redeemable debt after tax can also be ascertained by

using the following formula:
Kdb = kdb (1 - Tax rate)

68
8.3 COST OF PREFERENCE SHARE CAPITAL
Dividend paid to the preference shareholders is the cost of preference
share capital. The cost of preference share capital is based on the rate
of return required by the firm’s preference shareholders, which is
determined by the market of the preference shares. Since preference
dividend in not tax deductible, there is no need for tax adjustment in
calculating the effective cost of preference share capital. Like debt
capital, preference shares are divided into two categories i.e.,
irredeemable and redeemable. In India, Companies Amendment Act,
1988 prohibits issue of irredeemable preference shares.
Types of Redeemable Preference Share Capital and Its computation
(A) Cost of Irredeemable Preference Share Capital: In case of
irredeemable preference shares, the dividend at the fixed rate will be
payable to the preference shareholders perpetually. The cost of
irredeemable preference share capital can be calculated with the help of
the following formula:
Annual preference dividend
Cost of preference share capital(𝑘𝑝) = Net proceeds(NP)

The net proceeds indicate the net amount realised from the issue of
preference shares which can be determined as follows:
(a) Issued as par:
NP = Face value – Issue expenses
(b) Issued at premium
NP = Face value + Securities premium – Issue expenses
(c) Issued at discount
NP = Face value – Discount – Issue expenses
(B)Cost of Redeemable Preference Share Capital (RPS): If the
preference shares are redeemable at the end of a specified period, then,
the cost of preference share capital can be calculated by applying the
formula give under:
Annual cost
Cost of Redeemable preference share capital = Average value of RPS

(a) Computation of Annual cost

Rs.
Annual preference dividend xx
Add: Issue expenses, amortised p.a. xx
Add: Issue expenses, amortised p.a. xx
Discount on issue, amortised p.a.
(In case of issue at discount)

69
 Premium on redemption amortised p.a. xx
(In case of redemption at premium)
xx
Less: Premium on issue amortised p.a. xx
(In case of issue at premium)
Annual cost xx
xx

Note: The issue expenses, discount on issue, premium on redemption

and premium on issue are to be amortised over the tenure of the
preference shares to determine the annual cost.
(b) Computation of average value of RPS: The average value of
redeemable preference shares is the average of net proceeds (NP)
of the issue and the redemption value (RV).
𝑁𝑃+𝑅𝑉
Average value of RPS = 2

The Net proceeds (NP) is to be ascertained as given below:

(i) Issued at par; NP = Face value – Issue expenses
(ii) Issued at premium; NP = Face value + Securities Premium – Issue
expenses
(iii) Issued at discount; NP = Face value – Discount – Issue expenses
8.4 COMPUTATION OF COST OF EQUITY SHARE CAPITAL AND
RETAINED EARNINGS
8.4.1 Cost of Equity Capital
Computation of cost of equity is quite complex. Some people argue that
the equity capital is cost free as the firm is not legally bound to pay
dividend to equity shareholders. But this is not true. Shareholders invest
their funds with the expectation of dividends. The market value of equity
share depends on the dividends expected by shareholders, the book
value of firm and the growth in the value expected dividends with the
market value of equity share is the cost of return that must be earned on
new equity share capital financed investment in order to keep the
earnings available to the existing equity shareholders of the form
unchanged. The following are the different methods on the basis of
which the cost of equity capital may be computed:
(i) Dividend yield (or) Dividend price method: According to this
method, the cost of equity is calculated on the basis of a required rate of
return in terms of future dividends to be paid on equity shares for

70
maintaining their present market price. The cost of new equity share can
be determined according to the following formula:
𝐷1
Cost of equity (ke) = 𝑁𝑃

Where: D1 = Expected dividend per share

NP = Net proceeds per share

Note: In case of new issue, the firm with have to incur some floatation
costs such as fees to investment bankers, brokerage, underwriting
commission and commission to agents etc. so, the net proceeds per
share (Face value – Floatation costs) is considered for calculating cost
of equity. In case of existing equity shares, the cost of equity should be
calculated on the basis of market price of firm’s equity share according
to the following formula:
𝐷1
Cost of equity (ke) =
𝑀𝑃

Where: D1 = Expected dividend per share

MP = Market price per share

This method is simple and rightly emphasises the importance of
dividend, but it suffers from two serious limitations: (i) It ignores the
earnings on retained earnings which increases the rate of dividend on
equity shares and (ii) It ignores growth in dividends, capital gains and
future earnings. This method is sutable only when the firm has stable
earnings and a stable dividend policy over a reasonable length of time.
(ii) Dividend price plus growth (D/P + g) method: Under this method,
the cost of equity is determined on the basis of the expected dividend
rate plus the rate of growth in dividend. The growth rate in dividend is
assumed to be equal to the growth rate in earnings per share and
market price per share. The cost of equity, under this method, is
determined by using the following formula:
(a) In case of new issue of shares
𝐷1
Cost of equity (ke) = +g
𝑁𝑃
Where, D1 = Expected dividend per share
NP = Net proceeds per share
g = Growth rate in dividend
(b) In case of existing shares
𝐷1
Cost of equity (ke) = 𝑀𝑃 + g
Where, D1 = Expected dividend per share
MP = Market price per share
g = Growth rate in dividend

71
This method is considered to be the best conceptual measure of the cost
of equity as it satisfactorily determines the expectations of the investors.
However, it is sometimes very difficult to quantify the expected rate of
growth in dividend. Usually, it is presumed that the rate of growth in
dividend will be equal to the growth rate in earnings per share (EPS).
(iii) Earnings / price (E/P) Method: The advocates of this method co-
relate the earnings of the form with the market price of its shares.
Accordingly, the cost of equity would be based upon the expected rate of
earnings of the form. The argument is that each investor expects a
certain amount of the firm. The argument is that each investor expects a
certain amount of earnings, whether distributed or not form the firm in
whose shares he invests. Thus, if an investor expects that the fire in
which he is going to subscribe for shares should have at least a 20%
rate of earnings, the cost of equity can be construed on this basis.
Suppose the firm is expected to earn 30%, the investor will be prepared
30
to pay Rs. 150 (20 ×100) for each share of Rs. 100. This method is
similar to dividend price method; only it seeks to nullify the effect of
changes in the dividend policy. This method also does not seem to be a
complete answer to the cost of equity since it ignores the factor of capital
appreciation or depreciation in the market value of shares. The cost of
equity is determined under this method by applying the following
formula:
(a) In case of new issue of shares
𝐸𝑃𝑆
Cost of equity (ke) = 𝑁𝑃
Where, EPS = Earnings per share
NP = Net proceeds per share
(b) In case of existing shares
𝐸𝑃𝑆
Cost of equity (ke) = 𝑀𝑃
Where, EPS = Earnings per share
MP = Market price per share
This method is suitable when;
• The EPS is expected to remain constant:
• The payout is 100% (all the profits are distributed as dividends to
shareholders) ;
• The firm does not use any debt.
(i) Realised yield method: It has been suggested by many authors
that the yield actually realised for a period of time by investors in a
particular firm may be used as an indicator of the cost of equity. In other
words, this method takes into consideration the basic factor of the D/P +
g method, but instead of using the expected values of the dividends and

72
capital appreciation, past yields are used to denote the cost of capital.
This method is based upon the assumption that past behaviour will be
repeated in future, and therefore, may be used to measures the cost of
equity. This method is useful in the following conditions:
(a) The shareholders expect the realised yield of the past in future as
well.
(b) The firm remains in the same risk class.
(c) The market price of the shares does not change significantly.
(ii) Cost of equity under CAPM: The methods of calculation of cost
of equity discussed above are based on dividend. There is an alternative
to the dividend-based calculation of cost of equity and this alternative
known as CAPM (capital assets pricing model) and it is based directly
upon risk consideration. It is possible to ascertain the cost of equity by
using the mechanism of risk-return trade off as given by CAPM. At any
time, the security market has a spread of rates of returns ranging from
return on essentially the risk-free securities on the lower end of the scale
to the sizable return from other securities. The risk- return trade off
inherent in many classes of securities is reflected in this spread. Risk is
defined, for this purpose, as the variability of re turns inherent, in the
type of security, while the return is defined as the total economic return
obtained form it including interest, dividends and market appreciations.
The CAPM divides the total risk associated with a security/asset into two
classes i.e., (i) The diversifiable/unsystematic risk and (ii) non-
diversifiable or systematic risk. The diversifiable risk refers to that risk
which can be eliminated by more and more diversification. On the other
hand, non- diversifiable risk is that risk which affects all the firms at a
particular point of time and hence cannot be eliminated e.g., risk of
political uncertainties, risk of government policies etc. The CAPM further
states that the investor can eliminate the diversifiable risk by diversifying
into more and more securities, however, the non-diversifiable risk is the
point where investor’s attention is required. This non-diversifiable risk of
a security is measured in relation to the market portfolio and is denoted
by the beta coefficient 𝛽. In order to estimate the required rate of return
of the equity investors, the risk associated with the shares (as
represented by beta factor) and risk-return relationship in the securities
market need to be estimated. The CAPM as applied to find out the cost
of equity can be presented as follows:
ke = Rf + 𝛽 (Rm + Rf)
Where, ke = Cost of equity capital
Rf = Risk free return (Risk free interest rate)
𝛽 = The beta factor i.e., the measure of non-diversifiable risk

73
Rm= The expected cost of capital of market portfolio or average rate of
return on all assets or market return. For example, a firm having beta
coefficient of 1.6 finds the risk rate to be 9% and the market cost of
capital at 12%. The cost of equity of the firm will be:
ke = Rf + 𝛽 (Rm + Rf)
= 0.09 + 1.6 (0.12-0.09)
= 0.138 or 13.8%
8.4.2 COST OF RETAINED EARNINGS
Retained earnings are the accumulated number of undistributed profits
belonging to the equity shareholders. They provide a major source of
financing expansion and diversification of projects. Their cost is the
opportunity cost of the funds. If these were distributed to the
shareholders, they would have reinvested them in the same firm by
purchasing its equity and earned no the additional shares the same rate
of return as they are earning on their existing shares. Thus, the cost of
retained earnings is the same as the cost of equity capital. However,
unlike issue of equity shares, retained earnings do not involve the
payment of personal income tax as well as any floatation cost. This
makes their cost slightly lower than the cost of equity capital. The cost of
retained earnings may be calculated as follows:

(i) Cost of equity (ke) xx

(ii) Less: Tax on cost of equity xx

xx
(iii) Less: Brokerage
xx
(% on (i) – (ii))
Cost of retained earnings xx

Alternatively, the cost of retained earnings can be ascertained by using

the following formula:
Cost of retained earnings (kr) = ke (1-t) (1-b)
Where, ke = Cost of equity capital
t = tax rate
b = brokerage
8.4.3 Cost of Weighted Average Cost of Capital
After having ascertained the cost of each component of capital as
explained above, the average or composite cost of all the sources of
capital is to be determined. The cost of each component of the capital is
weighted by the relative proportion of that type of funds in the capital
structure. Then it is called Average Cost of Capital (WACC). WACC is
defined as the average of the costs of each source of funds employed by

74
the firm, properly weighted by the proportion they hold in the capital
structure of the firm. It is denoted by ko. The proportion or percentage or
weight of each component may be determined based on either book
value or market value of capital.
Benefits of market value approach
As the cost capital is used as a cut-off investment projects, the market
value approach is considered better due to the following reasons:
(a) It evaluates profitability as well as the long-term financial position of
the firm.
(b) Investors always consider the committing of his funds to a firm and
an adequate return on his investment. In such cases, book values
are of little significance.
(c) It considers price level changes.
Benefits of book value approach
However, as the market value fluctuates widely and frequently, the use
of book value weights is preferred in practice due to following reasons:
(a) The firms set their targets in terms of book value.
(b) It can easily be calculated from published accounts.
(c) The investors generally use the debt-equity ratio on the basis of
published figures to analyse the riskiness of the firm.
Computation of weighted average cost of capital
The following steps are to be taken to calculate WACC:
Step1: Calculate the cost of specific sources of funds, for example, cost
of debt, cost of equity etc.
Step 2: Multiply the cost of each source by its proportion in capital
structure.
Step3: Add the weighted component costs to get the firm’s WACC.
The following format may be adopted for computation of WACC:

Sources of Funds Amt. Proportion After Weighted

to Total Tax Cost Cost
Debt xx w1 kda kda × w1
Preference share xx w2 kp kp × w2
capital
Retained earnings xx w3 kr kr × w3
Equity share capital xx w4 ke ke × w4
Total xx WACC xxx

75
Significance of weighted average cost of capital
➢ In capital budgeting, WACC is used as a cut off rate (or Hurdle rate)
against which projects can be evaluated. A project can be considered
viable only if the returns from the project are higher than the cost
there of i.e., WACC.
➢ WACC represents the minimum rate of return at which a firm can
produce value for its investors (Debt and equity). If a firm’s return on
capital employed is less than its WACC, it means the firm is losing its
value wealth. Such a situation is most disadvantageous to equity
shareholders.
➢ WACC is useful in making economic value added (EVA) calculations.
8.5 CALCULATIONS OF INDIVIDUAL AND COMPOSITE COST OF
CAPITAL
Illustration: 1 (Cost of equity-dividend yield method)
Mustak Ltd. has a stable income and stable dividend policy. The
average annual dividend payout is Rs. 25 per share (face value: Rs.
100). You are required to ascertain:
(a) Cost of equity capital.
(b) Cost of equity capital if the market price of the share is Rs. 150.
(c) Expected market price in year 2 if cost equity is expected to rise to
20%.
(d) Dividend payout in year 2 if the company were to have an expected
market price of Rs. 160 per share, at the existing cost of equity.
Solution:
(a) Computation of cost of equity (ke)
𝑫𝟏
ke =
𝑵𝑷

D1 = Expected dividend per share: Rs. 25

NP = Net proceeds = Rs. 100
25
∴ ke = × 100 = 25%
100

(b) Computation of cost of equity if market price of share is Rs. 150

𝐷1
ke = 𝑀𝑃

D1 = Rs. 25

MP = Market price = Rs. 150

25
∴ ke = 100 × 100 = 16.67%

76
(c) Computation of market price if ke = 20%
𝐷1
ke =
𝑀𝑃
25 25
20% = 𝑀𝑃 = 0.20 = 𝑀𝑃

= 0.20 MP = 25
25
MP = 0.20 = Rs. 125

∴ Expected market price = Rs. 125

(d) Computation of dividend per share if market price is Rs. 160 at

the existing ke of 25%
𝐷1
ke = 𝑀𝑃
𝐷1
25% =
160

D1 = 160 × 25% = Rs. 40

∴ Expected dividend per share = Rs. 40.

Illustration: 2 (Cost of equity-Dividend yield +growth method)

Xavier Ltd. pays a dividend of Rs. 1 per share. Its shares are quoted at
Rs. 40 presently and investors expect a growth rate of 10% per annum.
Calculate (a) cost of equity capital; (b) expected market price per share if
anticipated growth rate is 11% and (c) Market price if dividend is Rs. 4,
cost of capital is 16% and growth rate is 10%.

Solution:
(a) Computation of cost of equity (ke)
𝐷1
ke = 𝑀𝑃 + g

D1 = Expected dividend per share = Rs. 4

MP = Market price per share = Rs. 40
g = Growth rate in dividend = 10%
4
∴ ke = (40 × 100) + 10% = 20%.

(b) Computation of market price if growth rate is 11%

𝐷1
ke = +g
𝑀𝑃
4
20% = 𝑀𝑃 + 11%
4
20%-11% = 𝑀𝑃
4
9% = 𝑀𝑃

77
0.09 MP = 4
4
MP = = Rs. 44.44
0.09

(c) Computation of market price if D1 = Rs. 4, ke = 16% and g = 10%

𝑫𝟏
ke = 𝑴𝒑 + g
4
16% = 𝑀𝑃 + 10%
4
16%-10% = 𝑀𝑃
4
6% = 𝑀𝑃

0.06 = 4
4
MP = =Rs. 66.67.
0.06

∴ Market price per share = Rs. 66.67.

Illustration: 3 (Cost of equity-Earning / price method)

Kaniska Ltd. wants to raise Rs. 30,00,000 by issue of new equity shares.
The relevant information is given below:

No. of existing equity shares 50,000

Profit after tax Rs.3,00,000
Market value of existing equity share Rs.20,00,000

(a) Compute the cost of existing equity share

(b) Compute the cost of new equity capital if the shares are issued at a
price of Rs. 35 per share and the floatation cost is Rs. 5 per share.

Solution:
(a) Computation of cost of existing equity (ke)
𝑃𝑟𝑒𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 3,00,000
EPS (Earnings per share) = 𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 = 50,000
= Rs. 6
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 20,00,000
MP = (Market value per share) = 𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
= 50,000
=Rs.40
6
∴ ke = 40 × 100 = 15%

(b) Computation of cost of new equity (ke)

𝐸𝑃𝑆
ke = 𝑁𝑃
× 100

NP (Net proceeds) = Issue price – Flotation cost = 35 - 5 = Rs. 30

6
∴ ke = 30 × 100 = 20%

78
Illustration: 4 (Cost of equity – Realised yield method)
An investor purchased 10 shares in a company at a cost of Rs. 480 on
1.1.2013. He held them for 5 years and finally sold them in Jan. 2006 for
Rs. 600. The amount of dividend received by him in each of these 5
years was Rs. 28,28,29,29 and Rs.29 respectively. Find out the cost of
equity capital under realised yield method.

Solution:
Under the realised yield method, cost of equity capital is the Internal
Rate of Return (IRR). IRR is the rate at which total present value of
inflows is equal to total present value of outflow. The IRR is calculated
by trial and error.
28+28+29+29+29
Average dividend received = 5
=Rs.28.6

Profit on sale of shares = 600-480 = Rs.120

Average profit on sale of shares = 120⁄5 = Rs.24

Total return for a year = 28.6 + 24 = Rs.52.6

52.6
Return on investment = × 100 = 10.95% (or) = 11%
480

The trial-and-error procedure to find out the IRR may be started with
11%
Statement showing present value of cash flows

Year Dividend Sale P.V. Factor Present value

Rs. Proceeds at 11%
2013 28 - 0.901 25.228
2014 28 - 0.812 22.736
2015 29 - 0.731 21.199
2016 29 - 0.659 19.111
2017 29 - 0.593 17.197
2018 - 600 0.593 355.800

Total P.V. of cash inflows 461.271

Less: Total P.V. of cash outflow (480 × 1) 480.000
NPV (-)18.729

Since NPV is negative, it is apparent that the IRR should be less than
11%. I us try 10% as the P.V. factor.

79
 Statement showing present value of cash flows

Year Dividend Sale P.V. factor Present

Rs. Proceeds At 10% Value
2013 28 - 0.909 25.452
2014 28 - 0.826 23.128
2015 29 - 0.751 21.779
2016 29 - 0.683 19.807
2017 29 - 0.621 18.009
2018 - 600 0.621 372.60
Total P.V of cash inflows 480.775
Less: Total P.V. of cash outflow (480 × 1) 480.000
NPV 0.775

IRR must be between 10% and 11%, because at 10% NPV is positive
and at 11% it is negative. Hence, the exact IRR can be ascertained with
the help of following formula:
𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉
IRR = Lower rate + 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒𝑑 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒𝑠 × Difference in rate
0.775 0.775
= 10% + 480.775−461.271 × (11-10) = 10% + 19.504 × 1

= 10% + 0.04 = 10.04%

∴ Cost of equity capital (ke) = 10.04%
Illustration: 5 (Cost of equity under CAPM)
The following information relate to Maars Ltd:
(i) Risk free return is 12%
(ii) Beta co-efficient 𝛽 of the company is 1.75

Compute the cost of equity using capital assets pricing model (CAPM) if
the expected market return is 5%. Also calculate the cost of equity if
𝛽 (a) rises to 2.25 and (b) falls to 1.50.

Solution:
I. Calculation of cost of equity under CAPM (ke)
ke under CAPM = Rf + 𝛽 (Rm + Rf)

Rf = Risk free return = 12%

𝛽 = Beta Co-efficient = 1.75

Rm = Market return = 15%

∴ ke under CAPM = 12% + [1.75 (15%-12%)]

= 12% + 0.0525 = 12.0525%.

80
II. Calculation of cost of equity if Beta increases to 2.25
ke under CAPM = 12% + [2.25(15%-12%)]
= 12% + 0.0675 = 12.0675%.

III. Calculation of cost of equity if Beta decreases to 1.5

ke under CAPM = 12% + [1.50(15%-12%)]
= 12% + 0.045 = 12.045%.

Illustration:6 (Cost of retained earnings)

The rate of return available to the equity shareholders in the Ava Ltd. is
20% and the personal tax rate applicable to shareholders is 22%. It is
expected that the shareholders will have to bear a brokerage cost of 3%
when they invest their dividends in alternative securities. Compute the
cost of retained earnings.

Solution:
To determine the cost of retained earnings, adjustments for tax and
brokerage are to be made as given below:

%
Cost of equity (ke) 20.00
Less: Personal tax rate (20 × 22%) 4.40
15.60
Less: Brokerage (15.6 × 3%) .468
Cost of retained earnings (kr)
15.132

Alternatively
kr = ke (1-Tax rate) × (1-Brokerage) = 20(1-0.22) × (0.97) = 15.132%.

Illustration: 7
Daniel holds 220 shares of Rs. 100 each in Asha Ltd. Asha Ltd. has
earned Rs. 10 per share and distributed Rs. 6 per share as dividend
among shareholders and the balance is retained. The market price of
the share is Rs. 110. If personal tax rate applicable to shareholders is
40%, find out cost of retained earnings.

Solution:
Amount retained on 220 shares = 220 × 4 = Rs. 880
880
No. of new shares to be acquired out of Rs.880 = = Rs.8
110

Earnings on 8 shares = 8 × 10 =Rs. 80

81
 𝐸(1−𝑡)
∴ Cost of retained earnings (kr) = 𝑀𝑃
× 100

E = Rs. 80; t = 40%; MP = Rs. 880

𝟖𝟎(𝟏−𝟎.𝟒𝟎)
∴ kr = × 100 = 5.45% (or)
𝟖𝟖𝟎
𝑬(𝟏−𝒕)
kr = 𝑴𝑷
× 100 = 5.45%

Illustration: 8 (WACC)
Following information is available with regards to the capital structure of
Edwards Ltd:

Amount After tax

Rs. Cost of capital
%
Debentures 12,00,000 5%
Preference share capital 4,00,000 10%
Equity share capital 8,00,000 15%
Retained earnings 16,00,000 12%

You are required weighted average cost of capital (WACC).

Solution:
Statement showing weighted average cost of capital

Source Amount Weights After Weighted

Rs. Tax cost Cost
%
(1) (2) (3) (4) 5 = (3 × 4)
Debentures 12,00,000 12⁄ = 0.30 5 1.5
40
Pref. share 4,00,000 4⁄ = 0.10 10 1.0
40
capital

Equity share 8,00,000 8⁄ = 0.20 15 3.0

40
capital
Retained 16,00,000 16⁄ = 0.40 12 4.8
40
earnings
40,00,000 10.30

∴ WACC = 10.30%
Illustration: 9

A company was recently formed to manufacture a new product. It has

the following capital structure:

82
 Rs.
(i) 9% Debentures 10,00,000
(ii) 7% Preference shares 4,00,000
(iii) Equity shares (48,000 shares) 16,00,000
(iv) Retained earning 10,00,000
40,00,000
The market price of equity share is Rs. 80. A dividend of Rs. 8 per share
is proposed. The company has marginal tax rate of 50% and
shareholder’s individual tax rate is 20%. Compute after tax weighted
average average cost of capital of the company.
Solution:
(i) Computation of after-tax cost of debt (kda)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
kda = × 100
𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠

Interest on debentures = (10,00,000 × 9%) Rs. 90,000

Less: Tax (90,000 × 50%) Rs. 45,000
Interest after tax 45,000
45,000
∴ kda = 10,00,000 × 100 = 4.5%

(ii) Computation of cost of equity (ke)

𝐷1
ke = 𝑀𝑃 × 100
D1 = Expected dividend per share = Rs. 8
MP = Market price per share = Rs. 80
8
∴ ke = 80 × 100 = 10%
(iii) Computation of cost of retained earnings (kr)
𝐷(1−𝑡) 8 (1−0.25)
kr = 𝑀𝑃
× 100 = 80
× 100 = 7.5%

Statement showing weighted average cost of capital

Source Amount Weights After Weighted

Rs. Tax cost Cost
%
(1) (2) (3) (4) 5 = (3 × 4)
Debentures 10,00,000 10/40 = 0.25 4.5 1.125
Pref. shares 4,00,000 4/40 = 0.10 7.0 0.70
Equity shares 16,00,000 16/40 = 0.40 10.0 4.00
Retained 10,00,000 10/40 = 0.25 7.5 1.875
earnings
Total 40,00,000 WACC 7.70

83
LET US SUM UP
The cost of capital of an investor in financial management is equal to the
return an investor can fetch from the next best alternative investment. In
simple words, it is the opportunity cost of investing the same money in a
different investment having similar risks and other characteristics. From
a financing angle, it is simply the cost paid for using the capital.
Alternatively, a percentage return on investment that convinces an
investor to invest in a particular project or company is the appropriate
cost of capital for that investor. There are several concepts of cost of
capital Cost of capital is the minimum return expected by investors in
financial investments.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. ___________ is the opportunity cost of investing the same money in a
different investment having similar risks and other characteristics.
a) Cost of Capital b) Cost of Margin
c) Analysis of Profit d) Analysis of Revenue
2. The cost of capital is the___________ rate of return.
a) Maximum b) Average
c) Minimum d) High
3. ___________ is known as fundamental factors affecting Cost of
Capital.
a) Market Risk b) Market Opportunity
c) Financial Risk d) Financial Opportunity
4. ___________ risk is the risk associated with the political, social, and
economic environment of a country.
a) Firm b) Individual
c) Country d) Exchange Rate
5. A___________ of a corporation decides how much percentage of
profits it will retain and how much will be distributed as dividends.
a) Capital Structure b) Cost of Capital
c) Criterion d) Dividend Policy
GLOSSARY

Cost of Capital : The cost of capital of an investor in financial

management is equal to the return an
investor can fetch from the next best
alternative investment. In simple words, it is
the opportunity cost of investing the same

84
 money in a different investment having
similar risks and other characteristics.

Inflation : All capital providers try to invest in a manner

that maximizes returns. The lower
benchmark for investing has always
been inflation. At the minimum, an
investment should beat inflation, and there
should be some real income.

Federal Reserve : All federal banks have got the power to

Policy influence the economy. US Federal Reserve
Board purchases the treasury securities,
normally held by banks, to boost the
economy. Let’s understand how it works.
When the ‘Federal Reserve Board’ buys
treasury securities from the banks, the banks
accumulate a lot of loanable funds with it.

Country Risk : Country risk is the risk associated with the

political, social, and economic environment
of a country. To understand with an
example, assume a country has trends of
suddenly changing the tax rates, regulations
relating to trade and commerce, etc. An
international investor would resist investing
in that country because their policy can
suddenly put any business at stake.

Investment Policy : A company is nothing but a set of different

projects it takes up. It is very important to
note that different projects would have
different risk profiles. If a company is adding
a project with a higher risk than the
organization’s overall risk level, it is
effectively increasing the organization’s risk.
With this increase in risk, the required rate of
return will also increase. This is how
investment policy impacts the cost of capital.

85
SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES

1. [Link]
2. [Link]
3. [Link]

ANSWERS TO CHECK YOUR PROGRESS

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

86
 BLOCK 3

Leverage and Capital Structure

Unit 9 : Introduction to Financial Management

Unit 10: Financial Function
Unit 11: Financial Planning
Unit 12: Sources and Forms of Finance

87
Unit 9

INTRODUCTION TO LEVERAGES
STRUCTURE
Overview
Learning Objectives
9.1 Introduction
9.2 Meaning of Leverages
9.3 Uses of Financial Leverages
9.4 Advantages and disadvantages of Leverages
9.5 Capital structure definition
9.6 Importance of Leverage
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
The financing or Capital structure decision is a significant managerial
decision. It influences the shareholder’s risk and return. The market
value of the share may be affected by the capital structure decision. The
Company will have to plan its capital structure initially, at the time of its
promotion. Subsequently, whenever funds have to be raised to finance
investments, a capital structure decision is involved.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• explain the meaning of leverages
• explain the uses of leverages
• describe the advantages and disadvantages of leverages.
9.1 INTRODUCTION
Financial decision is one of the integral and important parts of financial
management in any kind of business concern. A sound financial decision
must consider the board coverage of the financial mix (Capital
Structure), total amount of capital (capitalization) and cost of capital (K).
Capital structure is one of the significant things for the management,
since it influences the debt equity mix of the business concern, which

88
affects the shareholder’s return and risk. Hence, deciding the debt-equity
mix plays a major role in the part of the value of the company and
market value of the shares. The debt equity mix of the company can be
examined with the help of leverage.
9.2 MEANING OF LEVERAGES
The word ‘leverage’, borrowed from physics, is frequently used in
financial management.
The object of application of which is made to gain higher financial
benefits compared to the fixed charges payable, as it happens in physics
i.e., gaining larger benefits by using lesser amount of force.
In short, the term ‘leverage’ is used to describe the ability of a firm to use
fixed cost assets or funds to increase the return to its equity
shareholders. In other words, leverage is the employment of fixed assets
or funds for which a firm has to meet fixed costs or fixed rate of interest
obligation— irrespective of the level of activities attained, or the
level of operating profit earned.
Leverage occurs in varying degrees. The higher the degree of leverage,
the higher is the risk involved in meeting fixed payment obligations i.e.,
operating fixed costs and cost of debt capital. But, at the same time,
higher risk profile increases the possibility of higher rate of return to the
shareholders.

According to Ezra Solomon:

“Leverage is the ratio of net returns on shareholders equity and the net
rate of return on capitalisation”.
According to J. C. Van Home:
“Leverage is the employment of an asset or funds for which the firm
pays a fixed cost of fixed return.”
In the words of J. E. Walter, ‘Leverage may be defined as percentage
return on equity and the net rate of return on total capitalization’.
According to S. C. Kuchhal, the term leverage ‘is used to describe a
firm’s ability to use fixed cost bearing assets or funds to magnify the
return to its owners’.
9.3 USES OF FINANCIAL LEVERAGES
Financial leverage helps to examine the relationship between EBIT and
EPS. Financial leverage measures the percentage of change in taxable
income to the percentage change in EBIT. Financial leverage locates the
correct profitable financial decision regarding capital structure of the

89
company. Financial leverage is one of the important devices which is
used to measure the fixed cost proportion with the total capital of the
company. If the firm acquires fixed cost funds at a higher cost, then the
earnings from those assets, the earning per share and return on equity
capital will decrease.
9.4 ADVANTAGES AND DISADVANTAGES OF LEVERAGES

As with any other financial instrument, even leverage has its own
advantages and disadvantages that you must know before using it for
your business or individual

investments. As leverage is a multifaceted financial tool, it is a little

complex in nature and can enhance both gains and losses when
used by a company or an. individual investor. Thus, understanding
its advantages and disadvantages will help you expand your business
and give you an idea if your business is cut out to use this financial tool
just yet.
The advantages and disadvantages of leverage are as follows:
Advantages:
1. Companies or individual businesses that borrow loans through
leverage investments can make a relatively small investment.
2. Through this leveraged investment, these companies and
businesses can buy more assets and funds for their organisation.

3. Suppose the asset value increases and the conditions are favorable.
In that case, it benefits the borrowers greatly as they can get higher
returns for their investments which will help them to stay within the
profit margin.
Disadvantages:
1. The one risk that runs while using leverage is the loss that the
companies might face if the asset value declines and goes lower
than the interest that the companies have to pay on their debts.
2. This financial risk is especially high in certain businesses like
construction, oil production, and automobile construction, which may
face the highest losses if the asset value falls.
3. If not used properly, the leverage investment can prove fatal for
businesses and can even cause companies to go out of business.
This especially affects companies with less predictable income and
are less profitable. This is also why many first-time investors are

90
 advised against using leverage until they have gained enough
experience to avoid such a great loss to their business.
4. It is extremely important to keep the above advantages and
disadvantages in mind and to consider all the possible risks before
using a leveraged investment as a company or as an individual
investor.

9.5 CAPITAL STRUCTURE DEFINITION

The assets of the Company can be financed either by increasing the
owner’s claims or the creditor’s claims. The owner’s claims increase
when the firm raises funds by issuing ordinary shares or by retaining the
earnings, the creditor’s claims increase by borrowings. The various
means of financing represent the financial structure of an enterprise. The
left-hand side of the balance sheet represents the financial structure
of a company. Traditionally short-term borrowings are excluded from the
list of methods of financing the firm’s capital expenditure, and therefore,
the long-term claims are said to form the capital structure of the
enterprise. The term capital structure is used to represent the
proportionate relationship between debt and equity.

9.6 IMPORTANCE OF LEVERAGE

With the understanding of leverage, a finance manager can increase
earnings per share and dividend per share to equity shareholders as
well as market value of the firm. When the rate of return on investment is
more than the cost of debt capital, it gives more rate of return on equity
capital. This in turn maximises shareholders’ wealth, which is the basic
objective of financial management. The leverage can help increase both
the EPS and EBT.
The importance of leverage can be judged from the following
points:
1. Leverage is an important technique in deciding the optimum capital
structure of a firm. With the help of this technique, it is easy to
determine the ratio of various securities comprising the capital
structure of a firm at which the average cost of capital is minimum. If
financial leverage is present in a firm, it is possible to increase EPS
by increasing the EBIT in a firm.
2. Leverage is also very helpful in taking a capital budgeting decision. If
contribution in a firm is not able to meet the fixed operating costs,
then business will suffer loss. In other words, the degree of operating
leverage must be greater than 1 to make the project operationally
profitable.

91
3. Leverage is most important in assessing the risk involved in a firm.
Operating leverage measures the business risk of a firm. Financial
leverage measures the financial risk in a firm. The combined
leverage measures the total risk involved in a firm.
In leverage analysis, it is assumed that cost of capital always remains
constant. But, after a certain limit, the cost of financing generally starts
increasing.
LET US SUM UP
Leverage is an important technique in deciding the optimum capital
structure of a firm. With the help of this technique, it is easy to determine
the ratio of various securities comprising the capital structure of a firm at
which the average cost of capital is minimum. If financial leverage is
present in a firm, it is possible to increase EPS by increasing the EBIT in
a firm.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. __________ is studied with the help of Operating Leverage.
a) Analysis of Business Risk b) Analysis of Financial Risk
c) Analysis of Productive Risk d) Analysis of Credit Risk
2. __________ formula is used to measure the degree of Operating
leverage.
a) EBT/EBIT b) Contribution/EBIT
c) EBIT/EBT d) EBIT/Contribution
3. Financial risk is analysed with the help of _________.
a) Operating leverage b) Financial leverage
c) Combined leverage d) Operative leverage
4. _________ formula is used to measure the degree of financial
leverage
a) EBT/EBIT b) Contribution/EBIT
c) EBIT/EBT d) EBIT/Contribution
5. Financial leverage is also known as_________.
a) Composite leverage b) Break even profit
c) Tracing on equity d) Capital structure leverage

92
GLOSSARY

Leverage : The leverage of a company’s loan capital to

the value of its ordinary shares.

Analysis : detailed examination of the elements or

structure of something.

Structure : arrangement of something complex.

Composite leverage : It refers to high profits due to fixed costs. It

includes fixed operating expenses with fixed
financial expenses. It indicates leverage
benefits and risks which are in fixed quantity.

EBIT : measures a company's net income before

income tax and interest expenses are
deducted.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

93
Unit 10

TYPES OF LEVERAGES
STRUCTURE
Overview
Learning Objectives
10.1 Types of Leverage
10.2 Degree of Operating Leverage
10.3 Uses of Operating leverage
10.4 Effects of Operating leverage
10.5 Financial leverage
10.6 Uses of financial leverage
10.7 Degree of financial leverage
10.8 Combined leverage
10.9 Degree of Combined leverage
10.10 Importance of Combined leverage
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
The term Leverage in general refers to a relationship between two
interrelated variables. In financial analysis it represents the influence of
one financial variable over some other related financial variable. These
financial variables may be costs, output, sales revenue, earnings before
interest and tax, earnings before tax, earning per share, etc.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• explain the types of leverages
• calculate the leverages
• explain the importance of leverages.
10.1 TYPES OF LEVERAGE
There are three commonly used measures of leverages in financial
analysis. These are:

94
 i) Operating leverage,
ii) Financial leverage, and
iii) Combined leverage.

i) Operating Leverage:
Operating Leverage is defined as “the firm’s ability to use fixed operating
costs to magnify effects of changes in sales on its earnings before
interest and taxes”. In other words, operating leverage is the tendency of
the operating profit to vary disproportionately with sales. It is said to exist
when a firm has to pay fixed cost regardless of volume of output or
sales.
The operating leverage shows the relationship between the changes in
sales and the changes in fixed operating income. Thus, the operating
leverage has an impact mainly on fixed costs and also on variable costs
and contribution. Of course, there will be no operating leverage if there
are no fixed operating costs.
The operating leverage can be calculated by adopting the following
formula:
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Operating Leverage = 𝑂𝑅
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 𝐸𝐵𝐼𝑇
Where, EBIT = Earnings Before Interest and Tax.
ii) Financial Leverage:
The financial leverage is defined as the ability of a firm to use fixed
financial charges to magnify the effects of changes in operating profits,
on the firm’s earning per share. In other words, the financial leverage is
the tendency of a residual net income to vary disproportionately with
operating profit. It indicates the change that takes place in the taxable
income as a result of change in the operating income.
The financial leverage can be computed by adopting the following
formula:
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝐼𝑇
Financial Leverage = 𝑂𝑅
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
Where, EBIT = Earnings Before Tax.
iii) Combined Leverage:

The operating leverage explains the operating risk and financial leverage
explains the financial risk of the firm. However, a firm has to look into
overall risk or total risk of the firm i.e., operating risk as well as financial
risk. Hence, if we combine the operating risk and financial risk, the result

95
is combined leverage. Combined leverage thus expresses the
relationship between revenue on account of sales and the taxable
income.
The combined leverage can be computed by adopting following formula:
% 𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Combined Leverage = 𝑂𝑅
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 𝐸𝐵𝐼𝑇

Combined Leverage = Operating Leverage x Financial Leverage

10.2 DEGREE OF OPERATING LEVERAGE

The earnings before interest and taxes (i.e., EBIT) changes with
increase or decrease in the sales volume. Operating leverage is used to
measure the effect of variation in sales volume on the level of EBIT.
The formula used to compute operating leverage is:
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
Operating Leverage = = 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠

The operating Leverage at any volume of sales is defined as its degree.

The degree of operating leverage is computed by dividing contribution
by EBIT
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Degree of operating leverage =
𝐸𝐵𝐼𝑡
Here, Contribution = Sales – Variable cost
EBIT = Sales – Variable cost – Fixed cost
A high degree of operating leverage is welcome when sales are rising
i.e., favorable market conditions, and it is undesirable when sales are
falling. Because, higher degree of operating leverage means a relatively
high operating fixed cost for recovering which a larger volume of sales is
required.

The degree of operating leverage is also obtained by using the following

formula:
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 (𝐷𝑂𝐿) =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑈𝑛𝑖𝑡𝑠 𝑆𝑜𝑙𝑑

The value of degree of operating leverage must be greater than 1. If the

value is equal to 1 then there is no operating leverage.
10.3 USES OF OPERATING LEVERAGE

1. Operating leverage is one of the techniques to measure the impact

of changes in sales which lead for change in the profits of the
company.

96
2. If any change in the sales, it will lead to corresponding changes in
profit.
3. Operating leverage helps to identify the position of fixed cost and
variable cost.
4. Operating leverage measures the relationship between the sales and
revenue of the company during a particular period.

5. Operating leverage helps to understand the level of fixed cost which

is invested in the operating expenses of business activities.
6. Operating leverage describes the overall position of the fixed
operating cost.
10.4 EFFECTS OF OPERATING LEVERAGE
A high operating leverage entails that company has increased
production without investing in additional fixed costs. As production
rises, managers are in effect spreading fixed costs across a greater
number of units, so the additional units have a lower ratio of fixed costs
to total costs. When demand for company product increases, then
experts can easily ramp up production by increasing variable costs;
Company's fixed assets allow to magnify production. Managers can
increase production as long as their higher variable costs do not cause
total costs to exceed their sales revenues. However, at the time of a
recession, high operating leverage is risky.

10.5 FINANCIAL LEVERAGE

Financial leverage is primarily concerned with the financial activities
which involve raising of funds from the sources for which a firm has to
bear fixed charges such as interest expenses, loan fees etc. These
sources include long-term debt (i.e., debentures, bonds etc.) and
preference share capital.
Long term debt capital carries a contractual fixed rate of interest and its
payment is obligatory irrespective of the fact whether the firm earns a
profit or not.
As debt providers have prior claim on income and assets of a firm over
equity shareholders, their rate of interest is generally lower than the
expected return in equity shareholders. Further, interest on debt capital
is a tax-deductible expense.
These two facts lead to the magnification of the rate of return on equity
share capital and hence earnings per share. Thus, the effect of changes

97
in operating profits or EBIT on the earnings per share is shown by the
financial leverage.
According to Gitman financial leverage is “the ability of a firm to use
fixed financial charges to magnify the effects of changes in EBIT on
firm’s earnings per share”. In other words, financial leverage involves the
use of funds obtained at a fixed cost in the hope of increasing the return
to the equity shareholders.
Favorable or positive financial leverage occurs when a firm earns more
on the assets/ investment purchased with the funds, than the fixed cost
of their use. Unfavorable or negative leverage occurs when the firm does
not earn as much as the funds cost.
Thus, shareholders gain where the firm earns a higher rate of return and
pays a lower rate of return to the supplier of long-term funds. The
difference between the earnings from the assets and the fixed cost on
the use of funds goes to the equity shareholders. Financial leverage is
also, therefore, called as ‘trading on equity’.
Financial leverage is associated with financial risk. Financial risk refers
to risk of the firm not being able to cover its fixed financial costs due to
variation in EBIT. With the increase in financial charges, the firm is also
required to raise the level of EBIT necessary to meet financial charges. If
the firm cannot cover these financial payments, it can be technically
forced into liquidation.
10.6 USES OF FINANCIAL LEVERAGE
Financial leverage helps to examine the relationship between EBIT and
EPS. Financial leverage measures the percentage of change in taxable
income to the percentage change in EBIT. Financial leverage locates the
correct profitable financial decision regarding capital structure of the
company. Financial leverage is one of the important devices which is
used to measure the fixed cost proportion with the total capital of the
company. If the firm acquires fixed cost funds at a higher cost, then the
earnings from those assets, the earning per share and return on equity
capital will decrease.
10.7 DEGREE OF FINANCIAL LEVERAGE
Financing leverage is a measure of changes in operating profit or EBIT
on the levels of earning per share.
It is computed as:

98
 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝑃𝑆
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 𝐸𝑃𝑆
Financial𝑔 Leverage = = 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐸𝐵𝐼𝑇

The financial leverage at any level of EBIT is called its degree. It is

computed as ratio of EBIT to the profit before tax (EBT).
Degree of Financial leverage (DFL) = EBIT / EBT
The value of degree of financial leverage must be greater than 1. If the
value of degree of financial leverage is 1, then there will be no financial
leverage. The higher the proportion of debt capital to the total capital
employed by a firm, the higher is the degree of financial leverage and
vice versa.
Again, the higher the degree of financial leverage, the greater is the
financial risk associated, and vice versa. Under favourable market
conditions (when EBIT may increase) a firm having high degree of
financial leverage will be in a better position to increase the return on
equity or earning per share.
10.8 COMBINED LEVERAGE
Operating leverage shows the operating risk and is measured by the
percentage change in EBIT due to percentage change in sales. The
financial leverage shows the financial risk and is measured by the
percentage change in EPS due to percentage change in EBIT.

Both operating and financial leverages are closely concerned with

ascertaining the firm’s ability to cover fixed costs or fixed rate of interest
obligation, if we combine them, the result is total leverage and the risk
associated with combined leverage is known as total risk. It measures
the effect of a percentage change in sales on percentage change in
EPS.

10.9 DEGREE OF COMBINED LEVERAGE

The combined leverage can be measured with the help of the following
formula:

Combined Leverage = Operating leverage x Financial leverage

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
Combined Leverage = 𝑋
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
=
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
The degree of combined leverage is measured by using the following
formula:

99
Degree of Combined Leverage (DCL) = DOL X DFL
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
= 𝑋 ==
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇 % 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
Or, alternatively , at any given level
DCL = DOL X DFL
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝐸𝐵𝐼𝑇 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
= 𝑋 =
𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
The combined leverage may be favourable or unfavorable. It will be
favourable if sales increase and unfavorable when sales decrease. This
is because changes in sales will result in more than proportional returns
in the form of EPS. As a general rule, a firm having a high degree of
operating leverage should have low financial leverage by preferring
equity financing, and vice versa by preferring debt financing.
If a firm has both the leverages at a high level, it will be very risky
proposition. Therefore, if a firm has a high degree of operating leverage
the financial leverage should be kept low as proper balancing between
the two leverages is essential in order to keep the risk profile within a
reasonable limit and maximum return to shareholders.

10.10 IMPORTANCE OF COMBINED LEVERAGE

The importance of combined leverage is:
1. It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial

leverage.
3. A combination of high operating leverage and a high financial
leverage is very risky situation because the combined effect of the
two leverages is a multiple of these two leverages.
4. A combination of high operating leverage and a low financial
leverage indicates that the management should be careful as the
high risk involved in the former is balanced by the later.
5. A combination of low operating leverage and a high financial
leverage gives a better situation for maximising return and
minimising risk factor, because keeping the operating leverage at
low-rate full advantage of debt financing can be taken to maximise
return. In this situation the firm reaches its BEP at a low level of
sales with minimum business risk.
6. A combination of low operating leverage and low financial leverage
indicates that the firm losses profitable opportunities.

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Illustration: 1
A firm sells its only product at Rs.12 per unit. Its variable cost is Rs.8 per
unit. Present sales are 2,000 units. Calculate the operating leverage in
each of the following situations:
1. When fixed cost is Rs.2,000
2. When fixed cost is Rs.2,400
3. When fixed cost is Rs.3,000
Solution:
Profitability statement

Particulars Situation 1 Situation 2 Situation 3

Sales (2000 x 12) 24,000 24,000 24,000

Less: Variable cost (2,000 x 16,000 16,000 16,000

8)

Contribution 8,000 8,000 8,000

Less: Fixed cost 2,000 2,400 3,000

Operating profit (EBIT) 6,000 5,600 5,000

Operating leverage = 8,000 8,000 8,000

contribution 6,000 5,600 5,000
= 1.33 times = 1.43 times = 1.6 times
EBIT

Analysis: From the above statement, it is quite evident that the operating
leverage increases with every increase in share of fixed cost in the total
cost structure of the firm.

Illustration: 2
From the following information, calculate operating leverage:
No. of units produced and sold: 60,000
Selling price per unit: Rs.20
Variable cost per unit: Rs.10
Fixed cost per unit at current level of sales is Rs.5. what will be the new
operating leverage if the variable cost is Rs.12.
Solution:

101
 STATEMENT OF PROFIT

Particulars Rs.

Sales (60,000 x 20) 12,00,000

Less: variable cost (60,000 x 10) 6,00,000

Contribution 6,00,000

Less: Fixed cost (60,000 x 5) 3,00,000

EBIT 3,00,000

contribution 6,00,000
Operating leverage = = = 2 times
EBIT 3,00,000

STATEMENT OF PROFIT (Variable cost is Rs.12 per unit)

Particulars Rs.

Sales (60,000 x 20) 12,00,000

Less: variable cost (60,000 x 12) 7,20,000

Contribution 4,80,000

Less: Fixed cost (60,000 x 5) 3,00,000

EBIT 90,000

contribution 4,80,000
Operating leverage = = = 2.67 times
EBIT 90,000

Illustration: 3

Find out degree of operating leverage from the following data:

EBIT (2015) Rs.80,000 Sales (2015) Rs.40,000

EBIT (2016) Rs.1,00,000 Sales (2016) Rs.56,000

Solution:
% change in EBIT
Degree of operating leverage (DOL) =
% change in Sales
20,000
% change in EBIT = x 100 = 25%
80,000

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 16,000
% change in EBIT = x 100 = 40%
40,000
0.25
DOL= x 100 = 62.5%
0.40
Illustration: 4
Gandhi Ltd. has a choice of the following three financial plans:

Particulars Plan I Plan II (Rs.) Plan III (Rs.)

(Rs.)

Equity share capital 12 lakhs 10 lakhs 4 lakhs

10% Debentures 8 lakhs 10 lakhs 16 lakhs

EBIT 5 lakhs 5 lakhs 5 lakhs

You are required to ascertain the financial leverage in each case and
interpret it.
Solution:

PROFITABILITY STATEMENT

Particulars Plan I (Rs.) Plan II (Rs.) Plan III (Rs.)

EBIT 5,00,000 5,00,000 5,00,000

Less: Interest @ 10% 80,000 1,00,000 1,60,000

EBT 4,20,000 4,00,000 3,40,000

EBIT 5,00,000 5,00,000 5,00,000

Financial leverage =
EBT 4,20,000 4,00,000 3,40,000
= 1.19 times = 1.25 times = 1.47 times

Analysis:

Financial leverage is measure of the risk of operating with debt

financing. From the above statement, it is quite evident that if the
amount of debt financing is proportionately greater in comparison with
the equity capital, the degree of financial leverage also will be higher as
in the case of financial plan III (i.e., 1.47 times)
Illustration: 5

The capital structure of Son Gilbert Ltd. consists of the following

securities:

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Particulars Amount

22,500 10% Preference shares of Rs.100 each. 22,50,000

5, 00,000 Equity shares of Rs.10 each. 25,00,000

The company’s operating profit is Rs.6,00,000. The company is in 40%

tax bracket.
You are requiring to find out the financial leverage of the company. What
would be the new financial leverage if the operating profit increases to
Rs.9,00,000 and interpret your results.
Solution:

Statement showing Earnings before tax

Particulars (Rs.)

EBIT 5,00,000

Less: Preference dividend (pre-tax basis)

(22,50,000 x 10% = 2,25,000 x 100 / 60) 3,75,000

EBT 2,25,000

EBIT 6,00,000
Financial leverage =
EBT 2,25,000
= 2.27 times
Statement showing Earnings before tax (Operating profit Rs.9,00,000)

Particulars (Rs.)

EBIT 9,00,000

Less: Preference dividend (Gross) 3,75,000

EBT 5,25,000

EBIT 9,00,000
Financial leverage =
EBT 5,25,000
= 1.71 times

Analysis: the present financial leverage is 2.67 times. It means 1%

change in EBIT will cause 2.67% change in EBT in the same direction.

104
LET US SUM UP
In the Leverage analysis, the main focus is on the measurement of the
relationship between the two variables rather than measuring the
variables. The measurement of leverages is the technique used by the
business firms to measure the Risk – Return relationship of the firm
operating and financial activities. Leverage is the term which is
commonly used to describe the organizations’ ability to utilize the assets
which are having fixed costs (or) different sources of funds to increase
the returns to the firm. It is important to do timely and accurate leverage
analysis for success of a firm. The value of degree of financial leverage
must be greater than 1If the value of degree of financial leverage is 1,
then there will be no financial leverage.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. __________ leverage is one of the techniques to measure the impact
of changes in sales which lead for change in the profits of the company.
a) Financial b) Operating
c) Combined d) All of the above
2. Operating leverage =__________.
a) Sales/EBT b) Contribution/EBIT
c) Sales/ EBIT d) Contribution/EBT
3 Combined leverages = __________.
a) Sales/EBT b) Contribution/EBIT
c) Sales/ EBIT d) Contribution/EBT
4. Degree of Financial leverage (DFL) = __________.
a) EBIT / EBT b) EBT/EBIT
c) Sales/EBT d) Contribution/EBIT
5. Contribution minus fixed Cost = __________.
a) Sales b) Variable Cost
c) Fixed Cost d) Net Income
GLOSSARY

Leverage : Buying on margin

Operating : doing business to manage the expenses

105
Sales : Exchange of commodity for money

Return on : The profit made beyond the investment.

Investment

Risk : unpleasant happening or having a bad result.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.

7. Sudarsana Reddy G., (2017), Financial Management Principles and

Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

106
Unit 11

CAPITAL STRUCTURE
STRUCTURE
Overview
Learning Objectives
11.1 Introduction
11.2 Definitions of Capital Structure
11.3 Importance of Capital Structure
11.4 Optimum Capital Structure
11.5 Factors determining Capital Structure
11.6 Types of Capital Structure
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Capital Structure of a company refers to the composition or make up of
its capitalization and it includes all long-term capital resources”. The unit
deals with the concept of capital structure with the objectives and
determinants of capital structure.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• describe the concept of capital structure

• explain the objectives of capital structure

• list out the factors determining capital structure
• explain the theories of capital structure.

11.1 INTRODUCTION
Capital is the major part of all kinds of business activities, which are
decided by the size, and nature of the business concern. Capital may be
raised with the help of various sources. If the company maintains proper
and adequate level of capital, it will earn high profit and they can provide
more dividends to its shareholders. Meaning of Capital Structure Capital

107
structure refers to the kinds of securities and the proportionate amounts
that make up capitalization. It is the mix of different sources of long-term
sources such as equity shares, preference shares, debentures, long-
term loans and retained earnings. The term capital structure refers to the
relationship between the various long-term source 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. Capital
structure is the permanent financing of the company represented
primarily by long-term debt and equity.
11.2 DEFINITIONS OF CAPITAL STRUCTURE
According to Gerstenbeg, “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, reserve, share, and bonds.
According to Schwartz, “The capital structure of a business can be
measured by the ratio of various kinds of permanent loan and equity
capital to total capital”.
11.3 IMPORTANCE OF CAPITAL STRUCTURE

Capital structure decision is one of the strategic decisions taken by the

financial management. Considerable attention is required to decide the
mix up of various sources of finance. A judicious and right capital
structure decision reduces the cost of capital and increases the value of
a firm while a wrong decision can adversely affect the value of the firm.
Various sources of finance differ in terms of risk and cost. Hence, there
is utmost need of designing an appropriate capital structure.
Capital structure decisions are of great significance due to the following
reasons:
i) Capital structure determines the risk assumed by the firm.
ii) Capital structure determines the cost of capital of the firm.
iii) It affects the flexibility and liquidity of the firm,
iv) It affects the control of owners of the firm.
11.4 OPTIMUM CAPITAL STRUCTURE
An optimal capital structure is the one that has the best mix of debt and
equity financing that maximizes the market value of the company and
minimizes its cost of capital. In fact, a company would focus to minimize
its weighted average cost of capital so that funds can be acquired at the
lowest cost. However, some economists also assert that if there are no

108
taxes, agency cost and efficient flow of information then the value of firm
will not be affected by its capital structure. But in real word there are
taxes, agency cost and asymmetric information. Therefore, one needs to
have an optimal capital structure that minimizes the overall cost.
However, it is difficult to arrive at a particular mix of debt and equity and
call it as an optimal.

11.5 FACTORS DETERMINING CAPITAL STRUCTURE

The following factors are considered while deciding the capital structure
of the firm.
i) Leverage: It is the basic and important factor, which affect the capital
structure. It uses the fixed cost financing such as debt, equity and
preference share capital. It is closely related to the overall cost of capital.
ii) Cost of Capital: Cost of capital constitutes the major part for deciding
the capital structure of a firm. Normally long- term finance such as equity
and debt consist of fixed cost while mobilization. When the cost of
capital increases, value of the firm will also decrease. Hence the firm
must take careful steps to reduce the cost of capital.
iii) Nature of the business: Use of fixed interest/dividend bearing
finance depends upon the nature of the business. If the business
consists of long period of operation, it will apply for equity than debt, and
it will reduce the cost of capital.
iv) Size of the company: It also affects the capital structure of a firm. If
the firm belongs to large scale, it can manage the financial requirements
with the help of internal sources. But if it is small size, they will go for
external finance. It consists of high cost of capital.
v) Legal requirements: Legal requirements are also one of the
considerations while dividing the capital structure of a firm. For example,
banking companies are restricted to raise funds from some sources.
vi) Requirement of investors: In order to collect funds from different
type of investors, it will be appropriate for the companies to issue
different sources of securities.
vii) Government policy: Promoter contribution is fixed by the company
Act. It restricts to mobilize large, long-term funds from external sources.
Hence the company must consider government policy regarding the
capital structure.
11.6 TYPES OF CAPITAL STRUCTURE
1. Horizontal Capital Structure: The capital structure in which the
proportion of debt component is zero is Called as a Horizontal Capital

109
structure. Thus, the capital mix is of equity or retained earnings. Thus,
there is zero leverage.
2. Vertical Capital Structure: In a vertical capital structure, the capital
comprises of only that portion of equity which is necessary to form an
organization, rest by debt. Any incremental need for funds is met by
issuing debt.

3. Pyramid Shaped Capital Structure: In such a structure there is high

proportion of equity as compared to debt. It is useful when the cost of
equity as compared to debt.

4. Inverted Pyramid Capital Structure: It is the opposite of pyramid

capital structure. In this, there is small proportion of equity as compared
to debt.

LET US SUM UP
There is no specific model to design the Capital structure suitable for
business undertakings. Therefore, the Companies must frame their own
structure suiting to the specific situations, nature of the industry and type
of business. Designing Capital structure is nothing but deciding the
volume of Preference shares and long-term debt to be included in the
long-term funds of the company. There are many theories and
arguments regarding optimum Capital structure of business firms.
CHECK YOUR PROGRESS

Choose the Correct Answer:

1. The term Capital structure refers to the relationship between
__________.
a) Debentures, preference and equity shares
b) Preference and equity shares
c) Total of all long-term liabilities
d) Total of all outsiders’ funds
2. __________ is not a pattern of Capital structure.
a) Equity and preference shares
b) Only equity shares
c) Equity shares and short-term borrowings
d) Equity, preference shares and debentures

3. __________ is not the factors determine capital structure

a) Leverage b) Government policy

110
c) Size of the business d) Competition
4. __________ is Capital structure.
a) A balance between the assets and liabilities of the firm

b) A balance between the revenue and expenditure of the firm

c) A distribution of equity and debt
d) None of the above

5. The technical term for setting rates is __________.

a) Price determination b) Selling price
c) Profit making d) Utility ratemaking

GLOSSARY

Theories : a set of Principles on which an activity is based

Long term : Occurring over or relating to a long period of time.

Debt : a sum of money that is owed or due.

Decisions : A choice or a judgement after thinking various

possibilities.

Optimum : most conducive to a favourable outcome

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.

111
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.

WEB RESOURCES
1. [Link]
structure-overview/
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

112
Unit 12

THEORIES OF CAPITAL STRUCTURE

STRUCTURE
Overview
Learning Objectives
Learning Objectives
12.1 Introduction
12.1.1 Overview of Capital Structure
12.2 Features of Sound Capital Structure
12.3 Assumptions of Capital Structure
12.4 Pattern of Capital Structure
12.5 Theories of Capital Structure
12.5.1 Net Income Approach
12.5.2 Net Operating Income Approach
12.5.3 Modigliani and Miller Approach
12.5.4 Traditional Approach
12.6 Graded Illustration
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Capital is required at the stage of establishment, expansion,
diversification etc., Capital can be raised from different sources. That is
equity, debentures, preference shares, loans, retained earnings etc.
Capital structure of any firm is the combination of different sources of
finance used by the firm. Capital structure means the arrangement of
capital from different sources so that the funding needs of the business
are satisfied. Different types of capital impose different types of risks on
a company and hence capital structure affects the value of a company.
For example, if a company has raised funds in the form of equity shares
and bonds, we could say that company’s capital structure includes debt
and equity. Bank loans retained earnings and working capital might also
be part of the company’s capital structure. “Capital structure means the
type of securities to be issued and proportionate amounts that make up

113
the capitalisation. In this unit, let us explain the meaning and definition of
capital structure, features of capital structure, various theories of capital
structure and assessment of value of firm under each of these theories.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• define the Capital Structure and List out the features of Capital
Structure
• list out the factors determining Capital Structure and Importance
of Capital Structure
• discuss various theories of Capital Structure and assess the
value of firms under each of these theories.
12.1 INTRODUCTION
Economists speak of “capital” as wealth which is used in the production
of additional wealth. Businessmen frequently use the word capital in the
sense of total assets employed in a business. The accountant uses the
word in the sense of net assets, or stockholders’ interest as shown by
the balance sheet or the net worth of the stockholders’ equity. In law,
Capital means capital stock. The capital structure is made up of debt
and equity securities which comprise a firm’s finance of its assets. It is
the permanent financing of a firm represented by long-term debt, plus
preferred stocks and net worth.
The determination of the degree of liquidity of a firm is no simple task. In
the long run, liquidity may depend on the profitability of a firm; but
whether it survives to achieve long-run profitability depends to some
extent on its capital structure. This term includes only long-term debt and
total stockholders’ investment. It may be defined as one including both
short-term and long-term funds.
12.1.1 Overview of Capital Structure
In the recent past, there was a tremendous improvement in the capital
market. There is an abundant amount of funds which are ready for
investment. But the basic question is the rate of return on investment
which is demanded by the investors. To satisfy the expected rate of
return by the investor, business firms have to make different
combinations in long term debt and equity. This may require to have
efficient leverage of debt and equity to meet the obligation towards
investors. The fund manager has to use different long-term sources of
funds judiciously such that the overall cost of capital is maintained at
optimum level.

114
12.2 FEATURES OF SOUND CAPITAL STRUCTURE
The capital structure of a company should aim at maximising the long-
term market value of its equity shares. The financial management of a
company is expected to design and develop a sound capital structure
which is most advantageous for the company and its equity
shareholders.
i) Economy: A sound capital structure must ensure the minimum cost of
capital. Minimisation of the cost of financing enables the firm to increase
its surplus and wealth. Use of leverage helps to make the capital
structure economical.
ii) Safety: Under a sound capital structure fluctuations in earnings
should not involve heavy strain on the company’s financial structure.
Debt should be used to the extent that the burden of fixed charges does
not create the danger or risk of insolvency. The company must have
sufficient liquidity to meet its obligations in time.
iii) Balance: There must be a judicious balance between different types
of securities so that there is neither excess of debt nor the lack of trading
on equity. Risk and return should be properly balanced.
iv) Flexibility: The capital structure should not be rigid but dynamic
enough to be adapted to the changing needs of the company. It should
permit the company to raise further finance for expansion,
modernisation, etc. easily and economically.
v) Control: A sound capital structure should enable the existing group of
shareholders to retain the control of the company’s management in their
hands. The risk of the loss of control and interference in the autonomy of
management should be minimum.
vi) Simplicity: The capital structure should be easy to understand and
simple to operate. Use of several types of securities with varied terms
and conditions may create confusion among investors. It may also result
in an increase in the administrative cost of the company.
12.3 ASSUMPTIONS OF CAPITAL STRUCTURE
i) The organization uses only two types of capital, such as debt capital
and equity capital.
ii) The corporation tax does not exist and there is no bankruptcy cost.
iii) The organization distributes its 100% earnings through dividend.
iv) The organization has no retained earnings.
v) The operating earnings of an organization is given for a particular
date and expected to increase further.
vi) The total assets of an organization remain constant.
vii) The organization would continue its businesses perpetually.
viii) The business risk is independent of capital structure and financial
risks.

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ix) The organization can bring changes in capital structure without any
transaction cost.
12.4 PATTERN OF CAPITAL STRUCTURE

In the case of a new company, the capital structure may be in any

of the following four patterns:
1. Capital structure with equity shares only.
2. Capital structure with both equity shares and preference shares.
3. Capital structure with equity shares and debentures outstanding.
4. Capital structure with equity shares, preference shares and
debentures outstanding.
The choice of the company to adopt an appropriate capital structure
depends upon a number of factors such as the nature of the company’s
business, regularity of its earnings, conditions of the money market,
attitudes of the investors and such other factors. The company has to
decide how much finance is to be raised by the issue of shares (i.e.,
equity) and how much to be raised through borrowings (i.e. debt). There
is an important difference between these two methods viz. equity and
debt.

Equity consists of shareholders’ or owners’ funds on which payment of

dividend depends upon the company’s profits whereas debt or borrowing
represents a liability on which interest must be paid irrespective of the
profits i.e. interest must be paid whether the company makes profit or
loss. If the debt- proportion in the capital structure is high, it increases
the risk and it may lead to financial insolvency of the company in
adverse times. However, raising of funds through debt is cheaper as
compared to raising funds through equity. This is because interest on
debt is allowed as an expense for tax purposes whereas dividend on
shares is not allowed as expense as it will be paid only out of net profits,
if any. Therefore payment of dividend does not result in any benefit to
the company.
This means if the company is in the 50% tax bracket, and pays interest
at 14 percent on its debentures, the effective cost to it would be only half
of it i.e., 7 percent. But if the amount is raised by the issue of 14%
preference shares, the cost of raising this amount would be 14 percent.
Therefore, raising of funds by borrowing (i.e., through debt) is cheaper
resulting in higher availability of profits to the shareholders. This
increases the earnings per share (EPS) of the company which is the
basic objective of the company i.e., maximisation of wealth.

116
12.5 THEORIES OF CAPITAL STRUCTURE
Though there are many theories advocated by the noted economists, the
two different views have been drawn regarding capital structure of the
firm. One view states that the value of the firm depends on the capital
structure in-turn it emphasizes on the cost of capital. It advocates that
the optimal capital structure of the firm at which the overall cost of capital
(Ko) will be minimum and thereby the value of the firm increases. The
second viewpoint states that the optimal capital structure will not have
any bearing on the value of the firm and the market value of the firm
remains the same for any combination of capital ratio. Thus, the capital
structure of the firm is irrelevant with regard to the value of the firm.
To put forth the above view point some of the theories are
discussed in brief:
12.5.1 Net Income Approach
According to this approach, the cost of equity capital and cost of debt
capital are assumed to be independent to the capital structure. The
value of the firm rises by the use of more and more leverage and the
weighted average cost of capital declines. The cost of debt rD and cost
of equity rE remain unchanged when D/E varies. Because of rD and rE
being constant with respect to D/E, it means that rA, the average cost of
capital is-

rA = rD(D/D+E) + rE (E/D+E)
it declines as D/E increases. This occurs because when D/E increases,
rD which is lower than rE, has a higher weight in the calculation of rA.
Assumptions
i) The use of debt does not change the risk perception of investors, as
a result, the equity capitalisation rate and the debt capitalisation rate
remain constant with changes in leverage.
ii) The debt capitalisation rate is less than the equity capitalisation rate.
iii) Corporate income taxes do not exist.
12.5.2 Net Operating Income Approach
According to the net operating approach, the cost of equity increases in
accordance with leverage. Due to which the weighted average cost of
capital remains constant and the value of the firm also remains constant
as leverage is changed. The overall capitalization rate and the cost of
debt remain constant for all degrees of leverage.

RA = rD (D/D+E) +rE(E/D+E)

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RA and rD are constant for all degrees of leverage.
The cost of equity is-
RE = rA + (rA-rD)D/E

The net operating income position has been advocated by David

Durand. He argued that the market value of a firm depends on its net
operating income and business risk. The change in the degree of
leverage employed by a firm cannot change these underlying factors. It
merely changes the distribution of income and risk between debt and
equity without affecting the total income and risk which influence the
market value of the firm.
Assumptions
i) The market capitalises the value of the firm as a whole. Thus the
split between debt and equity is not important.
ii) The market uses an overall capitalisation rate to capitalise the net
operating income. This rate depends on the business risk. If
business risk is assumed to remain unchanged, the capitalisation
rate is a constant.
iii) The use of the costly debt funds increases the risk of shareholders.
This causes the equity capitalisation rate to increase. There the
advantage of debt is offset exactly by the increase in equity
capitalisation rate.

iv) The debt capitalisation rate is a constant.

v) Corporate income taxes do not exist.
12.5.3 Modigliani and Miller Approach
This theory was first proposed by Franco Modigliani and Merton Miller in
their classic contribution in capital structure which is regarded by many
as the most important paper on modern finance. This work stands as the
watershed between old finance and essentially loose connection of
beliefs based on accounting practices, rules of thumb and modern
financial economics, with its rigorous mathematical theories and
carefully documented empirical studies.
Assumptions
i) No corporate taxes.
ii) Perfect market.
iii) Expected earnings of all firms have the same risks.
iv) Investors act rationally.
v) The cut-off point of investment is capitalization rate.

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vi) Earnings are distributed to the shareholders.
The value of the firm is equal to its expected operating income divided
by the discount rate appropriate to its risk class. It is independent of its
capital structure.
R = r+E = o/r
r = Market value of the firm.

E = Market value of equity.

D = Market value of stock.
K = Discount rate applicable.

12.5.4 Traditional Approach

The Traditional approach is a combination of net income approach and
net operating income approach. This approach is also known as the
intermediate approach. According to the traditional approach, there is an
optimal capital structure and the management can increase the total
value of the firm through judicious use of financial leverage. Although
investors raise the required rate of return on equity in response to
increased risk perception caused by increased proportion of debt in
capitalisation, the increase in cost of equity capital does not entirely
offset the benefit of using cheaper debt funds. The response of
capitalisation costs to financial leverage can be divided into three
phases. The cost of debt remains constant in all the three phases. The
equity capitalisation cost is assumed to rise at an increasing rate with
financial leverage.
In the first phase, the overall cost of capital declines with financial
leverage because the rise in cost of equity does not entirely offset the
benefit incurred by using the cheaper fixed cost debt. The second phase
contains the only point at which the benefits of using cheaper debt are
entirely offset by rise in the cost of equity. At this point the overall cost of
capital is minimum. The optimum capital structure is at this point. After
this point, the third phase starts. The overall cost of capital begins to rise
because the rise in cost of equity is more the benefits of cheaper debt.
At the optimum structure, the firm’s overall cost of capital (weighted
average cost of capital) is lowest and its value is highest.
Thus, the traditional approach to capital structure implies that-
i) The cost of capital is dependent on the capital structure of the firm
and

ii) there is an optimal capital structure.

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12.6 GRADED ILLUSTRATION
I. EBIT-EPS Analysis
Illustration: 1

Bangaj Ltd. a widely held company is considering a major expansion of

its production facilities and the following financing alternatives are
available:

Alternatives (Rs. in lakh)

X Y Z
Equity share capital (Rs. 10 each) 60 30 10
12% Debentures - 20 25
15% Loan from a financial institution - 10 25

Expected rate of return before tax is 20%. The rate of dividend of the
company is not less than 18%. The company at present has low debt.
Corporate taxation is 35%. Which of the alternatives you would choose
Solution:

Particulars Alternatives
A B C
(Rs. in lakh) (Rs. in lakh) (Rs. in lakh)

Earnings before (60 × 20%) (60 × 20%) (60 × 20%)

interest 12.00 12.00 12.00
& taxes (EBIT)
Less: Interest on - - (20 × 12%) (25 × 12%)
Debentures 2.40 3.00
Interest on loan - - (10 × 15%) (25 × 15%)
1.50 3.75
Earnings before tax 12.00 8.10 5.25
(EBT)
Less: Tax @ 35% 4.20 2.835 1.8375
Earnings after tax 7.80 5.265 3.4125
(EAT)
Earnings per share 7.80 5.265 3.4125
6
: 1.30 : 1.755 : 3.4125
3 1
(EPS)

Note: EAT/No. of equity shares

Illustration: 2

Kaleem Ltd. has equity share capital of Rs. 12,00,000 divided into
shares of Rs. 100 each. It wishes to raise further Rs. 6,00,000 for

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 expansion-cum-modernisation scheme. The company plans the
following financing alternative:
Plan A – By issuing equity shares only.

Plan B – Rs. 2,00,000 by issuing equity shares and rs. 4,00,000 by

through debentures @ 10% p.a.
Plan C – Rs. 2,00,000 by issuing equity shares and Rs. 4,00,000 by
issuing 9% Preference shares.
Plan D – By raising term loan only at 10% p.a.
You are required to suggest the best alternative giving your comment
assuming that the estimated EBIT after expansion is Rs. 2,25,000 and
corporate rate of tax is 40%.
Solution:

Statement showing EPS under the various Financing plans

Particulars Plan A Plan B Plan C Plan D

Rs. Rs. Rs. Rs.

Earnings before 2,25,00 2,25, 2,25,00 2,25,000
interest and taxes 0 000 0
(EBIT) 4,00,000 6,00,00 60,000
Less: Interest on - ×10% 40,0 - 0×10
debt 00 %
2,25,00 1,85, 2,25,00 1,65,000
0 000 0
Earnings before tax 66,000
(EBT) 90,000 74,0 90,000
Less: Tax @ 40% 00 4,00,00
1,35,00 1,11, 0×9% 1,35,00 99,000
Earnings after tax 0 000 0 -
Less: Pref. dividend - - 36,000

Profit for equity

𝟏, 𝟑𝟓, 𝟎𝟎𝟎 𝟏, 𝟏𝟏, 𝟎𝟎𝟎
Shareholders 1,35,00 1,11, 99,000 99,000
𝟏𝟖, 𝟎𝟎𝟎 𝟏𝟒, 𝟎𝟎𝟎 𝟗𝟗, 𝟎𝟎𝟎
0 000
𝟏𝟒, 𝟎𝟎𝟎 𝟗𝟗,𝟎𝟎𝟎
EPS:
𝑷𝒓𝒐𝒇𝒊𝒕 𝒇𝒐𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝟏𝟐,𝟎𝟎𝟎
𝑵𝒐.𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔 7.50 7.93 7.07 8.25

121
 Illustration: 3
JSRTP Ltd. has the following capital structure;

/ Rs. in lakh
Equity shares: 2 lakh Nos. @ Rs. 10 each 20
Reserves & Surplus 5
11% Debentures each of face value Rs. 100 15
40

The company needs Rs. 10 lakhs to execute a new project which will
raise its operating profit (EBIT) from the current level of Rs. 6 lakhs to 8
lakh. It is considering the following options:
I. Issue of equity shares at a premium of Rs. 10 each for the entire
amount.
II. Issue of 13% Debentures for 10 lakhs required additionally.
III. Issue of equity shares for Rs. 6 lakhs at a premium of Rs. 30 per
share and issue of 13% Debentures for the balance amount.

The company’s tax rate is 50%. Evaluate the three options and advise
the company.
Solution:

Statement showing EPS under various financial plans

Particulars Option I Option II Option III

Earnings before Interest 8,00,000 8,00,000 8,00,000
& taxes (EBIT)
(15 lakh 1,65,000 15 lakhs 1,65,000 15 lakhs 1,65,000
× × ×
Less: Interest 11%) 11% 11%
1,30,000 52,000
10 lakhs 4 lakhs
× ×
13% 13%
Earnings before tax
(EBT) 6,35,000 5,05,000 5,83,000
6,35,000
×
Less: Tax 50% 3,17,500 5,25,000 2,52,500 5,83,000 2,91,500
× ×
50% 50%
3,17,500 2,52,500 2,91,500
Earnings after tax (EAT)

EPS:
𝐸𝐴𝑇 2,52,500 2,91,500
𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 3,17,500
1.27 2,00,000 1.2625 2,15,000 1.36
2,50,000

Illustration: 4
Martha Ltd. needs Rs. 10,00,000 for installation of a new factory which
would yield an annual EBIT of Rs. 1,80,000. The company has the

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objective of maximising the earnings per share. It is considering the
possibility of issuing equity shares plus raising debt of Rs. 1,50,000, Rs.
4,50,000 or Rs. 7,50,000. The current market borrowings were to
exceed Rs. 6,00,000. Cost of borrowings are indicated as under:
Upto Rs. 2,00,000 8% per annum
Between Rs. 2,00,001 and Rs. 5,00,000 10% per annum
Between Rs. 5,00,001 and Rs. 7,50,000 12% per annum

Assuming he tax rate to be 40%, work out the EPS and the scheme
which would meet the objective of the management.
Solution:
Statement showing EPS under different plans

Particulars Plan I Plan II Plan III

Equity: 8.5 lakh Equity: Rs. 5.5 Equity Rs. 2.5
lakh lakh
Debt Rs. 1.5
lakh Debt Rs. 4.5 Debt Rs. 7.5
lakh lakh
Rs.
Rs. Rs.

EBIT 1,80,000 1,80,000 1,80,000

Less: Interest on (1,50,000 × (2,00,000 × 8%) (2,00,000 ×
debt 8%) 12,000 16,000 8%) 16,000
(2,50,000 × (3,00,000 ×
10%) 25,000 10%) 30,000
(2,50,000 ×
12%) 30,000

EBT 1,68,000 1,39,000 1,04,000

(1,68,000 × (1,39,000 × (1,04,000 ×
Less: Tax
40%) 67,200 40%) 55,600 40%) 41,600

EAT 1,00,800 83,400 62,400

1,00,800 83,400 62,400

EPS = : 2,96 : 3.79 : 4.99
𝐸𝐴𝑇 34,000 22,000 12,500
𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

123
[Link] Income Approach
Illustration: 5
Bajanlal Ltd. is expecting an annual EBIT of Rs. 2,00,000. The company
has Rs. 2,00,000 in 10% Debentures. The equity capitalisation rate (ke)
is 12%. You are required to ascertain the total value of the firm and
overall cost of capital. What happens if the company borrows Rs.
2,00,000 at 10% to repay equity capital?
Solution:
Value of firm
Under NI approach = Market value of equity + Market value of debt
(i) Calculation of Market value of equity

Rs.
Earnings before interest & taxes (EBIT) 2,00,000
Less: Interest (2,00,000 × 10%) 20,000
Earnings available to equity shareholders 1,80,000
Earnings available to equity shareholders
Market value of equity = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒)
1,80,000
= 12%
= Rs. 15,00,000

(ii) Calculation of value of firm

Value of firm = Market value of equity + Market value of debt

= 15,00,000 + 2,00,000 = Rs. 17,00,000

(iii) Calculation of overall cost of capital (k0)
𝐸𝐵𝐼𝑇 2,00,000
k0 = × 100 = × 100 = 11.76%
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 17,00,000

Calculation of value of firm when the company borrows Rs. 2 lakh

to pay off equity capital
(i) Calculation of market value of equity

Rs.
EBIT 2,00,000
Less: Interest (4,00,000 × 10%) 40,000
Earnings available to equity shareholders 1,60,000
1,60,000
Market value of equity = 12%
= Rs. 13,33,333

(ii) Calculation of value of firm

Value of firm = Market value of equity + Market value of debt

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 = 13,33,333 + 4,00,000 = Rs. 17,33,333
(iii) Calculation of overall cost of capital (k0)
𝐸𝐵𝐼𝑇 2,00,000
k0 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 × 100 = 17,33,333 × 100 = 11.54%

I. Net Operating Income Approach

Illustration: 6

Najil Ltd. has an EBIT of Rs. 4,50,000. The cost of debt is 10% and the
outstanding debt is Rs. 12,00,000. The overall capitalisation rate (k0) is
15%. Calculate the total value of the firm and equity capitalisation rate
under NPI approach.
Solution:
(i) Calculation of Market value of firm
𝐸𝐵𝐼𝑇
Market value of firm = 𝑂𝑣𝑒𝑟𝑎𝑙𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑘0) × 100
4,50,000
= = Rs. 30,00,000
15%

(ii) Calculation of Market value of equity

Market value of firm = Market value of equity + Market value of debt
∴ Market value of equity = Market value of firm – Market value of debt
= 30,00,000 – 12,00,000 = Rs. 18,00,000

(iii) Calculation of earnings available to equity shareholders

Rs.
EBIT 4,50,000
Less: Interest (12,00,000 × 10%) 1,20,000
Earnings available to equity shareholders
3,30,000

(iv) Calculation of equity capitalization rate (ke)

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
ke = × 100
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
3,30,000
= 18,00,000 × 100 = 18.33%

NI and NOI Approach

Illustration: 7
Company A and Company B are in the same risk class and identical. In
all respects except that company A uses debt. While company B does
not. Levered company has Rs. 20 lakh debentures. Carrying 12% rate of
interest. Both Companies earn 20% before interest and taxes on their
total assets of Rs. 50 lakhs. Assume perfect capital markets, tax rate of

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50% and capitalisation rate of 10% for an equity company. Compute the
value of both companies under (a) Net Income (NI) approach; and (b)
Net operating Income (NOI) approach.
Solution:
(a) Value of Company Under NI Approach:
Market Value of Equity + Market Value of Debt.
(i) Computation of market value of equity

Company A Company B
(Geared Co.) (Ungeared
Co.)
Earnings before interest & Taxes 10,00,000 10,00,000
(EBIT)
(50,00,000 × 20%) 2,40,000 Nil
Less: Interest on debentures
(20,00,000 × 12%) 7,60,000 10,00,000
Earnings before tax (EBT) 3,80,000 5,00,000
Less: Tax @ 50% 3,80,000 5,00,000
Earnings available to equity
shareholder
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
Market value of Equity = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒)
3,80,000
Company A = 10%
= Rs.38,00,000
5,00,000
Company B = 10%
= Rs.50,00,000

(ii) Computation of Value of Company

Value of Company = Market value of Equity + Market value of debt

Company A = 38,00,000 + 20,00,000 = Rs.58,00,000
Company B = 50,00,000 + 0 = Rs.50,00,000

(b) (i) Value of Company A (Geared Co.) under NOI Approach

Market value of Equity + Market value of debt
𝐸𝐵𝐼𝑇 (100%−𝑇𝑎𝑥) 10,00,000 (100%∶50%)
Market value of Equity = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝑘𝑒) = 10%
5,00,000
= 10%
= Rs.50,00,000

Market value of debt = Value of debt × Tax Rate

= 20,00,000 × 50% = Rs.10,00,000

∴ Value of Company A = Market value of Equity + Market value of debt

= 50,00,000 + 10,00,000 = Rs.60,00,000

126
(ii)Value of Company B (Ungeared Co.) under NOI Approach =
Market value of Equity Only.
𝐸𝐵𝐼𝑇 (100%−𝑇𝑎𝑥) 10,00,000 (100%−50%)
Market value of Equity = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦
= 10%
5,00,000
= 10%
= Rs. 50,00,000

∴ Value of Company B = Rs.50,00,000

II. Traditional Approach

Illustration: 8
Kincaid Ltd. has a EBIT of Rs. 6,00,000. Presently the company is
entirely financed by equity of Rs.40,00,000 with equity capitalisation rate
of 16%. It is contemplating to redeem a part of its capital by introducing
debt financing. It has two options – to raise debt to the tune of 30% will
cost 10% and equity capitalization rate will rise to 17%. However, if the
firm opts for 50% debt, it will cost 12% and equity capitalization rate will
be 20%. Compute the market value of the firm, market value of equity
and the overall cost of capital.
Solution:
Statement showing Market value of firm, equity and overall cost of
capital
Particulars 0% Debt 30% Debt 50% Debt
(Rs. 12 lakh) (Rs. 20 lakh)
Rs. Rs. Rs.
EBIT 6,00,000 6,00,000 6,00,000

Less: Interest - (12lakh × 1,20,000 (20lakh

10%) 2,40,000 ×
12%)
Earnings available to 6,00,000 4,80,000 3,60,000
equity shareholders
Equity capital rate 16% 17% 20%
(ke)
Market value of 6,00,000 3,60,000 3,60,000
( 16 % ) = ( 20% ) = ( 20% ) =
equity
37,50,000 28,23,529 18,00,000
Add: Market value of Nil 12,00,000 20,00,000
debt
Market value of firm 37,50,000 40,23,529 38,00,000

127
Overall cost of capital (ko)
𝐸𝐵𝐼𝑇 6,00,000
= × 100 = ( × 100) 16%
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚 37,50,000
6,00,000 6,00,000
(40,23,529 × 100) 14.9% (38,00,000 × 100) 15.79%

III. Modigliani Miller Approach

Illustration: 9
Two firms R and S are identical except in the method of financing. Firm
R has no debt, while firm S has Rs.3,00,000 8%. Debentures in
financing. Both the firms have a Net operating income (EBIT) of
Rs.1,20,000 and equity capitalization rate of 12%. The corporate tax rate
is 35%. Calculate the value of the firm using MM approach.
Solution:
(i) Computation of value of Firm R which does not use any debt
(unlevered)

Rs.
EBIT 1,20,000
Less: Interest Nil
EBT 1,20,000
Less: Income tax @ 35% 42,000
EAT 78,000
78,000
Value of firm = 12%
= Rs.6,50,000

(ii) Computation of value of Firm S which uses debt (levered)

Value of Firm S = Value of unlevered firm + (Tax rate × Debt)
(Levered)
= 6,50,000 + (0.35 × 3,00,000) = Rs.7,55,000
LET US SUM UP
Capital structure means the arrangement of capital from different
sources so that the funding needs of the business are satisfied. Different
types of capital impose different types of risks on a company and hence
capital structure affects the value of a company. For example, if a
company has raised funds in the form of equity shares and bonds, we
could say that company’s capital structure includes debt and equity.
Bank loans retained earnings and working capital might also be part of
the company’s capital structure. The capital structure of a company
should aim at maximising the long-term market value of its equity
shares. The financial management of a company is expected to design

128
and develop a sound capital structure which is most advantageous for
the company and its equity shareholders.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. __________ means the arrangement of capital from different sources
so that the funding needs of the business are satisfied.
a) Preference Share Capital b) Equity Share Capital
c) Capital Structure d) Cost of Capital
2. Risk of __________ arises due to failure to pay fixed interest
liabilities.
a) Cash Insolvency b) Inadequacy
c) Untimely Capital d) Over-debt
3. The use of fixed interest-bearing securities along with owner’s equity
as sources of finance is known as __________.
a) Equity cum Preference Shares b) Trading on Equity
c) Bonus Shares d) IPO
4. A sound capital structure protects a business enterprise from such
__________ through a judicious mix of debt and equity in the capital
structure.
a) Operation Risk b) Working Capital Risk
c) Inventory Risk d) Financial Risk
5. Under which of the following theories, capital structure is optimum?
a) NI Approach b) NOI Approach
c) Traditional Approach d) MM Approach
GLOSSARY

Capital Structure : Capital structure means the arrangement of

capital from different sources so that the
funding needs of the business are satisfied.
Different types of capital impose different
types of risks on a company and hence
capital structure affects the value of a
company.

Trading on Equity : The use of fixed interest-bearing securities

along with owner’s equity as sources of
finance is known as trading on equity. It is an
arrangement by which the company aims at
increasing the return on equity shares by the
use of fixed interest-bearing securities (i.e.,
debenture, preference shares etc.).

129
Net Income : According to this approach, the cost of equity
Approach capital and cost of debt capital are assumed
to be independent to the capital structure.
The value of the firm rises by the use of
more and more leverage and the weighted
average cost of capital declines. The cost of
debt rD and cost of equity remain unchanged
when D/E varies.

Modigliani and Miller : This theory was first proposed by Franco

Approach Modigliani and Merton Miller in their classic
contribution in capital structure which is
regarded by many as the most important
paper on modern finance. This work stands
as the watershed between old finance and
essentially loose connection of beliefs based
on accounting practices, rules of thumb and
modern financial economics, with its rigorous
mathematical theories and carefully
documented empirical studies.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
structure/top-4-theories-of-capital-structure-with-calculations/65449
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

130
 BLOCK 4

DIVIDEND DECISIONS

Unit 13: Introduction to Dividend Decisions

Unit 14: Models in Dividend Decisions
Unit 15: Forms of Dividend

131
Unit 13

INTRODUCTION TO DIVIDEND
DECISIONS
STRUCTURE
Overview
Learning Objectives
13.1 Introduction
13.2 Meaning of dividend
13.3 Type of dividends
13.4 Meaning of dividend policy
13.5 Nature of dividend policy
13.6 Objectives of dividend policy
13.7 Factors affecting dividend policy
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
The unit deals with the concept of dividend and dividend Policy. The
objectives, importance and the theories of dividend is explained in detail.
Every organisation has to take a wise decision regarding divided
distribution. It involves cumbersome calculations. Therefore, this unit
gives a clarity on the calculation of dividend based on various models.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• describe the concept of dividend decision
• explain the theories of dividend
• interpret the relationship between dividends and stock prices.
13.1 INTRODUCTION
Since the primary objective of financial management is to maximize the
market value of equity shares, we may ask here, what is the relationship
between dividend policy and market price of equity shares?

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Does a high dividend payment decrease, increase or does not affect at
all the market price of equity shares?
These are controversial and unresolved questions in corporate finance.
An attempt has been made in this chapter to find answers for these
questions. Before we deal with different aspects of dividend policy, let us
first understand the concept of dividend.
13.2 MEANING OF DIVIDEND
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders after execution of
retained earnings. It is the reward of the shareholders for investment
made by them in the shares of the company.
In the other words, it is the return that a shareholder gets form the
company out of profit on his shareholding.
According to the Institute of Chartered Accountant of India, “A dividend
is a distribution to shareholders out of profits or reserves available for
this purpose”.
13.3 TYPE OF DIVIDENDS
Dividend is the portion of earnings available to equity shareholders that
are equally (per share basis) distributed among the equity shareholders.
Generally, corporations pay dividends in the form of cash. But cash form
of dividends may take place only when the cash is available with the
company. Sometimes, firms may declare dividends in the form of scrip,
bond, stock and property dividends.
1. Cash Dividends: Cash dividends are, by far, the most popular form
of dividend. In cash dividends, stockholders receive checks for the
amounts due to them. Cash generated by business earnings is used to
pay cash dividends. Sometimes, the firm may issue additional stock to
use proceeds so derived to pay cash dividends or bank may be
approached for the purpose. Generally, stockholders have strong
preference for cash dividends.
[Link] 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.
3. Scrip dividend: Under this form, a company issues the transferable
promissory note to the shareholders, wherein it confirms the payment of

133
dividend on the future date. A scrip dividend has shorter maturity periods
and may or may not bear any interest. These types of dividends are
issued when a company does not have enough liquidity and require
some time to convert its current assets into cash.
4. Property dividend: The Company makes the payment in the form of
assets in the property dividend. The asset could be any of this
equipment, inventory, vehicle or any other asset. The value of the asset
has to be restated at the fair value while issuing a property dividend.
5. Liquidating Dividend: When the board of directors decides to pay
back the original capital contributed by the equity shareholders as
dividends, is called as a liquidating dividend. These are usually paid at
the time of winding up of the operations of the firm or at the time of final
closure.
13.4 MEANING OF DIVIDEND POLICY
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders. It is the reward of
the shareholders for investments made by them in the shares of the
company. The investors are interested in earning the maximum return
on their investments and to maximise their wealth. A company, on the
other hand, needs to provide funds to finance its long-term growth.
If a company pays out as dividend most of what it earns, then for
business requirements and further expansion it will have to depend upon
outside resources such as issue of debt or new shares. Dividend policy
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.
Since dividend is a right of shareholders to participate in the profits and
surplus of the company for their investment in the share capital of the
company, they should receive fair amount of the profits. The company
should, therefore, distribute a reasonable amount as dividends (which
should include a normal rate of interest plus a return for the risks
assumed) to its members and retain the rest for its growth and survival.
13.5 NATURE OF DIVIDEND POLICY
1. Tied-up with retained earnings: A dividend policy is tied-up with the
retained earnings policy. It has the effect of dividing net earnings into
two parts – retained earnings and dividend.

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2. Constitutes important areas of decision-making and problem-
solving for the financial manager: Dividend policy has an influence on
the financing decision of the business. Distribution of dividends reduces
the cash funds of the business and to that extent it has to depend upon
external sources of finance. The cost of funds raised from external
sources is relatively higher than the cost of retained earnings. The
management will decide to pay dividend when the firm does not have
profitable investment opportunities.
3. Impact on shares: Dividend policy of the firm has far-reaching
consequences on the share prices, financing decision, growth rate of the
business, and the wealth of shareholders. Due to the market
imperfections and uncertainty, shareholders give a higher weightage to
the current dividends rather than future dividends and capital gains.
Thus, the payment of dividends influences the market price of shares.
Higher the rate of dividend, greater the price of shares and vice versa.
Higher market price of shares and bigger current dividends enhance the
wealth of shareholders.
4. Optimal dividend policy: Hence dividend is an active decision
variable. It has to be intelligently managed by the financial manager who
should endeavour to formulate an optimal dividend policy, i.e., a policy
impact on the wealth of shareholders.
13.6 OBJECTIVES OF DIVIDEND POLICY
Dividend policy refers to the decision of the board regarding distribution
of residual earnings to its shareholders. The primary objective of a
finance manager is the maximization of wealth of the shareholders.
Payment of dividend leads to increase in the price of shares on the one
hand but leads to a crunch in liquid resources for financing of
prospective projects. There is an inverse relationship between dividend
payment and retained earnings.
The main objectives of a dividend policy are:
1. Wealth Maximization: According to some schools of thought
dividend policy has significant impact on the value of the firm. Therefore,
the dividend policy should be developed keeping in mind the wealth
maximization objective of the firm.
2. Future Prospects: Dividend policy is a financing decision and leads
to cash outflows and also leads to decrease in availability of cash for
financing of profitable projects. If sufficient funds are not available, a firm
has to depend on external financing. Therefore, the dividend policy

135
needs to be devised in such a manner that prospective projects may be
financed through retained earnings.
3. Stable Rate of Dividend: Fluctuation in the rate of return adversely
affects the market price of shares. In order to have a stable rate of
dividend, a firm should retain a high proportion of earnings so that the
firm can keep sufficient funds for payment of dividend when it faces loss.
4. Degree of Control: Issue of new shares or dependence on external
financing will dilute the degree of control of the existing shareholders.
Therefore, a more conservative dividend policy should be followed in
order that the interest of existing shareholders is not hampered.
13.7 FACTORS AFFECTING DIVIDEND POLICY
1. Funds Liquidity: It should be framed in consideration of retaining
adequate working capital and surplus funds for the uninterrupted
business functioning.
2. Past Dividend Rates: There should be a steady rate of return on
dividends to maintain stability; therefore, previous year’s allowed return
is given due consideration.
3. Earnings Stability: When the earnings of the company are stable
and show profitability, the company should provide dividends
accordingly.
4. Debt Obligations: The organization which has leveraged funds
through debts need to pay interest on borrowed funds. Therefore, such
companies cannot pay a fair dividend to its shareholders.
5. Investment Opportunities: One of the significant factors of dividend
policy decision making is determining the future investment needs and
maintaining sufficient surplus funds for any further project.
6. Control Policy: When the company does not want to increase the
shareholders’ control over the organization, it tries to portray the
investment to be unattractive, by giving out fewer dividends.
[Link]’ Expectations: The investment objectives and
intentions of the shareholders determine their dividend expectations.
Some shareholders consider dividends as a regular income, while the
others seek for capital gain or value appraisal.

8. Nature and Size of Organization: Huge entities have a high capital

requirement for expansion, diversification or other projects. Also, some
business may require enormous funds for working capital and other

136
entities require the same for fixed assets. All this impacts the dividend
policy of the company.
9. Company’s Financial Policy: If the company’s financial policy is to
raise funds through equity, it will pay higher dividends. On the contrary, if
it functions more on leveraged funds, the dividend pay-outs will always
be minimal.
10. Impact of Trade Cycle: During inflation or when the organization
lacks adequate funds for business expansion, the company is unable to
provide handsome dividends.
11. Borrowings Ability: The Company’s with high goodwill has
excellent credibility in the capital as well as financial markets. With a
better borrowing capability, the organization can give decent dividends
to the shareholders.
12. Legal Restrictions: In India, the Companies Act 1956 legally abide
the organizations to pay dividends to the shareholders; thus, resulting in
higher goodwill.
13. Corporate Taxation Policy: If the organization has to pay
substantial corporate tax or dividend tax, it would be left with little profit
to pay out as dividends.
[Link] Policy: If the government intervenes a particular
industry and restricts the issue of shares or debentures, the company’s
growth and dividend policy also gets affected.
15. Divisible Profit: The last but a crucial factor is the company’s
profitability itself. If the organization fails to generate enough profit, it
won’t be able to give out decent dividends to the shareholders.
LET US SUM UP
Dividend is a periodic reward given by a company to its shareholders for
their investment in share capital. Dividend is usually recommended by
the board of directors and involves set of calculation. The unit deals with
dividend policy and the theories of policy.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. Retained earnings are __________.

a) Internal sources of funds b) External sources of funds

c) Owner’s fund d) Public fund
2. Dividend is the component of which rate of return?

137
a) Capital return b) Current return
c) Both d) None of the above
3. Dividend can be paid in the form of __________.
a) Share b) Security
c) Cash d) All of the above
4. A policy of consistency in the payment of dividend is known as
__________.
a) Stable dividend Policy b) Strict dividend Policy
c) Liberal dividend Policy d) Moderate Dividend policy
5. As per the Modigliani Miller hypothesis of dividend irrelevance price of
share at year zero is __________.
a) Do + Po/1+Ke b) (D1+p1) X (1+Ke)
c) D1 + P/1+Ke d) 1 – (Do + Po) + Ke
GLOSSARY

Dividend : a reward company gives to its shareholders for

investment.

Policy : a course of principles and actions.

Discounting : A process of converting a value received in a

future time period to an Equivalent value received
immediately.

Decisions : A choice or a judgement after thinking various

possibilities.

Theories : a set of principles on which the practice is based

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition, Chaitanya
Publishing House, Allahabad.

138
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

139
Unit 14

MODELS IN DIVIDEND DECISIONS

STRUCTURE
Overview
Learning Objectives
14.1 Introduction
14.2 Theories of Dividend
14.2.1 Irrelevance Theory of Dividend
14.2.2 Relevance Theory of Dividend
14.3 Graded Illustration
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
According to one school of thought the dividends are irrelevant and the
amount of dividends paid does not affect the value of the firm while the
other theory considers that the dividend decision is relevant to the value
of the firm. A dividend theory 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. In this unit, let us outline the
important theories of dividend namely relevant and irrelevant theory of
dividend. We can also discuss the computation of dividend payable
under each of the theories.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• define theory of dividend
• outline the various theories of dividend
• compute the value of firm under various models of theory of
dividend.
14.1 INTRODUCTION
Dividend refers to that portion of profit which is distributed among the
owners or shareholders of the firm. The finance manager has to take few

140
decisions which are inter – related like investment, financing and
dividend decisions. Dividend decision is related to the shareholder’s
share in the profits of the company. The dividend theories relate with the
impact of dividend on the value of the firm. According to one school of
thought the dividends are irrelevant and the amount of dividends paid
does not affect the value of the firm while the other theory considers that
the dividend decision is relevant to the value of the firm. A dividend
theory 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.
14.2 THEORIES OF DIVIDEND
Thus, there are conflicting theories on dividends.
i) Irrelevance Theory of Dividend
ii) Relevance Theory of Dividend

14.2.1 Irrelevance Theory of Dividend

The advocates of this school of thought argue that the dividends have no
impact on the share price or market value of the firm. The argue that the
shareholders do not differentiate between the present dividend and the
future capital gains and are basically interested in higher returns either
earned by the firm by investing the profits in future profitable
investments. They believe that the profits are distributed as dividends
only if no adequate investment opportunities for investments for the
business.
The various theories supporting this thought are as follows:
1. Modigliani and Millers Approach
1. Modigliani and Miller’s hypothesis: According to Modigliani and
Miller (M-M), dividend policy of a firm is irrelevant as it does not affect
the wealth of the shareholders. They argue that the value of the firm
depends on the firm’s earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision
the split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M – M’s hypothesis of
irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist

3. The firm has a fixed investment policy

141
4. Risk of uncertainty does not exist. That is, investors are able to
forecast future prices and dividends with certainty and one discount rate
is appropriate for all securities and all time periods. Thus, r = K = Kt for
all t.
Under M – M assumptions, r will be equal to the discount rate and
identical for all shares. As a result, the price of each share must adjust
so that the rate of return, which is composed of the rate of dividends and
capital gains, on every share will be equal to the discount rate and be
identical for all shares.
Thus, the rate of return for a share held for one year may be
calculated as follows:
𝐷 + (𝑃1+ 𝑃0 ) 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛𝑠(𝑜𝑛 𝑙𝑜𝑠𝑠)
r= =
𝑃0 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒

Where P^ is the market or purchase price per share at time 0, P, is the

market price per share at time 1 and D is dividend per share at time 1.
As hypothesized by M – M, r should be equal for all shares. If it is not so,
the low-return yielding shares will be sold by investors who will purchase
the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate
will also be equal for all firms under the M-M assumption since there are
no risk differences.
From the above M-M fundamental principle we can derive their valuation
model as follows:
(𝐷1+ 𝑃1 ) (𝐷1+ 𝑃1 )
𝑃0 = 𝑃0 = 𝑟= 𝐾
(1 + 𝑟) (1 + 𝐾)

Multiplying both sides of equation by the number of shares outstanding

(n), we obtain the value of the firm if no new financing exists.
𝑁(𝐷1+ 𝑃1 )
𝑉 = 𝑛𝑃0 =
(1 + 𝐾)

If the firm sells m number of new shares at time 1 at a price of P^, the
value of the firm at time 0 will be
𝑁𝐷1+ (𝑛 + 𝑚)𝑃1 − 𝑚𝑃1
𝑛𝑃0 =
(1 + 𝐾)

The above equation of M – M valuation allows for the issuance of new

shares, unlike Walter’s and Gordon’s models. Consequently, a firm can
pay dividends and raise funds to undertake the optimum investment

142
policy. Thus, dividend and investment policies are not confounded in M –
M model, like waiter’s and Gordon’s models.
Criticism
Because of the unrealistic nature of the assumption, M-M’s hypothesis
lacks practical relevance in the real-world situation. Thus, it is being
criticized on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be
same whether the firm pays dividends or not. But, because of the
transactions costs and inconvenience associated with the sale of shares
to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that
the discount rate (k) should be same whether firm uses the external or
internal financing.
If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is
dropped and uncertainty is considered, dividend policy continues to be
irrelevant. But according to number of writers, dividends are relevant
under conditions of uncertainty.
14.2.2 Relevance Theory of Dividend
The relevance theory of dividend argues that dividend decision affects
the market value of the firm and therefore dividend matters. This theory
suggests that investors are generally risk averse and would rather have
dividends today (“bird-in-the-hand”) than possible share appreciation
and dividends tomorrow. The relevance theory of dividend proposes that
dividend policy affect the share price. Therefore, according to this
theory, optimal dividend policy should be determined which will ensure
maximization of the wealth of the shareholders.
Relevance theory can be discussed with following models:
1. Walter Approach
2. Gorden Approach
1. Walter’s model: Professor James E. Walter argues that the choice of
dividend policies almost always affects the value of the enterprise. His
model shows clearly the importance of the relationship between the

143
firm’s internal rate of return (r) and its cost of capital (k) in determining
the dividend policy that will maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is
debt or new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are
constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the
earnings pershare (E), and the divided per share (D) may be changed in
the model to determine results, but any given values of E and D are
assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as
follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share
is the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K)
and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]
Criticism
Walter’s model is quite useful to show the effects of dividend policy on
an all-equity firm under different assumptions about the rate of return.
However, the simplified nature of the model can lead to conclusions
which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows
1. Walter’s model of share valuation mixes dividend policy with
investment policy of the firm. The model assumes that the investment
opportunities of the firm are financed by retained earnings only and no
external financing debt or equity is used for the purpose when such a
situation exists either the firm’s investment or its dividend policy or both

144
will be sub-optimum. The wealth of the owners will maximise only when
this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact,
decreases as more investment occurs. This reflects the assumption that
the most profitable investments are made first and then the poorer
investments are made.
The firm should step at a point where r = k. This is clearly an erroneous
policy and fall to optimise the wealth of the owners.
3. A firm’s cost of capital or discount rate, K, does not remain constant; it
changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walter’s model abstracts from the effect of
risk on the value of the firm.
2. Gordon’s Model
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.
Assumptions
Gordon’s model is based on the following assumptions.
1. The firm is an all-Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the
growth rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful
value for the share.
According to Gordon’s dividend capitalisation model, the market value of
a share (Pq) is equal to the present value of an infinite stream of
dividends to be received by the share.
Thus:
𝐸1 (1 − 𝑏)
𝑃0 =
𝐾 − 𝑏𝑟

145
The above equation explicitly shows the relationship of current earnings
(E,), dividend policy, (b), internal profitability (r) and the all-equity firm’s
cost of capital (k), in the determination of the value of the share (P0).
14.3 GRADED ILLUSTRATION
Illustration: 1 (Growth firm) – Welter Model
The cost of capital and the rate of return on investment of Gellet Ltd. are
10% and 18% respectively. The company has 5 lakh equity shares of
Rs. 10 each outstanding and earnings per share are Rs. 20. Compute
the market price per share and value of firm in the following situations.
Use Walter Model and comment on the results.
(i) No retention, (ii) 40% retention, (iii) 80% retention.
Solution:
(i) 0% retention: 100% payout
𝑟
𝐷+ (𝐸−𝐷)
𝑘
Market price per share under Walter Model =
𝑘

D = Dividend per share = EPS × Payout

= 20 × 100% = Rs.20
R = Rate of return = 18%
K = Cost of capital = 10%
E = Earnings per share = Rs.20
0.18
20+[ ](20−20) 20
0.10
∴ Market price per share = 0.10
= 0.10 = Rs.200

Value of firm = No. of equity shares × Market price per share

= 5,00,000 × 200= Rs. 10,00,00,000
(ii) 40% retention; 60% payout
D = Dividend per share: 20 × 60% = Rs.12
0.18
20+[ ]×(20−20)
0.10
∴ Market price per share =
0.10
26.4
= 0.10 = Rs.264

Value of firm = 5,00,000 shares × Rs.264 = Rs.13,20,00,000

(iii) 80% retention: 20% payout

D = Dividend per share = 20 × 20% = Rs.4.
0.18
4+[ ]×(20−4) 32.8
0.10
∴ Market price per share = 0.10
= 0.10 = Rs.328

146
Value of Firm = 5,00,000 shares × 328 = Rs.16,40,00,000.

Analysis: Gellot Ltd is a growth firm (r>k). As payout increases, the

value of firm decreases. Ideal payout is 0%.
Illustration: 2 (Normal firm)-Walter Model
The earnings per share of Nainar Ltd. are Rs.15 and the rate of
capitalization applicable to the company is 12%. The productivity of
earning (r) is 12%. Compute the market value of the company’s share if
the payout is (i) 12% (ii) 50% (iii) 70%. Which is the optimum payout?
Solution:
Computation of market value per share
(i) Payout = 20%
𝑟
𝐷+ (𝐸−𝐷)
𝑘
Market value per share = 𝑘

D = Dividend per share = EPS × Payout ratio = 15 × 20% = Rs.3

r = Rate of return = 12%
k = Cost of capital = 12%
E = Earnings per share = Rs.15
0.12
3+[ ]×(15−3) 15
0.12
∴ Market value per share = 0.12
= 0.12 = Rs.125

(ii) Payout= 50%

D = Dividend per share = 15 × 50% = Rs.7.50
0.12
7.50+[ ]×(15−7.50) 15
0.12
∴ Market value per share = 0.12
= 0.12 = Rs.125

(iii) Payout is 70%

D = Dividend per share = 15 × 70% = Rs.10.5
0.12
10.5+[ ]×(15−10.5) 15
0.12
∴ Market valur per share = 0.12
= 0.12 = Rs.125

Analysis: Nainar Ltd. is a normal firm (r=k). Market value per share
remains the same for all pay outs. Hence ther is on optimum payout.
Illustration: 3 (Declining firm)-Walter Model
The earnings per share of Wick Mayer Ltd. are Rs.12. The rate of
capitalization is 15% and the rate of return on investment is 9%.
Compute the market price per share using Walter’s formula if the
dividend payout is (a) 25% (b) 50% and (c) 100%. Which is the ideal
payout?

147
Solution:
(i) Computation of market price per share where payout is 25%
𝑟
𝐷+( )×(𝐸−𝐷)
𝑘
Market price per share = 𝑘

D = Dividend per share = EPS × Payout ratio = 12 × 15% = Rs.3

r = Rate of retum = 9%
k = Cost of capital = 15%

E = Earnings per share = Rs. 12

0.09
3+( )×(12−3) 8.4
015
∴ Market price per share = 0.15
= 0.15 = Rs.56

(ii) Computation of market price per share when payout is 50%

D = Dividend per share = 12 × 50% = Rs.6
0.09
6+( )×(12−6) 9.6
0.15
∴ Market price per share = 0.15
= 0.15 = Rs.64

(iii) Computation of market price per share when payout is 100%

D = Dividend per share = 12 × 100% = Rs.12
0.09
12+( )×(12−12) 12
0.15
∴ Market price per share = 0.15
= 0.15 = Rs.80

Analysis: Wick Mayer Ltd. is a declining firm (r<k). Market price per
share is the highest when payout ratio is 100% Hence, the ideal payout
ratio for the company is 100%.
Illustration: 4
Details regarding three companies are given below:

Bet Ltd. Set Ltd. Get Ltd.

r = 18% r = 20% r = 8%

k = 15% k = 20% k = 10%

E = Rs. 30 E = Rs.40 E = 20

By using Walter’s model, you are required to

(i) Calculate the value of an equity share of each of these
companies when dividend payout is (a) 30%, (b) 60%, (c)
100%.
(ii) Comment on the results drawn.
Solution:

148
I. Bet Ltd
(a) Computation of value of an equity share when payout is 30%
𝑟
𝐷+( )×(𝐸−𝐷)
𝑘
Value of an equity share = 𝑘

D = Dividend per share = EPS × Payout ratio = 30 × 30% = Rs.9

r = Rate of return = 18%

k = Cost of capital = 15%

E = Earnings per share = Rs. 30

0.18
9+( )×(30−9) 34.2
0.15
∴ Value of an Equity share = 0.15
= 0.15 = Rs.228

(b) Computation of value of an equity share when payout is 60%.

D = Dividend per share = 30 × 60% = Rs.18
0.18
18+( )×(30−18) 32.4
0.15
∴ Value of an equity share = 0.15
= 0.15 = Rs.216

(c) Computation of value of an equity share when payout is 100%.

D = Dividend per share = 30 × 100% = Rs.30
0.18
30+( )×(30−30) 30
0.15
∴ Value of an equity share = 0.15
= 0.15 = Rs.200

Analysis: Bet Ltd. is a growth firm (r > k). If payout increases, share
price declines. It is better to retain the entire profit with the firm So, the
ideal payout is 0%
II. Set Ltd.
(a) Computation of value of an equity share when payout is 30%.
𝑟
𝐷=( )×(𝐸−𝐷)
𝑘
Value of an equity share = 𝑘

D = Dividend per share = EPS × Payout ratio = 40 × 30% = Rs.12

r = Rate of return = 20%

k = Cost of capital = 20%

E = Earnings per share = Rs.40
0.20
12+( )(40−12) 40
0.20
∴ Value of an equity share = 0.20
= 0.20 = Rs.200

(b) Computation of value of an equity share when payout is 60%

D = Dividend per share = 40 × 60% = Rs.24
0.20
24+( )(40−24) 40
0.20
∴ Value of an equity share = 0.20
= 0.20 = Rs.200

149
(c) Computation of value of an equity share when payout is 100%.
D = Dividend per share = 40 × 100% = Rs.40
0.20
40+( )(40−40) 40
0.20
∴ Value of an equity share = 0.20
= 0.20 = Rs.200

Analysis: Set Ltd. is a normal form (r = k). Dividend payout does not
affect the value of equity share of the firm.
III. Get Ltd.
(a) Computation of value of an equity share when payout is 30%.
𝑟
𝐷+( )×(𝐸−𝐷)
𝑘
Value of an equity share = 𝑘

D = Dividend per share = EPS × Payout ratio = 20 × 30% = Rs. 6

r = Rate of return = 8%
k = Cost of capital = 10%
E = Earnings per share = Rs.20
0.08
6+( )(20−6) 17.2
0.10
∴ Value of an equity share = 0.10
= 0.10 = Rs.172

(b) Computation of value of an equity share when payout is 60%

D = Dividend per share = 20 × 60% = Rs.12
0.08
12+( )(20−12) 18.4
0.10
∴ Value of an equity share = 0.10
= 0.10 = Rs.184

(c) Computation of value of an equity share when payout is 100%

D = Dividend per share = 20 × 100% = Rs.20
0.08
20+( )(20−20) 20
0.10
∴ Value of an equity share = = = Rs.200
0.10 0.10

Analysis: Get Ltd. is a declining firm (r < k). If payout ratio increases,
the value of an equity increases. It is better to distribute all the profits to
the shareholders of the firm. Hence, the ideal payout is 100%.

Illustration: 5 (Growth firm)-Gordon Model

The following data relates to Ashok Ltd.
Earnings per share = Rs. 14

Capitalisation rate = 15%

Rate of return = 20%
Determine the market price per share under Gordon’s model if retention
is (a) 40%, (b) 60%, (c) 20%.
Solution:

150
Computation of market price per share under Gordon’s Model
(a) Retention ratio = 40%
𝐷
Market price per share = 𝑘−𝑔

D = Dividend per share = EPS × Payout ratio = 14 × 60% = Rs. 8.40

k = Cost of capital = 15%

g = Growth rate = Retention ratio (b) × Rate of return (r)
= 40% × 20%
= 0.4 × 0.2 = 0.08 × 100 = 8%
8.40 8.40
∴ Market price per share = 15%−8% = 7%
= Rs.120

(b) If Retention ratio = 60%

D = Dividend per share = 14 × 40% = Rs.5.6
g = Growth rate = b × r = 60% × 20%

= 0.6 × 0.2 = 0.12 × 100% =12%

5.6 5.6
∴ Market price per share = 15%−12% = 3% = Rs. 186.67

(c) If Retention ratio = 20%

D = Dividend per share = 14 × 80% = Rs.11.20
g = Growth rate = b × r = 20% × 20%

= 0.2 × 0.2 = 0.4 × 100% =4%

11.20 11.20
∴ Market price per share = = = Rs. 101.82
15%−4% 11%

Analysis: Ashok Ltd. is a growth firm (r > k).

Illustration: 6 (Normal firm)-Gordon Model
Du Preez Ltd. gives you the following information:
Earnings per share: Rs.45
Cost of capital: 18%
Return on investment: 18%
Ascertain the market value per share using Gordon’s Moderl, if the
payout is (a) 30%, (b) 60%, (c) 90%.
Solution:
Computation of market value per share under Gordon’s Model
(a) Payout ratio = 30%: Retention ratio = 70%
𝐷
Market value per share = 𝑘−𝑔

151
D = Dividend per share = EPS × Payout ratio = 45 × 30% = Rs.13.50

k = Cost of capital = 18%

g = Growth rate = Retention ratio (b) × Rate of return (r)
= 70% × 18% = 0.7 × 0.18 = 0.126 × 100 = 12.6%
13.50 12.50
∴ Market value per share = 18%−12.6% = 5.40% = Rs.250.

(b) Payout ratio = 60% Retention ratio = 40%

D = Dividend per share = 45× 60% = Rs.27
g = Growth rate = b × r = 40% × 18% = 0.4 × 0.18
= 0.072 × 100 = 7.2%
27 27
∴ Market value per share = 18%−7.2% = 10.8% = Rs.250.

(c) Payout ratio = 90% Retention ratio = 10%

D = Dividend per share = 45× 90% = Rs.40.50

g = Growth rate = b × r = 10% × 18% = 0.1 × 0.18

= 0.018 × 100 = 1.8%
40.50 40.50
∴ Market value per share = 18%−1.8% = 16.2% = Rs.250.

Analysis: Du preez Ltd is a normal firm (r = k). The share price remains
the same for different payout ratios.

Illustration: 7 (Declining firm)-Gordon Model

Pattal Ltd. earns a profit of Rs.35 per share. The rate of capitalisation is
15% and the productivity of retained is 10%. Using Gordon’s model,
determine the market price per share if the payout is (a) 20%, (b) 40%
and (c) 70%.
Solution:

Computation of market price per share under Gordon’s Model

(a) Payout ratio: 20%, Retention ratio: 80%
𝐷
Market price per share = 𝑘−𝑔

D = Dividend per share = EPS × Payout ratio = 35 × 20% = Rs.7

k = Cost of capital = 15%

g = Growth rate = Retention ratio (b) × of return (r) = 80% × 10%
= 0.8 × 0.10 = 0.08 × 100 = 8%
7 7
∴ Market price per share = 15%−8% = 7% = Rs.100

152
(b) Payout ratio = 40%: Retention ratio = 60%
D = Dividend per share = 35 × 40% = Rs.14
g = Growth rate = b × r = 60% × 10% = 0.6 × 0.10 = 0.06 × 100 = 6%
14 14
∴ Market price per share = 15%−6% = 9% = Rs.155.56

(c) Payout ratio = 70%: Retention ratio = 30%

D = Dividend per share = 35 × 70% = Rs.24.5
g = Growth rate = b × r = 30% × 10% = 0.3 × 0.10 = 0.03 × 100 = 3%
24.5 24.5
∴ Market price per share = 15%−3% = 12% = Rs.204.17

Analysis: Pattal Ltd. is a declining firm (r < k)

Illustration: 8 (Changes in cost of capital)-Gordon Model
The following data relates to Bailey Ltd.
Rate of return = 12%
Earnings per share = Rs.60
Find out the market price per share in the following cases, using
Gordon’s Model:

Dividend payout Retention Cost of capital

(i) 25 75 20%
(ii) 50 50 15%
(iii) 80 20 10%

Solution:
Computation of market price per share under Gordon’s Model
(i) Payout ratio: 25%, Retention ratio: 75%, Cost of capital: 20%.
𝐷
Market price per share = 𝑘=𝑔

D = Dividend per share = EPS × Payout ratio = 60 × 25% = Rs.15

k = Cost of capital = 20%

g = Growth rate = Retention ratio (b) × of return (r) = 75% × 12%

= (0.75 × 0.12) × 100 =9%

15 15
∴ Market price per share = 20%−9% = 11% = Rs.136.36.

(ii) Payout ratio: 50%, Retention ratio: 50%, Cost of capital: 15%
D = Dividend per share = 60 × 50% =Rs.30

153
k = Cost of capital = 15%
g = Growth rate = b × r = 50% × 12% = (0.5 × 0.12) × 100 =6%
30 30
∴ Market price per share = 15%−6% = 9% =Rs.333.33

(iii) Payout ratio: 80%, Retention ratio: 20%, Cost of capital: 10%
D = Dividend per share = 60 × 80% =Rs.48
k = Cost of capital = 10%
g = Growth rate = b × r = 20% × 12% = (0.2 × 0.12) × 100 =2.4%
48 48
∴ Market price per share = 10%−2.4% = 7.6% =Rs.631.58

LET US SUM UP
According to one school of thought the dividends are irrelevant and the
amount of dividends paid does not affect the value of the firm while the
other theory considers that the dividend decision is relevant to the value
of the firm. A dividend theory 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.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. The advocates of this school of thought argue that the dividends have
no impact on the share price or market value of the firm ___________.
a) Relevance Theory of Dividend b) Irrelevance Theory of Dividend
c) Composite Dividend d) Fixed Dividend
2. According to ___________, dividend policy of a firm is irrelevant as it
does not affect the wealth of the shareholders.
a) Walter Approach b) Gordon Approach
c) MM Approach d) SM Approach

3. The ___________ of dividend proposes that dividend policy affect the

share price.
a) Relevance Theory b) Irrelevance Theory

c) Hypothesis d) Nullified Statement

4. ___________ argues that the choice of dividend policies almost
always affects the value of the enterprise.

a) David Miller b) Stephen

154
c) Gordon d) Walter
5. Stock dividend is also known as ___________.
a) Scrip Dividend b) Bonus Shares
c) Right Shares d) Property Dividend
GLOSSARY

MM Approach : According to Modigliani and Miller (M-M),

dividend policy of a firm is irrelevant as it
does not affect the wealth of the
shareholders. They argue that the value of
the firm depends on the firm’s earnings
which result from its investment policy.

Walter Model : Professor James E. Walterargues that the

choice of dividend policies almost always
affects the value of the enterprise. His model
shows clearly the importance of the
relationship between the firm’s internal rate
of return (r) and its cost of capital (k) in
determining the dividend policy that will
maximise the wealth of shareholders.

Irrelevance Theory : The advocates of this school of thought

of Dividend argue that the dividends have no impact on
the share price or market value of the firm.
The argue that the shareholders do not
differentiate between the present dividend
and the future capital gains and are basically
interested in higher returns either earned by
the firm by investing the profits in future
profitable investments. They believe that the
profits are distributed as dividends only if no
adequate investment opportunities for
investments for the business.

Relevance Theory of : The relevance theory of dividend argues that

Dividend dividend decision affects the market value of
the firm and therefore dividend matters. This
theory suggests that investors are generally
risk averse and would rather have dividends
today (“bird-in-the-hand”) than possible

155
 share appreciation and dividends tomorrow.
The relevance theory of dividend proposes
that dividend policy affect the share price.
Therefore, according to this theory, optimal
dividend policy should be determined which
will ensure maximization of the wealth of the
shareholders.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
walters-model-gordons-model-and-modigliani-and-millers-
hypothesis/29462
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

156
Unit 15

FORMS OF DIVIDEND
STRUCTURE
Overview
Learning Objectives
15.1 Dividend meaning
15.2 Forms of dividend
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Dividends are periodic payments made to shareholders by the company
they’ve invested in. When a company is earning enough revenue to
cover its basic operating costs and projects, it can choose to divide up
excess funds among its shareholders.

How much an investor can expect to earn in dividends will depend on a

few different factors, including how many shares you own, the company
you’ve invested in, and how often they decide to pay dividends. It’s
important to note that these payments can fluctuate in response to
changes in the company’s profits, or even broader market conditions if
there are major changes in the company’s specific sector.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• state the meaning of the dividend
• explain the various forms of dividend.
15.1 DIVIDEND MEANING
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders after execution of
retained earnings. It is the reward of the shareholders for investment
made by them in the shares of the company.

In the other words, it is the return that a shareholder gets form the
company out of profit on his shareholding.

157
According to the Institute of Chartered Accountant of India, “A dividend
is a distribution to shareholders out of profits or reserves available for
this purpose”.
15.2 FORMS OF DIVIDEND
1. Cash Dividend: Cash dividends are the most commonly used
dividend type. In this type of dividend, the dividend amount is paid by
transferring a sum of money. The money can be transferred
electronically or through cash and check. When the company declares
the dividend, then all the shareholders existing on the date specified by
the company are eligible to receive the payment of dividend before the
company makes a payment; the company must arrange enough cash to
pay off the dividends.
2. Stock Dividend: Stock dividends refer to the dividend which is paid
by allotting a certain number of shares to the existing shareholders
without taking any kind of consideration. The stock dividend is treated
differently in two different cases where; the first case is when the
company issues less than 25 % of the outstanding shares, then it is
treated as a stock dividend, but if the issue is more than 25% of the
outstanding number of shares, then the same is treated as stock split
and nit stock dividend.
3. Scrip Dividend: A scrip dividend is the type of dividend issued by the
company in which the company gives transferrable promissory notes
which promise to pay the shareholders the amount of dividend on some
later date. The notice issued may or may not be interest-bearing.
4. Property Dividend: Property dividend is paid using non-monetary
items such as assets, inventories, etc., rather than directly paying cash.
The company pays this dividend when the company does not have
enough cash reserves to pay off dividends. The company has to record
this distribution at the fair market value of the asset, and the difference
between the fair market value and the asset’s book value is recorded as
gain/loss.
5. Liquidating Dividend: The liquidating dividend is the dividend
declared by the company usually when the company is in liquidation and
the directors decide to pay back to the shareholders their original
contribution towards the capital of the company.
LET US SUM UP

A dividend is generally considered to be a cash payment issued to the

holders of company stock. However, there are several types of

158
dividends, some of which do not involve the payment of cash to
shareholders. The various forms of dividend must be maintained by the
company based on the needs of the shareholders and stakeholders.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. In this type of dividend, the dividend amount is paid by transferring a
sum of money __________.
a) Cash dividend b) Stock dividend
c) Property dividend d) Liquidating dividend
2. __________ refer to the dividend which is paid by allotting a certain
number of shares to the existing shareholders without taking any kind of
consideration.
a) Cash dividend b) Stock dividend
c) Property dividend d) Liquidating dividend
3. __________ is the type of dividend issued by the company in which
the company gives transferrable promissory notes which promise to pay
the shareholders the amount of dividend on some later date.
a) Cash dividend b) Scrip dividend
c) Property dividend d) Liquidating dividend
4. __________ is paid using non-monetary items such as assets,
inventories, etc., rather than directly paying cash.
a) Cash dividend b) Stock dividend
c) Property dividend d) Liquidating dividend
5. __________ is the dividend declared by the company usually when
the company is in liquidation.
a) Cash dividend b) Stock dividend
c) Property dividend d) Liquidating dividend
GLOSSARY

Property : A thing or things that belong to someone

Liquidated : A firm being winding up or closed down

Scrip : A firm issued by the company to its

shareholders in the form of a certificate
instead of a cash dividend

159
Decision : a choice of judgement that make after
thinking about various possibilities

Capital : an amount of money that is used to start a

business or to put in a bank

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition, Chaitanya
Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

160
 BLOCK 5

WORKING CAPITAL, CASH AND

RECEIVABLE MANAGEMENT

Unit 16: Introduction to Working Capital

Management
Unit 17: Kinds of Working Capital
Unit 18: Inventory Management Techniques

Unit 19: Cash Management

Unit 20: Receivables Management

161
Unit 16

INTRODUCTION TO WORKING CAPITAL

MANAGEMENT
STRUCTURE
Overview
Learning Objectives
16.1 Introduction
16.2 Meaning of Working Capital
16.3 Definitions of Working Capital
16.4 Concept of Working Capital
16.4.1 Gross Working Capital
16.4.2 Net Working Capital
16.5 Nature of Working Capital
16.6 Need for Working Capital
16.7 Importance of Working Capital
16.8 Elements of Working Capital
16.9 Components of Working Capital
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Working Capital is a part of the capital which is needed for meeting day
to day requirement of the business concern. For example, payment to
creditors, salary paid to workers, purchase of raw materials etc.,
normally it consists of recurring in nature. It can be easily converted into
cash. Hence, it is also known as short-term capital. In an ordinary sense,
working capital denotes the amount of funds needed for meeting day-to-
day operations of a concern. This is related to short-term assets and
short-term sources of financing. Hence it deals with both, assets and
liabilities in the sense of managing working capital it is the excess of
current assets over current liabilities. In this article we will discuss about
the various aspects of working capital. In this unit, we shall learn the

162
concept of working Capital, nature of working capital, elements and
Components of Working Capital.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• write a note on working capital and understand the basics of
working capital
• discuss the concept of working capital
• outline importance, elements and components of working capital.
16.1 INTRODUCTION
Working capital management is also one of the important parts of the
financial management. It is concerned with short-term finance of the
business concern which is a closely related trade between profitability
and liquidity. Efficient working capital management leads to improve the
operating performance of the business concern and it helps to meet the
short-term liquidity. Hence, study of working capital management is not
only an important part of financial management but also are overall
management of the business concern. Working capital is described as
the capital which is not fixed but the more common uses of the working
capital is to consider it as the difference between the book value of
current assets and current liabilities.
16.2 MEANING OF WORKING CAPITAL
Working Capital refers to a firm’s investment in short-term assets, cash,
short-term securities, accounts receivables and inventories. Working
Capital is a part of the capital which is needed for meeting day to day
requirement of the business concern. For example, payment to creditors,
salary paid to workers, purchase of raw materials etc., normally it
consists of recurring in nature. It can be easily converted into cash.
Hence, it is also known as short-term capital. In an ordinary sense,
working capital denotes the amount of funds needed for meeting day-to-
day operations of a concern. This is related to short-term assets and
short-term sources of financing. Hence it deals with both, assets and
liabilities—in the sense of managing working capital it is the excess of
current assets over current liabilities. In this article we will discuss about
the various aspects of working capital.

16.3 DEFINITIONS OF WORKING CAPITAL

According to the definition of Mead, Baker and Malott, “Working Capital
means Current Assets”.

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According to the definition of J.S. Mill, “The sum of the current asset is
the working capital of a business”.
According to the definition of Weston and Brigham, “According to the
definition of Bonneville, “Any acquisition of funds which increases the
current assets, increase working capital also for they are one and the
same”.
According to the definition of Shubin, “Working Capital is the amount of
funds necessary to cover the cost of operating the enterprises”.
According to the definition of Genestenberg, “Circulating capital means
current assets of a company that are changed in the ordinary course of
business from one form to another, for example, from cash to
inventories, inventories to receivables, receivables to cash”.
Shubin defines, “Working capital is the amount of funds necessary to
cover the cost of operating the enterprise.”
Weston and Brigham define, “Working capital refers to a firm’s
investment in short term assets – cash, short term securities accounts
receivables and inventories.”
Hoagland defines, “Working capital is descriptive of that capital which is
not fixed. But the more common use of the working capital is to consider
it as the difference between the book value of current assets and the
current liabilities.”
Mead, malott and Field defines, “Working capital means current assets.”
Bonneville defines, “Any acquisition of funds which increases the current
assets, and which increases the working capital for they are one and the
same.”
J.S. Mill defines, “The sum of the current assets is the working capital of
business.”
16.4 CONCEPT OF WORKING CAPITAL
The funds invested in current assets are termed as working capital. It is
the fund that is needed to run the day-to-day operations. It circulates in
the business like the blood circulates in a living body. Generally, working
capital refers to the current assets of a company that are changed from
one form to another in the ordinary course of business, i.e. from cash to
inventory, inventory to work in progress (WIP), WIP to finished goods,
finished goods to receivables and from receivables to cash.
There are two concepts in respect of working capital

i) Gross working capital and

ii) Networking capital.

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16.4.1 Gross Working Capital
The sum total of all current assets of a business concern is termed as
gross working capital. So,
Gross working capital = Stock + Debtors + Receivables + Cash.
16.4.2 Net Working Capital
The difference between current assets and current liabilities of a
business concern is termed as the Net working capital.
Hence, Net Working Capital = Stock + Debtors + Receivables + Cash –
Creditors – Payables.
16.5 NATURE OF WORKING CAPITAL
The nature of working capital is as discussed below:
1. It is used for purchase of raw materials, payment of wages and
expenses.
2. It changes form constantly to keep the wheels of business moving.
3. Working capital enhances liquidity, solvency, creditworthiness and
reputation of the enterprise.
4. It generates the elements of cost namely: Materials, wages and
expenses.
5. It enables the enterprise to avail the cash discount facilities offered
by its suppliers.
6. It helps improve the morale of business executives and their
efficiency reaches at the highest climax.
7. It facilitates expansion programmes of the enterprise and helps in
maintaining operational effi¬ciency of fixed assets.
16.6 NEED FOR WORKING CAPITAL
Working capital plays a vital role in business. This capital remains
blocked in raw materials, work in progress, finished products and with
customers.
1. Adequate working capital is needed to maintain a regular supply of
raw materials, which in turn facilitates smoother running of
production process.
2. Working capital ensures the regular and timely payment of wages
and salaries, thereby improving the morale and efficiency of
employees.

165
3. Working capital is needed for the efficient use of fixed assets.
4. In order to enhance goodwill a healthy level of working capital is
needed. It is necessary to build a good reputation and to make
payments to creditors in time.
5. Working capital helps avoid the possibility of under-capitalization.
6. It is needed to pick up stock of raw materials even during economic
depression.
7. Working capital is needed in order to pay fair rate of dividend and
interest in time, which increases the confidence of the investors in
the firm.
16.7 IMPORTANCE OF WORKING CAPITAL
It is said that working capital is the lifeblood of a business. Every
business need funds in order to run its day-to-day activities.
The importance of working capital can be better understood by the
following:

1. It helps measure profitability of an enterprise. In its absence, there

would be neither production nor profit.
2. Without adequate working capital an entity cannot meet its short-
term liabilities in time.
3. A firm having a healthy working capital position can get loans easily
from the market due to its high reputation or goodwill.
4. Sufficient working capital helps maintain an uninterrupted flow of
production by supplying raw materials and payment of wages.
5. Sound working capital helps maintain optimum level of investment in
current assets.
6. It enhances liquidity, solvency, credit worthiness and reputation of
enterprise.
7. It provides 6 funds to meet unforeseen contingencies and thus helps
the enterprise run successfully during periods of crisis.
16.8 ELEMENTS OF WORKING CAPITAL

Working capital is composed of various current assets and current

liabilities, which are as follows:
(A) Current Assets: These assets are generally realized within a short
period of time, i.e., within one year.
Current assets include:

166
(1) Inventories or Stocks
i) Raw materials
ii) Work in progress
iii) Consumable Stores
iv) Finished goods
(2) Sundry Debtors

(3) Bills Receivable

(4) Pre-payments
(5) Short-term Investments
(6) Accrued Income and
(7) Cash and Bank Balances
(B) Current Liabilities: Current liabilities are those which are generally
paid in the ordinary course of business within a short period of time, i.e.,
one year.
Current liabilities include:
(1) Sundry Creditors
(2) Bills Payable
(3) Accrued Expenses
(4) Bank Overdrafts
(5) Bank Loans (short-term)
(6) Proposed Dividends
(7) Short-term Loans
(8) Tax Payments Due
16.9 COMPONENTS OF WORKING CAPITAL
Management of working capital means managing different components.
These are discussed hereunder:
1. Management of Cash: Every enterprise irrespective of its scale
requires a certain amount of cash to meet its day-to-day obligations.
Hence, the enterprise needs to decide carefully how much should be
carried in cash. Management of cash aims at striking a balance between
two contradictory objectives of meeting the cash disbursement needs
and minimizing the amount locked up as cash balance.

167
For this purpose, cash management addresses to the following four
problems:
i. Controlling the level of cash.
ii. Controlling inflows of cash.
iii. Controlling outflows of cash.
iv. Optimum use of surplus cash.

2. Management of Inventory: Inventories refer to raw material, work-in-

progress and finished goods. These constitute a major portion, about
60%, of total current assets. There are three major motives for holding
inventories in a firm, namely, transaction motive, precautionary motive
and speculative motive. But, holding inventories involves costs, i.e.,
ordering costs and carrying costs.
Hence, inventories need to be maintained at an optimum size inventory
management is a trade-off between cost of acquiring and cost of holding
inventories. Among various models evolved for managing inventories,
the commonly used model is Economic Ordering Quantity (EOQ) Model
based on Baumol’s cash management model.
The other model of inventory management is ABC Analysis also known
as Control by Importance and Exception (CIE). This method controls
expensive inventory items more closely than less expensive items.
3. Management of Accounts Receivable: Accounts receivable
represent the amount of goods sold on credit with a view to increase the
volume of sales. Accounts receivable constitute a major portion of
current assets. According to the Indian Chamber of Commerce and
Industry (ICCI) study of 417 companies, the ratios of accounts
receivable to total assets, current assets and sales were, on average,
17%, 30% and 14-15% respectively.
The main objective of maintaining accounts receivable are achieving
growth in sales, increasing profits and meeting competition. Like
inventories, maintaining accounts receivable also involves certain costs
such as – capital costs, administrative costs, collection costs and
defaulting costs, i.e., bad debts.
The size of accounts receivable depends on the level of sales, credit
policy, terms of trade, efficiency of collection, etc. A larger size of
accounts receivable increases profitability and reduces liquidity and vice
versa. Therefore, accounts receivable need to be maintained at an
optimum size.

168
The optimum size of accounts receivable occurs at a point where there
is a “trade-off” between profitability and liquidity.
4. Management of Accounts payable: Accounts payable are just
reverse to accounts receivable. Accounts payable emerge due to credit
purchase. This refers to a learning of goods and inventories to the buyer.
This is also called ‘buy-now, pay-later’. The underlying objective of
accounts payable is to slow down the payments process as much as
possible.
But it should be noted that the saving of interest cost should be offset
against loss of credit standing of the enterprise. The enterprise has,
therefore, to ensure that the payments to the creditors are made at the
stipulated time periods after obtaining the best credit terms possible.
The salient points to be noted on effective management of
accounts payable are:
i. Obtain most favourable credit terms with the prevailing credit practice.

ii. Make payments on maturity or due dates.

iii. Keep a good track record of past dealings with the suppliers.
iv. Avoid the tendency to divert payables.
v. Provide full information to the suppliers.
vi. Keep a constant check on the incidence of delinquency.
LET US SUM UP
Working capital denotes the amount of funds needed for meeting day-to-
day operations of a concern. This is related to short-term assets and
short-term sources of financing. Hence it deals with both, assets and
liabilities in the sense of managing working capital it is the excess of
current assets over current liabilities. In this article we will discuss about
the various aspects of working capital. Working Capital is a part of the
capital which is needed for meeting day to day requirement of the
business concern. For example, payment to creditors, salary paid to
workers, purchase of raw materials etc., normally it consists of recurring
in nature. It can be easily converted into cash.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. ___________ is a part of the capital which is needed for meeting day
to day requirement of the business concern.
a) Fixed Capital b) Floating Capital

169
c) Working Capital d) Share Capital
2. The sum total of all current assets of a business concern is termed
as___________.
a) Gross Working Capital b) Net Working Capital
c) Effective Working Capital d) Surplus Working Capital
3. ___________ assets are generally realized within a short period of
time.
a) Fixed Assets b) Current Assets
c) Building d) Land
[Link] is abbreviated as ___________.
a) Control by Instant and Exception
b) Control by Instant and Enumeration
c) Control by Importance and Enumeration
d) Control by Importance and Exception
5. ___________ is the following is a long-term source of working capital.
a) Issues of shares b) Issues of debentures
c) Loans d) Depreciation
GLOSSARY

Working Capital : Working Capital refers to a firm’s investment in

short-term assets, cash, short-term securities,
accounts receivables and inventories. Working
Capital is a part of the capital which is needed
for meeting day to day requirement of the
business concern.

Gross Working : The sum total of all current assets of a business

Capital concern is termed as gross working capital.

Management of : Inventories need to be maintained at an

Inventory optimum size inventory management is a trade-
off between cost of acquiring and cost of
holding inventories. Among various models
evolved for managing inventories, the
commonly used model is Economic Ordering
Quantity (EOQ) Model based on Baumol’s cash
management model.

170
Management of : Accounts payable are just reverse to accounts
Accounts receivable. Accounts payable emerge due to
Payable credit purchase. This refers to a learning of
goods and inventories to the buyer. This is also
called ‘buy-now, pay-later’. The underlying
objective of accounts payable is to slow down
the payments process as much as possible.

Liabilities : responsible for a sum of money

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
[Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

171
Unit 17

KINDS OF WORKING CAPITAL

STRUCTURE
Overview
Learning Objectives
17.1 Methods of working capital calculation
17.2 Types of working capital
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Working capital is the life line of any business. It is the day today funds
required to run the business. Every firm must calculate the working
capital requirement of the future. There are various methods applicable
for the calculation of working capital.

LEARNING OBJECTIVES
After learning this unit, you will be able to;
• explain the types of working capital calculation

• discuss the methods of working capital.

17.1 METHODS OF WORKING CAPITAL CALCULATION
There are broadly three methods of estimating or analyzing the
requirement of working capital of a company viz. percentage of revenue
or sales, regression analysis, and operating cycle method. Estimating
working capital means calculating future working capital. It should be as
accurate as possible because the planning of working capital would be
based on these estimates and banks and other financial institutes
finance the working capital needs to be based on such estimates only.

1. Percentage of Sales Method

Percentage of Sales Method is the easiest of the methods for calculating
the working capital requirement of a company. This method is based on
the principle of ‘history repeats itself’. For estimating, a relationship of
sales and working capital is worked out for say last 5 years. If it is

172
constantly coming near say 40% i.e., working capital level is 40% of
sales, the next year’s estimation is done based on this estimate. If the
expected sales are 500 million dollars, 200 million dollars would be
required as working capital.
The advantage of this method is that it is very simple to understand and
calculate also. The disadvantage includes its assumption which is
difficult to be true for many organizations. So, where there is no linear
relationship between the revenue and working capital, this method is not
useful. In new startup projects also, this method is not applicable
because there is no past.
2. Regression Analysis Method
Regression Analysis Method is a statistical estimation tool utilized by
mass for various types of estimation. It tries to establish a trend
relationship. We will use it for working capital estimation. This method
expresses the relationship between revenue & working capital in the
form of an equation (Working Capital = Intercept + Slope * Revenue).
The slope is the rate of change of working capital with one unit change
in revenue. Intercept is the point where regression line and working
capital axis meet (Will not go deeper into statistical details). At the end of
the statistical exercise with past revenue and working capital data.
3. Operating Cycle Method
The operating Cycle Method is probably the best of the methods
because it takes into account the actual business or industry situation
into consideration while giving an estimate of working capital. A general
rule can be stated in this method. The longer the working capital
operating cycle, the higher would be the requirement of working capital
and vice versa. We would agree to the point also. The following formula
can be used to estimate or calculate the working capital
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of
Operating Cycle / 365 Days) + Bank and Cash Balance.
17.2 TYPES OF WORKING CAPITAL
The working capital in India is as mentioned below –
1. Permanent Working Capital

Permanent Working Capital is called the fixed working capital. It

comprises the current assets in minimum which is required for keeping
the business operations working. This needs to be noted that fixed
working capital size always depends on the growth and production

173
scale. Mostly, these long-term sources are used for availing a working
capital of fixed type.
2. Variable Working Capital
The ever-changing working capital or variable is generally that the
amount which is invested for a very short-term period. This may also be
defined as the extra working capital used to account for the various
changes in sales activities and production. The changing working capital
is known as the working capital of temporary nature.
3. Reserve Margin Working Capital
The Reserve Margin Working Capital comprises a small-term
arrangement in which business entities account for unforeseen
expenses. This is also called the cushion working capital which aids to
mitigate the not warranted business-oriented uncertain risks, which
allows the entities for sustaining in an emergency.
4. Seasonal Variable Working Capital

Generally, any business requires working capital for meeting the

demands of some customers in the peak seasons. The business owners
do need to opt for some additional assistance. This working capital,
which is generated in a small-time frame, is considered as working
capital or seasonal nature.
5. Regular Working Capital
Regular Working Capital is a particular type of working capital that can
be defined as the lowest working capital which needs to be checked by a
company.

6. Special Variable Working Capital

Special Variable Working Capital can be defined as an extra working
capital that a business needs for fulfilling unique circumstances. Such a
changing working capital needs to be channeled – for funding the
release of the new products, for risk management, and for marketing
campaigns among others.
7. Gross Working Capital
Gross Working Capital is the fund that is invested by a company’s
current assets which serve as an indicator for Gross Working Capital.
Below mentioned are the parts of the gross working capital: -
• Cash
• Inventory
• Accounts receivables

174
 • Marketable securities
• Short span investments
1. Net Working Capital
This is an important working capital. The networking capital shows the
amount under which the company’s current assets would surpass the
then-current liabilities. This is the difference between the current
liabilities and a business’s total assets.
The cycle of Working Capital
The WCC or the Working Capital Cycle is defined as the span of time
which is required for converting the current net liabilities and also needs
to convert the different assets into some cash by any company. It acts
as an indicator that can be used to determine organizational efficiency
for effectively managing the liquidity position for the short-term and also
the cycle, that is calculated using days. It is actually the time span that
lies in between the revenue generation using cash by selling products
and material buying for producing various products.
The shorter will be the working capital cycle, the faster the company
would free up the cash that is blocked. If the working cycle is much
longer, the capital would get stuck in between without getting the returns
for this operational cycle. Such businesses are always striving to lower
the working capital cycle for viewing towards enhancing this liquidity for
the short-term.
The working capital formula is as follows:
Working Capital = current assets - current liabilities

The ratio of the working capital indicates whether there are ample short-
term assets that have the organization that is necessary for managing
the short-term debt. A ratio that is lower than one indicates the negative
working capital whereas a sufficient or positive working capital is
generally indicated by the ratio which is between 1.2 and 2.0. A ratio
above two generally indicates there are some extra assets that are not
currently invested by the organization and would represent a missed
opportunity.
The company might be in some trouble if these current assets are not
exceeding the liabilities at that moment. The working capital is also
necessary for the efficiency of the company. Money that is stuck in the
market, a bigger inventory or the goods given to the customers that have
not paid by them, would not be even considered useful when it would
come to settling some obligations.

175
LET US SUM UP
The Current assets and Current liabilities determine the quantum of
Working Capital. Any asset which can be converted into cash within a
period of one is year is considered as current assets. The Working
Capital maintained by the Company determine the liquidity position of
the Company. Therefore, it is integral part of managing the funds. There
are various methods to calculate working capital.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1.__________ method is based on the principle of ‘history repeats itself’.
a) Percentage sales b) Regression analysis
c) Operating cycle d) Average method
2. Working capital = __________.
a) Current assets - Current liabilities
b) Current assets - liquid assets
c) Current assets - Absolute liquid assets
d) None of the above
3. __________ working capital is the fund invested by the firm’s current
assets
a) Net working capital b) Gross working capital
c) Weighted working capital d) Average working capital
4. __________ working capital is the lowest requirement of the
company
a) Seasonal b) Special
c) Regular d) None of the above
5. __________ working capital is required to meet the demands of the
customers in peak
a) Seasonal b) Special
c) Regular d) None of the above
GLOSSARY

Working Capital : Capital used in day-to-day business.

Current assets : Assets expected to be converted to cash

immediately.

176
Profit : A financial gain.

Liabilities : Responsible for a sum of money.

Liquidity : Ability to refund the immediate liability.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S.C., (2016), Financial Management,15th Edition, Chaitanya
Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES

1. [Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

177
Unit 18

INVENTORY MANAGEMENT
TECHNIQUES
STRUCTURE
Overview
Learning Objectives
18.1 Introduction
18.2 Meaning of Inventory Management
18.3 Objectives of Inventory Management
18.4 Importance of Inventory Management
18.5 Types of Inventory Management
18.6 Factors Affecting Level of Inventory
18.7 Techniques of Inventory Management
18.8 Graded Illustration
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Inventory Management refers to the activities that are employed in
maintaining the optimum number or the amount of every inventory item.
Production process modification is the manufacturing procedure that is
used to come up with new or modified items. Volume reduction is the
processing of waste materials to reduce the space they occupy.
Generally speaking, the application of managerial functions on the basis
of management principles in the field of inventory is termed as inventory
management. Managerial functions primarily include planning,
organising, control and coordination. In this unit, you will be learning of
meaning and objectives of Inventory Management, Purposes of Holding
Inventory, Risk and Cost associated with Inventory.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• define the inventory management

178
 • discuss the objectives, importance and types of inventory
management
• explain the cost and risks associated with inventory.
18.1 INTRODUCTION
Inventory management occupies the most significant position in the
structure of working capital. Management of inventory may be defined as
the sum of the total of those activities necessary for the acquisition,
storage, disposal or use of materials. Inventory is one of the important
components of current assets. Inventory management is an important
area of working capital management, which plays a crucial role in
economic operation of the firm. Maintenance of large size of inventories
requires a considerable amount of funds to be invested on them.
Efficient and effective inventory management is necessary in order to
avoid unnecessary investment and inadequate investment.
A considerable amount of funds is required to be committed in
inventories. It is absolutely imperative to manage inventories efficiently
and effectively in order to optimise investment in them. Prudent
inventory management is one of the challenging tasks of the financial
manager.
18.2 MEANING OF INVENTORY MANAGEMENT
Inventory Management refers to the activities that are employed in
maintaining the optimum number or the amount of every inventory item.
Production process modification is the manufacturing procedure that is
used to come up with new or modified items. Volume reduction is the
processing of waste materials to reduce the space they occupy.
Generally speaking, the application of managerial functions on the basis
of management principles in the field of inventory is termed as inventory
management. Managerial functions primarily include planning,
organising, control and coordination. When all these four functions are
performed with respect to inventory, it may be called inventory
management.
In this sense, the inventory management signifies the planning,
organising, controlling and coordinating the quantity and value of the
inventory. Really speaking, the objective of inventory management is to
plan the optimum size of inventory which is neither excessive nor
deficient and is timely available. For timely availability along with
optimum size, there is need for controlling as well. Only on the basis of
various control techniques one can ensure whether inventory would be
timely available.

179
18.3 OBJECTIVES OF INVENTORY MANAGEMENT
The objectives of inventory management may be viewed in two they are
operational and financial the operational objective is to maintain
sufficient inventory, to meet demands for product by efficiently
organising the firm’s production and sales operations and financial view
is to minimise inefficient inventory and reduce inventory carrying costs.
These two conflicting objectives of inventory management can also be
expressed in terms of costs and benefits associated with inventory. The
firm should maintain investments in inventory imply that maintaining an
inventory involves cost, such that smaller the inventory, lower the
carrying cost and vice versa. But inventory facilitates (benefits) the
smooth functioning of the production.
An effective inventory management should:
1. Ensure a continuous supply of raw materials and supplies to facilitate
uninterrupted production,
2. Maintain sufficient stocks of raw materials in periods of short supply
and anticipate price changes,
3. Maintain sufficient finished goods inventory for smooth sales
operation, and efficient customer service,
4. Minimise the carrying costs and time, and
5. Control investment in inventories and keep it at an optimum level.
6. Others – apart from the above, the following are also objects of
inventory management. Control of materials costs, elimination of
duplication in ordering by centralisation of purchasers, supply of right
quality of goods at reasonable prices, provide data for short-term and
long- term planning and control of inventories.
Therefore, management of inventory needs careful and accurate
planning so as to avoid both excess and inadequate inventory in relation
to the operational requirement of a firm. To achieve higher operational
efficiency and profitability of a firm, it is very essential to reduce the
amount of capital locked up in inventories.
This will not only help in achieving higher return on investment by
minimising tied-up working capital, but will also improve the liquidity
position of the enterprise.
18.4 IMPORTANCE OF INVENTORY MANAGEMENT
1. Inventory management is now an integral part of general
management. Three important functional aspects of a business are
closely related to inventory management and this functional

180
 management is production management, marketing management
(sales management) and financial management.
2. As far as production management and marketing management are
concerned, these are related to the physical aspect of inventory
management; financial management is concerned with the financial
aspect of the inventory management.
3. Production managers will always strive to have such a large
inventory of raw materials and of such a good quality as to ensure
stable production operations. Similarly, marketing managers aim at
satisfying ever-increasing demands for improved customers’ service
by having large inventory of inside goods.
4. On the other hand, a finance manager’s efforts will be to keep
investments in different types of inventories at a minimum possible
level so that the business concern may earn maximum return.
5. Needless to mention that the production manager and marketing
manager cannot oversight the financial aspects of inventory
management. In fact, a proper coordination is needed taking into
account the goal of the entire business, for which budgetary control
is the appropriate technique.
6. The above discussion indicates that taking into account the needs of
each business concern; one has to determine the quantity of
inventory. The quantity of inventory should neither be excessive nor
is deficient of what is required. In other words, the size of inventory
quantity should be economical or optimal.
18.5 TYPES OF INVENTORY MANAGEMENT
1. Raw Material: A basic material on which a manufacturing process is
carried to make a product. Raw materials can be unprocessed natural
substances or in a semi-processed state.
2. Work in Progress: WIP is a stage of a transformation process that is
either under way or will take place in the future.
3. Consumable: These are the materials which are needed to smooth
running of the manufacturing process.
4. Finished Goods: Finished product is resulting material after it has
been processed and forms an essential part of virtually all business
operations.
5. Spares: It is also a part of inventories, which includes small spares
and parts.

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18.6 FACTORS AFFECTING LEVEL OF INVENTORY
There is no hard and fast rule regarding the level of inventory to be kept
by the firms, this is affected by several factors; the important among
them are as under:
1. Nature of Business: Most important determinant of the level of
inventory is the nature of the business. A manufacturing firm will have a
high level of inventory as compared to the trading firm.
2. Nature of Product: If the product is perishable the level of inventory
should be kept low due to the chances of rotting, on the other hand
durable products can be kept easily with less probability of loss. The
firms dealing in seasonal products have to hold large stock of finished
goods during peak season to meet the demand.
3. Financial Position: A firm which is financially sound may buy
material in bulk and hold them for future use. While a firm having
shortage of funds cannot maintain a large stock level.

4. Length of Manufacturing Cycle: Length of Manufacturing cycle and

the requirement of working capital are directly related with each other.
Manufacturing cycle is the time lag between the conversions of raw
material into finished goods. The longer the time required for inventory to
convert in finished goods the greater the requirement of inventory.
5. Rate of Inventory Turnover: The rate of inventory turnover is the
time period within which inventory completes the cycle of production and
sales affects the level of inventory. When the turnover rate is high,
investment in inventories tends to be low and vice-versa.

6. Inventory Cost: There are some costs associated with the inventory
like ordering cost and holding cost. This cost also affects the level of
inventory, because a firm normally determines the inventory level on the
basis of economic order quantity and these costs affect the economic.
18.7 TECHNIQUES OF INVENTORY MANAGEMENT
1. ABC analysis: The ABC analysis groups inventory into three classes.
Class A contains 80 percent of the total value of inventory. Class B
contains 15 percent of the total value of inventory while class C contains
5 percent of the total value of inventory. The ABC analysis gives a
simple and quick review of the inventory. The ABC analysis also gives a
clear view and meaning of the whole assortment of products in the
inventory, thereby making it an efficient method to control inventory
investment. The ABC analysis makes it easy for an inventory manager
to devote resources to only those places where it will have the biggest

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positive feedback. Nike, Inc is an American manufacturer of shoes. In
their ABC analysis, leather forms class A, sole forms class B while shoe
lace forms class C. ABC analysis is a vital method for management of
inventory.
2. Economic Order Quantity (EOQ): EOQ is a technique for inventory
management that minimizes ordering and holding costs for the year.
EOQ is a crucial accounting formula that determines when the
combination of inventory carrying cost, order and costs are the least.
The result obtained from the formula gives the most effective quality to
order. There are two models used in EOQ: Q and P models. In the Q
model, whenever the stock on hand reaches the recorder point, a fixed
quantity of materials is ordered. Advantages of the Q model is that the
inventory materials are at the most economical quantity and inventory
control personnel automatically devote attention to stocking the only
items that are needed, when they are needed. A major disadvantage of
the Q model is that the suppliers may be inconvenienced by orders that
are raised at irregular intervals. In the P model, the stock position of
every item in the inventory is closely monitored. Advantages of the P
model is that the inventory and ordering costs are low and the model can
be used on materials that are used irregularly or in seasons. Sales
estimates are easily calculated for seasonal materials and the purchase
of these materials can be planned in advance. A disadvantage of the P
model is that is inefficient because it compels a periodic review of
inventory.
3. VED Analysis: VED analysis is an inventory management technique
that classifies inventory based on its functional importance. It
categorizes stock under three heads based on its importance and
necessity for an organization for production or any of its other activities.
VED analysis stands for Vital, Essential, and Desirable.
i) V-Vital category: As the name suggests, the category “Vital” includes
inventory, which is necessary for production or any other process in an
organization. The shortage of items under this category can severely
hamper or disrupt the proper functioning of operations. Hence,
continuous checking, evaluation, and replenishment happen for such
stocks. If any of such inventories are unavailable, the entire production
chain may stop. Also, a missing essential component may be of need at
the time of a breakdown. Therefore, the order for such inventory should
be beforehand. Proper checks should be put in place by the
management to ensure the continuous availability of items under the
“vital” category.

183
ii) E- Essential category: The essential category includes inventory,
which is next to being vital. These, too, are very important for any
organization because they may lead to a stoppage of production or
hamper some other process. But the loss due to their unavailability may
be temporary, or it might be possible to repair the stock item or part.
iii) D- Desirable category: The desirable category of inventory is the
least important among the three, and their unavailability may result in
minor stoppages in production or other processes.
4. Stock Level: Stock level refers to the amount of goods or raw
materials that should be maintained by businesses to continue their
activities and avoid any situations like understocking or overstocking.
Every organization should always keep an optimum amount of inventory
to ensure the regular operation of its production activities.
a) Minimum Level: This represents the quantity which must be
maintained in hand at all times. If stocks are less than the minimum
level, then the work will stop due to shortage of materials.
Following factors are taken into account while deciding minimum stock
level:
(i) Lead Time: A purchasing firm requires some time to process the
order and time is also required by the supplier/vendor to execute the
order. The time taken in processing the order and then executing it is
known as lead time. It is essential to maintain some inventory during this
period to meet production requirements.
(ii) Rate of Consumption: It is the average consumption of materials
items in the industry. The rate of consumption will be decided on the
basis of past experience and production plans.
(iii) Nature of Material: The nature of material also affects the minimum
level. If a material is required only against special orders of the
customer, then minimum stock will not be required for such materials.
Wheldon has given the following formula for calculating minimum stock
level: Minimum stock Level = Re-ordering Level – (Normal Consumption
x Normal Reorder Period)
(iv) Re-ordering Level: When the quantity of materials reaches a
certain level then fresh order is sent to procure materials again. The
order is sent before the materials reach minimum stock level.
Re-ordering level is fixed with following formula:

Reordering Level = Maximum Consumption Rate x Maximum Reorder

period.

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b) 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 termed as overstocking. A firm avoids overstocking
because it will result in high material costs. Overstocking will lead to the
requirement of more capital, more space for storing the materials, and
more charges of losses from obsolescence.
c) Danger Level: It is the level below which stocks should not fall in any
case. If danger level approaches, then immediate steps should take to
replenish the stocks even if more cost is incurred in arranging the
materials. Danger level can be determined with the following formula:
Danger Level = Average Consumption x Maximum reorder period for
emergency purchases.
d) Average Stock Level: The Average stock level is calculated such as:
Average Stock Level = Minimum stock Level + 1/2 of Reorder Quantity.
5. FSN Analysis: FSN meaning Fast-moving, the slow-moving and non-
moving in inventory management. FSN is one of the inventory
management techniques and it is about segregating products based on
their consumption rate, quantity, and the rate at which the inventory is
used. Fast-moving inventory, as the name suggests, comprises the
stock that moves quickly and needs to be replenished very often.
Generally, the stock that lies in this category has an inventory turnover
ratio of more than 3 and constitutes around 10-15% of the total
inventory. Slow-moving inventory is the inventory that crawls slowly
through the supply chain and has an inventory turnover ratio between 1-
3. It is generally 30-35% of the total stock.
The inventory that rarely moves with the inventory turnover ratio below 1
and makes 60-65% of the total stock is called the Non-moving inventory.
Importance and Usage of FSN Analysis
FSN analysis helps the management to make informed and accurate
inventory decisions. It helps in the optimum utilization of scarce
resources and guides the management to make the best use of the
money, time, and space available.
• It helps to identify the “deadstock.” The management needs to invest
only as per the actual stay and consumption of that product and not
make extra purchases. Also, it can identify which item is not moving
at all and dispose of it at discounted rates.
• FSN analysis also helps in space management effectively. Slow-
moving and non-moving categories of goods can be bought only in

185
 limited quantities to avoid jamming of storage space. Also, fast-
moving goods can be stored at locations near to entry and exit points
of godowns or warehouses that have clear access all the time. It
would help in saving time and labor.
• This analysis can be an excellent buying guide in the case of
seasonal products. The management will have a clear picture of the
time of the year when a product turns into a fast-moving one from a
slow or non-moving category. As a result, it can time its purchase
accordingly.
• FSN analysis helps to effectively allocate monetary resources to
items that are fast-moving and beneficial for the organization. As a
result, it helps to avoid blocking money in the slow-moving or non-
moving category of goods.
6. HML Analysis: The cost per item (per piece) is considered for this
analysis. The items of inventory should be listed in the descending order
of unit value and it is up to the management to fix limits for these
categories. High-cost items (H), Medium Cost items (M) and Low-Cost
item (L) help in bringing controls over consumption at the departmental
level.
This classification is as follows:
a. High-Cost items (H): Items whose unit value is very high
b. Medium Cost items (M): Items whose unit value is of medium value.
c. Low-Cost items (L): Items whose unit value is low.
This type of analysis helps in exercising control at the shop floor level
i.e., at the use point.
18.8 GRADED ILLUSTRATION
Illustration: 1
From the following information, determine the EOQ:

Annual consumption 90,000 units

Cost per unit Rs. 50
Buying cost per order Rs. 10
Cost of carrying inventory 10% of cost

Solution:
Computation of Economic Order Quantity (EOQ)
2 𝐴𝐵
EOQ = √ 𝐶𝑆

186
Where,
A = Annual usage = 90,000 units
B = Buying cost per order = Rs. 10
C = Cost per unit = Rs. 50
S = Storage and carrying cost per unit = 10%
2 ×90,000 × 10
EOQ = √ 50 ×10%
= √3,60,000 = 600 units

Illustration: 2

Eind out the economic order quantity form the following particulars:
Annual usage: Rs.1,20,000
Cost of placing and receiving one order: Rs. 60

Annual carrying cost = 10% of inventory value.

Solution:
Computation of Economic Order Quantity (EOQ)
2 𝐴𝐵
EOQ = √
𝑆

Where,

A = Annual usage of material in rupees = Rs.1,20,000

B = Buying cost per order = Rs.60
S = Storage and carrying cost = 10%
2 × 1,20,000 ×60
EOQ = √ = √14,00,00,000 = Rs.12,000
10%

Illustration: 3
Find out the EOQ and order schedule for raw materials and packing
materials with the following data given to you:
i) Cost of ordering: Raw materials: Rs. 1,000 per order Packing
materials: Rs.5,000 per order
ii) Cost of holding inventory: Raw materials: 1 paise per unit p.m.
Packing materials: 5 paise per unit p.m.
iii) Production rate: 2,00,000 units per month.
Solution:

(i) Computation of EOQ for Raw materials

2 𝐴𝐵
EOQ for Raw materials = √ 𝑆

187
Where,
A = Units consumed in a month =2,00,000 units
B = Buying cost per order = Rs.1,000
S = Storage & carrying cost = 1 paise
2 × 2,00,000 ×1,000
=√ 0.01
= √4,000,00,00,000 = 2,00,000 units

Order schedule
Monthly requirement of Raw materials =2,00,000 units

EOQ for Raw materials = 2,00,000 units

Therefore, one order per 2,00,000 units per month will be sufficient to
meet the monthly requirements of raw materials.

(ii) Computation of EOQ for packing materials

2 𝐴𝐵
EOQ for packing materials = √ 𝑆

where,
A = 2,00,000 units
B = Rs.5,000

S = 5 paise
2 ×2,00,000 ×5,000
EOQ for packing materials = √
0.05

= √4,000,00,00,000 = 2,00,000 units

Order schedule

Monthly requirement of packing materials: 2,00,000 untis

EOQ for packing materials: 2,00,000 units
Therefore, one order for 2,00,000 units per month will be sufficient to
meet the monthly requirements of packing materials.
Illustration: 4
Form the following particulars, find out
(a) How much should be ordered each time?
(b) What should be the inventory level immediately before the material
order is received? and
(c) When should the order be placed?

188
Annual consumption 12,000 units (360 days)
Cost per unit Re.1
Ordering cost Rs. 2 per order
Inventory carrying charge 24%
Normal lead time 15 days
Safety stock 30 days consumption

Solution:
(a) Computation of EOQ
2 𝐴𝐵
EOQ = √ 𝐶𝑆

Where,
A = Annual consumption = 12,000 units
B = Ordering cost = Rs. 12
C = Cost per unit = Re.1
S = Storage & carrying cost = 24%
2 ×12,000 ×12
EOQ = √ = √12,00,000 = 1,095 units
1 ×24%

(b) Computation of inventory level before the order is received

Inventory level immediately before the material ordered should be equal
to safely stock i.e., it should be equal to 30 days consumption
12,000
Safety stock = 360
× 30 = 1,000 units

(c) Computation of Reorder level

Reorder level = Safely stock + Lead time consumption
12,000
= 1,000 units + 360
× 15 = 1,000 + 500 = 1,500 units.

Illustration: 5

A chemical company user Rs. 25,000 worth of materials per year. The
administration cost per purchase is Rs. 25 and carrying cost is 20% of
the average inventory. The company currently has an optimum
purchasing policy but has been offered a 0.4 % discount if they purchase
five times per year. Should the offer be accepted? If not, what counter
offer should be made?
Solution:
(i) Computation of EOQ
2𝐴𝐵
EOQ = √ 𝑆

189
Where,
A = Annual consumption: Rs.25,000
B = Ordering cost (or) Administration cost for purchase: Rs.25
S = Carrying cost = 20%
2 ×25,000 ×25
EOQ = √ 0.20
= √62,50,000 = 2,500 units.

(ii) Computation of No. of orders

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 25,000
No. of orders = 𝐸𝑂𝑄
= 2,500
= 10 orders

(iii) Computation of total cost of inventory if the order is placed for

EOQ
Rs.
Cost of purchase 25,000
Ordering cost (10 orders × 25) 250
Carrying cost (2,500 × 1⁄2 × 20%) 250

25,500

(iv) Computation of total cost of inventory if purchases are

made five times a year
Rs.
Cost of purchase 25,000 24,900
Less: Discount (25,000 × 0.4%) 100 125
Ordering cost (5 orders × 25) 500
25,000
Carrying cost ( = 5,000 × 1⁄2 × 20%) 25,525
5

(v) Computation of savings in cost by following EOQ

Rs.
Total cost of inventory if purchases are
made five times 25,525
Less: Total cost of inventory by following EOQ 25,500

Savings in inventory cost 25

Analysis: For getting a discount of Rs.100, rate of discount is 0.4%.

therefore, for getting a further discount of Rs.25, further rate of discount
0.4
should be 0.1% (100 × 25). Thus, the rate of discount should be more
than 0.5% to make the offer attractive.

190
Illustration: 6
Compute various stock levels from the following data:

Normal consumption 300 units per day

Maximum consumption 420 units per day
Minimum consumption 240 units per day
Reorder quantity 3,600 units
Reorder period 10 to 15 days
Normal reorder period 12 days

Solution:
(i) Reorder level = Maximum consumption × Max. Reorder period
= 420 × 15 = 6,300 units
(ii) Maximum stock level = Reorder level + Reorder quantity –
(Minimum consumption × Minimum reorder period)
= 6,300 + 3,600 – (240 × 10)
= 7,500 units
(iii) Minimum stock level = Reorder level - (Normal consumption ×
Normal Reorder period)
= 6,300 – (300 × 12) = 2,700 units
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑙𝑒𝑣𝑒𝑙+𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑙𝑒𝑣𝑒𝑙
(iv) Average stock level = 2
7,500+2,700
= 2
= 5,100 units
(or)
1
= Minimum level+ of Reorder quantity
2
1
= 2,700 + (3,600)
2
= 4,500 units.

Illustration: 7
From the following information, you are required to calculate reorder
level, maximum level, minimum level and average level for materials X
and Y.

X Y
Normal usage per week 150 200
Reordering quantity 900 1500
Maximum usage per week 225 250
Minimum usage per week 75 100
Reorder period (week) 12 to 18 6 to 12

Solution:
(i) Reorder level = Maximum consumption × Max. Reorder period
Material X = 225 × 18 = 4,050 units

191
 Material Y = 250 × 12 = 3,000 units
(ii) Maximum level = Reorder level + Reorder quantity – (Minimum
consumption × Minimum Reorder period)
Material X = 4,050 + 900 – (75 × 12) = 4,050 units
Material Y = 3,000 + 1,500 – (100 × 6) = 3,900 units
(iii) Minimum level = Reorder level – (Normal consumption × Normal
Reorder period)
Material X = 4,050 – (150 × 15) = 1,800 units
Material Y = 3,000 – (200 × 9) = 1,200 units
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑙𝑒𝑣𝑒𝑙+𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑙𝑒𝑣𝑒𝑙
(iv) Average level = 2
4,050+1,800
Material X = 2
= 2,925 units
3,900+1,200
Material Y = 2
= 2,550 units
(or)
1
Average level = Minimum level + 2 of Reorder quantity
1
Material X = 1,800 + 2 (900) = 2,250 units
1
Material Y = 1,200 + 2 (1,500) = 1,950 units

Illustration: 8

A Ltd. uses inventory turnover as one performance measure to evaluate

its production manager. Currently, its inventory turnover (based on cost
of goods sold/inventory) is 10 times p.a as compared with industry
average of 4. Average sales are Rs. 4,50, 000 p.a Variable cost of
inventory have consistently remained at 70 % of sales with fixed costs of
Rs. 10,000. Carrying cost of inventory (excluding financing costs) is 5%
p.a. Sales force complained that low inventory levels are resulting in
lost-sales due to stock outs. Sales manager has made an estimate
based on stock-out reports as under:

Inventory policy Inventory turnover Sales (Rs.)

Current 10 4,50,000
A 8 5,00,000
B 6 5,40,000
C 4 5,65,000

One the basis of above estimates, assuming a 40% tax rate and an
after-tax required return of 20% on investment in inventory, which policy
would you recommend?
Solution:
Working Notes
(i) Computation of cost of goods sold
Cost of goods sold = Variable cost + Fixed cost

192
 Current = 4,50,000 × 70% + 10,000 = Rs. 3,25,000
A = 5,00,000 × 70% + 10,000 = Rs. 3,60,000
B = 5,40,000 × 70% + 10,000 = Rs. 3,88,000
C = 5,65,000 × 70% + 10,000 = Rs. 4,05,000
(ii) Computation of investment in inventory under various
policies
Current = 3,25,000 / 10 = Rs. 32,000
A = 3,60,000 / 8 = Rs. 45,000
B = 3,88,000 / 6 = Rs. 64,667
C = 4,05,500 / 4 = Rs. 1,01,375
(iii) Computation of inventory carrying cost
Current = 32,500 × 5% = Rs.1,625
A = 45,000 × 5% = Rs. 2,250
B = 64,667 × 5% = Rs.3,233
C = 1,01,375 × 5% = Rs. 5,069

Statement showing evaluation of inventory policies

Particulars Current Policy Policy Policy
policy A B C
Rs. Rs. Rs. Rs.
Sales 4,50,000 5,00,000 5,40,000 5,65,000
Less: Cost of 3,25,000 3,60,000 3,88,000 4,05,500
goods sold

Gross profit 1,25,000 1,40,000 1,52,000 1,59,500

Less: Inventory 1,625 2,250 3,233 5,069
carrying cost
Profit before tax 1,23,375 1,37,750 1,48,767 1,54,431
Less: Tax @ 40% 49,350 55,100 59,507 61,772
Profit after tax 74,025 82,650 89,260 92,659
Incremental profit - 8,625 6,610 3,399
Incremental - 12,500 19,667 36,708
investment
Incremental return - 69% 33.6% 9.3%
(%)

Analysis: Although all the three inventory policies offer an after-tax rate
of return more than 16%, yet policy A is the best as the rate of return on
incremental investment is highest in this case.
LET US SUM UP
Many businesses select one inventory management technique, and
some prefer a unique blend of techniques, that best suits their particular

193
needs. However, what implements an integrated inventory management
software to your business is Asset Infinity. Nevertheless, the technique
your business chooses to employ, it if does not have the ability to track,
trace and account your inventory in real-time, anyhow it will run into
trouble. There are several inventory management techniques that you
can use to manage, track, and analyze your production and sales
system.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. ___________ refers to the activities that are employed in maintaining
the optimum number or the amount of every inventory item.
a) Working Capital Management b) Receivable Management
c) Inventory Management d) Cash Management
2. JIT stands for___________.
a) Just in Time b) Just in Total
c) Just in Tandem d) Just in Teller
3. The ABC analysis groups inventory into ___________ classes.
a) 3 b) 4 c) 5 d) 6
4. ___________ analysis is an inventory management technique that
classifies inventory based on its functional importance.
a) HML b) ABC c) FSN d) VED
5. ___________ is a purchasing firm requires some time to process the
order and time is also required by the supplier/vendor to execute the
order.
a) Lead Time b) Lead Concept
c) Ordering Cost d) Replacement Model
GLOSSARY

Inventory : Inventory Management refers to the activities

Management that are employed in maintaining the
optimum number or the amount of every
inventory item. Production process
modification is the manufacturing procedure
that is used to come up with new or modified
items. Volume reduction is the processing of
waste materials to reduce the space they
occupy.

194
ABC Analysis : The ABC analysis groups inventory into
three classes. Class A contains 80 percent
of the total value of inventory. Class B
contains 15 percent of the total value of
inventory while class C contains 5 percent of
the total value of inventory.

Economic Order : EOQ is a technique for inventory

Quantity (EOQ) management that minimizes ordering and
holding costs for the year. EOQ is a crucial
accounting formula that determines when the
combination of inventory carrying cost, order
and costs are the least. The result obtained
from the formula gives the most effective
quality to order.

VED Analysis : VED analysis is an inventory management

technique that classifies inventory based on
its functional importance. It categorizes stock
under three heads based on its importance
and necessity for an organization for
production or any of its other activities. VED
analysis stands for Vital, Essential, and
Desirable.

Danger Level : It is the level below which stocks should not

fall in any case. If danger level approaches,
then immediate steps should take to
replenish the stocks even if more cost is
incurred in arranging the materials.

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.

195
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
[Link]
2. [Link]
3. [Link]
ANSWERS TO CHECK YOUR PROGRESS

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

196
Unit 19

CASH MANAGEMENT
STRUCTURE
Overview
Learning Objectives
19.1 Nature of Cash
19.2 Motive for holding Cash
19.3 Objectives of cash management
19.4 Cash planning
19.5 Factors determining Cash need
19.6 Limitations of Cash Management
19.7 Graded Illustration
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Cash is one of the components of current assets. It is the medium of
exchange for the purpose of goods and services and for discharging
liabilities. Cash management is one of the key areas of working capital
management as cash is both the beginning and end of working capital
cycle. Adequate availability of cash is essential to meet the business
needs. Since it is necessary in daily business operations and is
productive, the cash owned by an enterprise at any time should be
carefully regulated.
LEARNING OBJECTIVES
After learning this unit, you will be able to;
• describe the concept of cash and its motive
• list out the objectives of cash management
• explain the factor determining cash need.
19.1 NATURE OF CASH
Cash is the medium of exchange for the purchase of goods and services
and for discharging liabilities. In cash management the term cash has
used in two senses.

197
Narrow sense: Under this cash covers currency and generally accepted
equivalent of cash., example cheques, demand drafts and banks
demand deposit.
Broad sense: Cash includes not only the above stated but also near
cash assets. There are banks’s time deposits and marketable
securities. The marketable security can easily sell and converted into
cash.
19.2 MOTIVE FOR HOLDING CASH
Cash is the most crucial component of the working capital of a firm, as
every transaction results either in an inflow or outflow of cash. Cash has
no earning power, but still a firm need cash. There are three possible
motives for holding cash
1. The transaction motive: This motive arises due to the necessity of
having cash for various disbursements like purchase of raw materials,
payment of business expenses, payment of tax, payment of dividend
and so on. The need to hold cash would not arise, if there is perfect
synchronization between cash receipt and cash payments. Hence,
if firm must have an adequate cash balance particularly when
payments are in excess of receipts to meet obligations. The requirement
of cash to meet routine cash needs is known as transaction motive and
such motive refers to the holding of cash to meet the anticipated
obligations.
2. The precautionary motive: Apart from the non-synchronization of
anticipated cash flows in the ordinary course of business, firm may
require cash for the payment of unexpected disbursements. The
unexpected cash needs at a short notice may be the result of strikes,
failure of important customers, slow down in collection etc.,
3. The speculative motive: It refers to the desire of a firm to take
advantage of opportunities which present themselves at unexpected
moments and which are typically outside the normal course of business.
In simple language it is a motive of holding cash relates for investing in
profitable opportunities as and when they arise.
19.3 OBJECTIVES OF CASH MANAGEMENT

Why do we need to manage cash flow in the organization? What is the

use of cash management in the business? Following purposes of cash
management will resolve the above queries:

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1. Fulfil Working Capital Requirement: The organization needs to
maintain ample liquid cash to meet its routine expenses which possible
only through effective cash management.
2. Planning Capital Expenditure: It helps in planning the capital
expenditure and determining the ratio of debt and equity to acquire
finance for this purpose.
3. Handling Unorganized Costs: There are times when the company
encounters unexpected circumstances like the breakdown of machinery.
These are unforeseen expenses to cope up with; cash surplus is a
lifesaver in such conditions.
4. Initiates Investment: The other aim of cash management is to invest
the idle funds in the right opportunity and the correct proportion.
5. Better Utilization of Funds: It ensures the optimum utilization of the
available funds by creating a proper balance between the cash in hand
and investment.

6. Avoiding Insolvency: If the business does not plan for efficient cash
management, the situation of insolvency may arise. It is either due to
lack of liquid cash or not making a profit out of the money available.
19.4 CASH PLANNING
Cash planning and control of cash is the central point of finance
functions. Maintenance of adequate cash is one of the prime
responsibilities of financial manager. It is possible only through
preparation of cash (Cash Budget)
Cash control also includes in cash planning, since planning and control
are the twins of management. Cash planning is a technique to plan and
control the use of cash. A projected cash statement prepared based on
expected cash receipts and payments, anticipating the financial
conditions the firm.
19.5 FACTORS DETERMINING CASH NEED
The factors which determine the cash need are
1. Synchronization of cash flows: Synchronization of cash flows
arises only when there is no balance between the expected cash
inflows and cash outflows. There is no need to manage cash balance if
there is perfect match between cash inflows and cash outflows,
otherwise there is a need to manage cash balance for managing
synchronization.

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2. Short Costs: This is another factor to be considered while
determining the cash needs, short costs are those costs that arise with a
short fall of cash for the firm requirements namely cost of transportation,
cost of borrowing, cost of deterioration of credit rating, cost for loss of
cash discount.
3. Surplus cash balance Costs: It is self-explanatory, it means that the
cost associated with excess or surplus cash balance.
4. Management Costs: Management costs are those costs involved
with setting up and operating cash management staff. These
costs are generally fixed over a period and are mainly include staff
salary, storage, handling cost of security and so on.
19.6 LIMITATIONS OF CASH MANAGEMENT
Cash management is an inevitable part of business organizations.
However, it has a few shortcomings which make it unsuitable for small
organizations; these are as follows:

Cash management is a very time consuming and skilful activity which

is required to be performed regularly.
As it requires financial expertise, the company may need to hire
consultants or other experts to perform the task by
paying administrative and consultation charges.
Small business entities which are managed solely, face
problems such as lack of skills, knowledge, time and risk-taking ability
to practice cash management.
19.7 GRADED ILLUSTRATION

Illustration: 1
The following forecasts are provided in respect of kallis Ltd. for the year
2019:

Rs.
Sales 13,50,000
Purchases 9,00,000
Cost of goods sold 9,15,000
Average debtors 1,50,000
Average creditors 80,000
Average stock 1,52,000

Find out the cash operating cycle given that all sales and purchases are
made on credit.

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Solution:
Computation of Cash Operating Cycle
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘
Stock turnover cycle: × 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑
1,52,500
61 days
9,15,000
× 365 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
Debtors’ collection period = 𝑆𝑎𝑙𝑒𝑠
× 365
1,50,000 41 days
13,50,000
× 365 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
Less: Creditors payment period: 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠
× 365 102 days
80,000
9,00,000
× 365
32 days

Cash operating cycle 70 days

Illustration: 2
Rachakan Ltd. provides you the following information:
(i) Cash turnover ratio: 4.5 times
(ii) Annual cash outflow: Rs.1,75,000
(iii) Accounts payable can be stretched by 20 days.
What would be the effect of stretching accounts payable on the minimum
operating cash requirement? Assuming the firm can earn 12% on its
investment, what would be the saving on cost?
Solution:

(i) Computation of cosh cycle

Cash turnover ratio = 4.5 times
𝑁𝑜.𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
∴ Cash cycle =
𝐶𝑎𝑠ℎ 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
360
= 4.5
= 80 days
(ii) Computation of average daily cash balance required
Annual cash requirements = Rs.1,75,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ ×𝐶𝑎𝑠ℎ 𝑐𝑦𝑐𝑙𝑒
∴ Average daily cash balance = 𝑁𝑜.𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
1,75,000 ×80
=
360
= Rs.38,889
(iii) Computation of interest on average daily cash balance
Interest on average daily cash balance = 38,889 × 12%
= Rs. 4,667
(iv) Computation of new cash cycle if accounts payable is stretched
by 20 days.
New cash cycle = 80 – 20 = 60 days

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 360
New cash turnover ratio = 60
= 60 times
(v) Computation of average daily cash balance
Annual cash requirement = Rs.1,75,000
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ ×𝑁𝑒𝑤 𝑐𝑎𝑠ℎ 𝑐𝑦𝑐𝑙𝑒
Average daily cash balance = 𝑁𝑜.𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
1,75,000 ×60
= 360
= Rs.29,167
(vi) Computation of interest on average daily cash balance
Interest on average daily cash balance: 29,167 × 12% =
Rs.3,500
(vii) Computation of reduction in average cash balance & interest
saved
Reduction in average cash balance = 38,889 – 29,167
= Rs.9,722
Interest saved due to reduction in average cash balance:
4,667 – 3,500 = Rs.1,167

Illustration: 3
Form the following information, prepare a cash budget for June 2018:

Rs.
Cash in hand on 1.6.2018 20,000
Cash purchases for June 2018 1,40,000
Cash sales for June 2018 2,00,000
Office expenses for June 2018 6,000
Interest payable in June 2018 2,000
Purchase of office furniture in June 2018 5,000

Solution:

Particulars Rs.
Estimated opening cash balance: 20,000
Add: Estimated Cash Receipt:
Cash sales 2,00,000
Total Receipts (A) 2,20,000

Less: Estimated Cash Payments:

1,40,000
Cash purchases
2,000
Interest payable
5,000
Purchase of furniture
Total Payments (B) 1,47,000
Estimated closing cash balance (A - B) 73,000

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LET US SUM UP
Cash is one of the components of current assets and it is a medium of
exchange for the purpose of goods and services and for discharging
liabilities. Efficient management of cash involves an effort to minimise
investment in cash without impairing to liquidity of the firm. It implies a
proper balancing between the two conflicting objectives of the liquidity
and profitability.
CHECK YOUR PROGRESS
Choose the Correct Answer:
[Link] is one of the components of ___________.
a) Current assets b) Current liabilities
c) Fixed assets d) Fictitious assets
2. Cash requirement for the future can be forecasted through
___________.
a) Flexible budget b) Cash budget

c) Working capital budget d) All of the above

3. ___________ is also known as short term cash forecasting
a) Flexible budget b) Cash budget
c) Working capital budget d) All of the above
4. Surplus cash is ___________.
a) Productive b) Unproductive

c) Risky d) Feed assets

5. Cash is the most ___________ assets.
a) Floating b) Circulating
c) Liquid d) Rotating
GLOSSARY

Cash Management : Cash management, also known as treasury

management, is the process that involves
collecting and managing cash flows from the
operating, investing, and financing activities
of a company. In business, it is a key aspect
of an organization’s financial stability.

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Budget : A plan of how to spend an amount of money
over a period of time

Liquid Cash : anything in the form of cash

Forecast. : Prediction for the future

Receivable Cash : Any amount which the company has earned

Management however not yet received, i.e., its
outstanding and is expected to be received
in future, is known as receivables

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.

2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,

Tata McGraw-Hill Publishing Company limited, New Delhi.
3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
management/
2. [Link]
3. [Link]

ANSWERS TO CHECK YOUR PROGRESS

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

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Unit 20

RECEIVABLES MANAGEMENT
STRUCTURE
Overview
Learning Objectives
20.1 Introduction
20.2 Meaning of Receivables Management
20.3 Objectives of Receivable Management
20.4 Costs of Receivables
20.5 Benefits of Receivables
20.6 Credit Policy in Receivable Management
20.7 Setting a Credit Policy
Let Us Sum Up
Check Your Progress
Glossary
Suggested Readings
Web Resources
Answers to Check Your Progress
OVERVIEW
Accounts receivables refer to the dues owed by the customers for goods
purchased from the firm or services rendered by the firm in the ordinary
course of business. Accounts receivable implies futurity, i.e., cash will be
received in future though uncertain. Sales cannot be done for cash alone
and credit is inevitable in the modern business units, which is the basis
for receivables. Thus, the receivables arise when a firm sells its products
or services on credit and does not receive cash immediately. It is a
marketing technique by granting trade credit to protect its sales from the
competitors and attract the potential customers to buy its products at
favourable terms. The customers from whom receivables have to be
collected in the future are known as debtors. These debtors constitute
about one-third of current assets in Indian industrial units. Since a
substantial amount is tied-up in this segment of current assets, a careful
analysis and proper management is very much essential. In cash sales
there will not be any risk, whereas in credit sales risk is there, as the
seller receives payment later for delivery of goods affected today. This
Unit covers the concept of receivables management to get a detail
understanding of the cash management.

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LEARNING OBJECTIVES
After learning this unit, you will be able to;
• explain the concept of receivables management
• list out the objectives of receivable management
• describe the cost and benefits involved in receivables
management
• brief the credit policy terms in receivables management.
20.1 INTRODUCTION
Receivables management is the process of making decisions relating to
investment in trade debtors. If you want to increase sales turnover and
profits of the firm, you have to sell goods on credit basis, which includes
the risk of bad debts. 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 credit”.

Receivables represent amounts owed to the firm as a result of sale of

goods or services in the ordinary course of business. These are claims
of the firm against its customers and form part of its current assets.
Receivables are also known as account receivables, trade receivables,
or book debts. The receivables are carried for the customers. The period
for credit and extent of receivables depends upon the credit policy
followed by the firm. The purpose of maintaining or investing in
receivables is to meet competition, and to increase the sales and profits.
20.2 MEANING OF RECEIVABLES MANAGEMENT
Receivable management is a process of managing the account
receivables within a business organization. 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 organization. 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.

206
Receivables management aims at raising the sales volumes and profit of
the business by managing and providing credit facilities to customers. A
proper receivables 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.
20.3 OBJECTIVES OF RECEIVABLE MANAGEMENT
i) Monitor and Improve Cash Flow
ii) Minimizes bad debt losses
iii) Avoids invoice disputes
iv) Boost up sales volume
v) Improve customer satisfaction
vi) Helps in facing competition

i) Monitor and Improve Cash Flow: Receivables management

monitors and control all cash movements of organizations. 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
organization.
ii) Minimizes bad debt losses: Bad debts are harmful to organizations
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 amount timely
and informs the collection department on due dates. Customers are
notified for amount standing against them and charges interest on delay
in payments.
iii) Avoids invoice disputes: Receivables management has an efficient
role in avoiding any disputes arising in business. Disputes adversely
affect the relationship between customers and business organizations.
Complete and fair record of all transactions with customers are
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.

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iv) Boost up sales volume: Receivables management increase the
sales and the profitability of the organization. By extending the credit
facilities to their customers businesses 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.
v) Improve customer satisfaction: Customer satisfaction and retention
are key goals of every business. By lending credit, it supports financially
weak customers who can’t purchase business products fully on a cash
basis. This strengthens the relationship between customer and
organization. Customers are happy with the services of their business
partners. Receivable management help in organizing better credit
facilities for their customers.
vi) 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.
20.4 COSTS OF RECEIVABLES
There are various costs & benefits attached with a credit policy. These
may be enumerated as follows.
1. Cost of financing: The credit sales delay the time of sales realization
& therefore the time gap between incurring the cost & the sales
realization is extended. This results in blocking of funds for a longer
period. The firm on the other hand, has to arrange funds to meet its own
obligations towards payment to the supplier, employees etc., and these
funds are to be procured at some explicit or implicit cost. This is known
as cost of financing the receivables.
2. Administrative cost: A firm will also require incurring various costs in
order to maintain the record of credit customers both before the credit
sales as well as after the credit sales

208
3. Delinquency cost: The firm have to incur additional costs known as
delinquency costs, if there is delay in the payment by a customer. The
firm may have to incur cost on reminders, phone calls, postages, legal
notices etc. There is always an opportunity cost of the funds tied up in
the receivables due to delay in payment.
4. Cost of default by the customer: If there is a default by the
customer & the receivables becomes partly or wholly, unrealizable, then
this amount is known as bad debt, also becomes cost to the firm. This
cost does not appear in case of sales.
20.5 BENEFITS OF RECEIVABLES
1. Increase in sales: Most of the firms sell goods on credit, either
because of trade customs or other conditions. The sales can be further
increased by liberalizing the credit terms. This will attract more
customers to the firm resulting in higher sales & growth of the firm.
2. Increase in profits: Increase in sales help the firm in a) to easily
recover the fixed expenses & attaining the break-even level. b) Increase
the operating profit of the firm
3. Extra profit: Sometimes, the firm makes the credit sales higher than
the usual cash selling price. This brings an opportunity to the firm to
make extra profit over & above the normal profit.
20.6 CREDIT POLICY IN RECEIVABLE MANAGEMENT
The discharge of the credit function in a company embraces a number of
activities for which the policies have to be clearly laid down. Such a step
will ensure consistency in credit decisions and actions. A credit policy
thus, establishes guidelines that govern grant or reject credit to a
customer, what should be the level of credit granted to a customer etc.
A credit policy can be said to have a direct effect on the volume of
investment a company desires to make in receivables. A company falls
prey of many factors pertaining to its credit policy. In addition to specific
industrial attributes like the trend of industry, pattern of demand, pace of
technology changes, factors like financial strength of a company,
marketing organization, growth of its product etc. also influence the
credit policy of an enterprise. Certain considerations demand greater
attention while formulating the credit policy like a product of lower price
should be sold to customer bearing greater credit risk. Credit of smaller
amounts results, in greater turnover of credit collection. New customers
should be least favoured for large credit sales.

209
The profit margin of a company has direct relationship with the degree or
risk. They are said to be inter-woven. Since every increase in profit
margin would be counterbalanced by increase in the element of risk.
Credit policy of every company is at large influenced by two conflicting
objectives irrespective of the native and type of company. They are
liquidity and profitability. Liquidity can be directly linked to book debts.
Liquidity position of a firm can be easily improved without affecting
profitability by reducing the duration of the period for which the credit is
granted and further by collecting the realized value of receivables as
soon as they fail due. To improve profitability one can, resort to lenient
credit policy as a booster of sales, but the implications are:
To improve profitability on
• Changes of extending credit to those with week credit rating
• Unduly long credit terms.
• Tendency to expand credit to suit customer’s needs; and
• Lack of attention to over dues accounts.
20.7 SETTING A CREDIT POLICY
To establish a credit policy, a company must establish credit terms,
credit standards and a collection policy.
1. Credit Terms
Credit terms refer to the stipulations recognized by the firms for making
credit sale of the goods to its buyers. In other words, credit terms literally
mean the terms of payments of the receivables. A firm is required to
consider various aspects of credit customers, approval of credit period,
acceptance of sales discounts, provisions regarding the instruments of
security for credit to be accepted are a few considerations which need
due care and attention like the selection of credit customers can be
made on the basis of firms, capacity to absorb the bad debt losses
during a given period of time. However, a firm may opt for determining
the credit terms in accordance with the established practices in the light
of its needs. The amount of funds tied up in the receivables is directly
related to the limits of credit granted to customers. These limits should
never be ascertained on the basis of the subjects’ own requirements,
they should be based upon the debt paying power of customers and his
ledger record of the orders and payments. There are two important
components of credit terms which are detailed below

210
2. Credit period
The credit period lays its multi-faced effect on many aspects the volume
of investment in receivables; its indirect influence can be seen on the net
worth of the company. A long period credit term may boost sales but it‘s
also increase investment in receivables and lowers the quality of trade
credit. While determining a credit period a company is bound to take into
consideration various factors like buyer’s rate of stock turnover,
competitors’ approach, the nature of commodity, margin of profit and
availability of funds etc. The period of credit diners form industry to
industry. In practice, the firms of same industry grant varied credit period
to different individuals. as most of such firms decide upon the period of
credit to be allowed to a customer on the basis of his financial position in
addition to the nature of commodity, quality involved in transaction, the
difference in the economic status of customer that may considerably
influence the credit period.
The general way of expressing credit period of a firm is to coin it in terms
of net date that is, if a firm’s credit terms are “Net 30”, it means that the
customer is expected to repay his credit obligation within 30 days.
Generally, a free credit period granted, to pay for the goods purchased
on accounts tends to be tailored in relation to the period required for the
business and in turn, to resale the goods and to collect payments for
them. A firm may tighten its credit period if it confronts fault cases too
often and fears occurrence of bad debt losses. On the other side, it may
lengthen the credit period for enhancing operating profit through sales
expansion. Anyhow, the net operating profit would increase only if the
cost of extending credit period will be less than the incremental
operating profit. But the increase in sales alone with extended credit
period would increase the investment in receivables too because of the
following two reasons: (i) Incremental sales result into incremental
receivables, and (ii) The average collection period will get extended, as
the customers will be granted more time to repay credit obligation.
3. Cash Discount Terms
The cash discount is granted by the firm to its debtors, in order to induce
them to make the payment earlier than the expiry of credit period
allowed to them. Granting discount means reduction in prices entitled to
the debtors so as to encourage them for early payment before the time
stipulated to the credit period. Grant of cash discount beneficial to the
debtor is profitable to the creditor as well. A customer of the firm i.e.,
debtor would be realized from his obligation to pay Soon that too at
discounted prices. On the other hand, it increases the turnover rate of

211
working capital and enables the creditor firm to operate a greater volume
of working capital. It also prevents debtors from using trade credit as a
source of working capital. Cash discount is expressed is a percentage of
sales.
A cash discount term is accompanied by (a) the rate of cash discount,
(b) the cash discount period, and (c) the net credit period. For instance,
a credit term may be given as “1/10 Net 30” that mean a debtor is
granted 1 percent discount if settles his accounts with the creditor before
the tenth day starting from a day after the date of invoice. But in case the
debtor does not opt for discount he is bound to terminate his obligation
within the credit period of thirty days. Change in cash discount can either
have positive or negative implication and at times both. Any increase in
cash discount would directly increase the volume of credits sale. As the
cash discount reduces the price of commodity for sale, so, the demand
for the product ultimately increases leading to more sales. On the other
hand, cash discount lures the debtors for prompt payment so that they
can relish the discount facility available to them. This in turn reduces the
average collection period and bad debt expenses thereby, bringing
about a decline in the level of investment in receivables. Ultimately the
profits would increase. Increase in discount rate can negatively affect the
profit margin per unit of sale due to reduction of prices.
A situation exactly reverses of the one stated above will occur in case of
decline in cash discount. Yet, the management of business enterprises
should always take note of the point that cash discount, as a percentage
of invoice prices, must not be high as to have an uneconomic bearing on
the financial position of the concern. It should be seen in this connection
that terms of sales include net credit period so that cash discount may
continue to retain its significance and might be prevented from being
treated by the buyers just like quantity discount. To make cash discount
an effective tool of credit control, a business enterprise should also see
that is allowed to only those customers who make payments at due date.
And finally, the credit terms of an enterprise on the receipt of securities
while granting credit to its customers. Credit sales may be got secured
by being furnished with instruments such as trade acceptance,
promissory notes or bank guarantees.
4. Credit Standards

Credit standards refers to the minimum criteria adopted by a firm for the
purpose of short listing its customers for extension of credit during a
period of time. The nature of credit standard followed by a firm can be
directly linked to changes in sales and receivables. A liberal credit

212
standard always tends to push up the sales by luring customers into
dealings. The firm, as a consequence would have to expand receivables
investment along with sustaining costs of administering credit and bad
debt losses.
As a more liberal extension of credit may cause certain customers to
the less conscientious in paying their bills on time. Contrary, to these
strict credit standards would mean extending credit to financially sound
customers only. This saves the firm from bad debt losses and the firm
has to spend lesser by a way of administrative credit cost. But this
reduces investment in receivables besides depressing sales. In this way
profit sacrificed by the firm on account of losing sales amounts to more
than the cost saved by the firm. Prudently, a firm should opt for lowering
its credit standard only up to that level where profitability arising through
expansion in sales exceeds the various costs associated with it. That
way, optimum credit standards can be determined and maintained by
inducing trade-off between incremental returns and incremental costs.
5. Collection Policy
Collection policy refers to the procedures adopted by a firm (creditor)
collect the amount from its debtors when such amount becomes due
after the expiry of credit period. The requirements of collection policy
arise on account of the defaulters i.e. the customers not making the
payments of receivables in time. As a few turn outs to be slow payers
and some other non-payers. A collection policy shall be formulated with
a whole and sole aim of accelerating collection from bad debt losses by
ensuring prompt and regular collections. Regular collection on one hand
indicates collection efficiency through control of bad debts and collection
costs as well as by inducing velocity to working capital turnover. On the
other hand, it keeps debtors alert in respect of prompt payments of their
dues. A credit policy is needed to be framed in context of various
considerations like short-term operations, determinations of level of
authority, control procedures etc. Credit policy of an enterprise shall be
reviewed and evaluated periodically and if necessary, amendments shall
be made to suit the changing requirements of the business. It should be
designed in such a way that it co-ordinates activities of concerned
departments to achieve the overall objective of the business enterprises.
Finally, poor implementation of good credit policy will not produce
optimal results.
To conclude, the credit policy of a company should be developed in
accord with the strategic, marketing, financial and organizational context
of the business and be designed to contribute to the achievement of

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corporate objectives. The corporate strategy can include trade credit
management not just in terms of its contribution to collection and cash
flow but as a means of generating sales and profits, and of investing in
customers by building relationships. The management of trade credit
can help build stable and long-term relationships with customers,
generate information about the customer and their requirements and
facilitate different customer strategies in terms of credit granting, credit
terms and customer service. The objective is to generate growing but
profitable sales. A credit policy thus, establishes guidelines that govern
grant or reject credit to a customer, what should be the level of credit
granted to a customer etc. A credit policy can be said to have a direct
effect on the volume of investment a company desires to make in
receivables.
LET US SUM UP
In this unit, it has been discussed that receivables management is a very
important area of total working capital management. It means that an
effective and efficient management of receivables can contribute a lot for
the improvement of the profitability and liquidity of a business firm. The
important dimensions of credit policy are credit terms, credit standards
and collection efforts. In general, liberal credit standards tend to push up
sales accompanied by a higher incidence of bad debt loss, a larger
investment of receivables and a higher cost of collection. On the other
hand, a stiff credit policy has opposite effects. In judging the credit
worthiness of an applicant for credit, the basic factors are character,
capacity and conditions.
CHECK YOUR PROGRESS
Choose the Correct Answer:
1. The goal of receivables management is to maximise a trade-off
between_________.
a) Risk and Profitability b) Liquidity and Profitability
c) Return and Liquidity d) Risk and liquidity
2. _________ refer to the stipulations recognized by the firms for making
credit sale of the goods to its buyers

a) Credit Policy b) Credit terms

c) Credit analysis d) Credit period

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3. _________ refers to the procedures adopted by a firm (creditor)
collect the amount of from its debtors when such amount becomes due
after the expiry of credit period.
a) Credit Policy b) Credit terms
c)Credit analysis d) Credit period
4. The firm have to incur additional costs known as _________ if there is
delay in the payment by a customer
a) Appreciation cost b) Administrative Cost
c) Delinquency Cost d) Cost of financing
5. _________ is the Cost incurred to maintain the record of credit
customers.
a) Appreciation cost b) Administrative Cost
c) Delinquency Cost d) Cost of financing
GLOSSARY

Accounts : money owed by debtors or customers

Receivable

Collection Policy : it describes the procedures a firm follows in

attempting to collect its receivables

Credit Period : The time given to a buyer to make full payment

for credit purchases

Credit Policy : Norms and guidelines to determine whether and

how much credit is to be extended to a
customer

Credit Terms : The repayment terms extended by a firm to its

debtors

SUGGESTED READINGS
1. James C. VanHorne, John M. Wachowicz, (2015), Fundamentals of
Financial Management, 13th Edition, Pearson Education India,
Noida.
2. Khan M Y & Jain P. K, (2014), Financial Management,7th Edition,
Tata McGraw-Hill Publishing Company limited, New Delhi.

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3. Kuchhal S. C., (2016), Financial Management,15th Edition,
Chaitanya Publishing House, Allahabad.
4. Maheswari, S. N. (2013), Financial Management: Principles and
Practice, Sultan Chand and Sons, New Delhi.
5. Pandey I.M., (2016), Financial Management,11th Edition, Vikas
Publishing House, New Delhi.
6. Prasanna Chandra, (2017), Financial Management, 9th Edition, Tata
McGraw-Hill Publishing Company limited, New Delhi.
7. Sudarsana Reddy G., (2017), Financial Management Principles and
Practice, Third Revised edition, Himalaya Publishing House,
Mumbai.
WEB RESOURCES
1. [Link]
2. [Link]
3. [Link]

ANSWERS TO CHECK YOUR PROGRESS

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

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