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FM COmplete notes- V SEM NEP

bachelors of commerce (University of Mysore)

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Syllabus
Module No. 1: Introduction to Financial Management
Introduction –Meaning of Finance, Finance Function, Objectives of Finance function,
Organization of Finance function -Meaning and definition of Financial Management;
Goals of Financial Management, Scope of Financial Management, Functions of Financial
Management, Role of Finance Manager in India. Financial planning-- Meaning –Need –
Importance -Steps in financial Planning – Principles of a sound financial plan and
Factors affecting financial plan.
Module No. 2: Time Value of Money
Introduction – Meaning of time value of money-time preference of money- Techniques of
time value of money: Compounding Technique-Future value of Single flow, Multiple flow
and Annuity -Discounting Technique-Present value of Single flow, Multiple flow – and
Annuity. Doubling Period- Rule 69 and 72.
Module No. 3: Financing Decision
Introduction-Meaning and Definition of Capital Structure, Factors determining the
Capital Structure, Concept of Optimum Capital Structure, EBIT-EPS Analysis-
Problems. Leverages: Meaning and Definition, Types of Leverages- Operating Leverage,
Financial Leverage and Combined Leverages. Problems.
Module No. 4: Investment Decision
Introduction-Meaning and Definition of Capital Budgeting, Features, Significance – Steps
in Capital Budgeting Process. Techniques of Capital budgeting: Traditional Methods –
Pay Back Period, and Accounting Rate of Return – DCF Methods: Net Present Value
Internal Rate of Return and Profitability Index- Problems.
Module 5: Working Capital Management
Introduction- Meaning and Definition, types of working capital, Operating cycle,
Determinants of working capital needs – Estimation of working capital requirements.
dangers of excess and inadequate working capital, Merits of adequate working capital,
Sources of working capital. Cash Management, Receivable Management, and Inventory
Management (Concepts only).

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Module No. 1: Introduction to Financial Management
Theory
INTRODUCTION
“Financial prosperity is impossible without constant planning and management of
money”.
Finance represents money management and the process of acquiring needed funds. It is
the life-blood of business. It is the basic requirement of all kinds of business activities.
It is the art and science of managing money.
Finance is the master key Which provides to access all other resources that are
employed in the production and marketing of goods and services. The efficient
functioning of every business is dependent, not on the mere availability of finance, but
on the efficient utilization of finance. Money helps to get more money only when it is
efficiently managed or utilized.
MEANING
It refers to all those managerial activities or efforts which are concerned with the
ascertainment of finance needed by the firm determination of the sources suitable under
the given circumstances, collection of funds in time and control over the utilization of
funds.
DEFINITION
“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business”.
Guthumann and Dougall
“Financial management is concerned with raising financial resources and their effective
utilization towards achieving the organisational goals”
Dr. S. N. Maheshwari
Nature or Features or Characteristics of Financial Management
Nature of financial management is concerned with its functions, its goals, trade-off with
conflicting goals, its indispensability, its systems, its relation with other subsystems in
the firm, its environment, its relationship with other disciplines, the procedural aspects
and its equation with other divisions within the organisation.
1. Financial Management is an integral part of overall management. Financial
considerations are involved in all business decisions. So financial management is
pervasive throughout the organisation.
2. The central focus of financial management is valuation of the firm. That is financial
decisions are directed at increasing/maximization/ optimizing the value of the firm.

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3. Financial management essentially involves risk-return trade-off Decisions on
investment involve choosing of types of assets which generate returns accompanied by
risks. Generally higher the risk, returns might be higher and vice versa. So, the financial
manager has to decide the level of risk the firm can assume and satisfy with the
accompanying return.
4. Financial management affects the survival, growth and vitality of the firm. Finance is
said to be the life blood of business. It is to business, what blood is to us. The amount,
type, sources, conditions and cost of finance squarely influence the functioning of the
unit.
5. Finance functions, i.e., investment, rising of capital, distribution of profit, are
performed in all firms - business or non-business, big or small, proprietary or corporate
undertakings. Yes, financial management is a concern of every concern.
6. Financial management is a sub-system of the business system which has other
subsystems like production, marketing, etc. In systems arrangement financial sub-
system is to be well-coordinated with others and other sub-systems well matched with
the financial subsystem.
SCOPE OF FINANCIAL MANAGEMENT
1. Estimating financial requirements
The first and foremost task of financial manager is to estimate long term and short-term
financial requirements. The financial plan should estimate the funds accurately as
excess funds may tempt the organisation to indulge in unnecessary expenditure. On the
contrary, inadequacy of funds may adversely affect the operations of the business and
idle cash may not fetch any returns to the business.
2. Deciding capital structure
After deciding the quantum of funds to be raised for the business, the task of the finance
manager remains in framing the capital structure. Capital structure refers to the kind
and proportion of different securities for raising such funds. A decision about various
sources of funds should be linked to the cost of raising funds. A proper blend of equity
and debt should be made up in the business to finance long and short-term
requirement.
3. Selecting a source of finance
An appropriate source of finance is selected after the formulation of capital structure.
Various sources from which finance maybe raised, include share capital, debentures,
financial institutions, commercial banks, public deposits etc.
4. Selecting a pattern of investment

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After procuring the required funds, decision about the use of funds is to be made. To
choose the best among the rest, various techniques may be employed such as capital
budgeting, cost volume profit analysis, etc in making decisions about capital
expenditures.
5. Proper cash management
Cash is a liquid asset which has to be maintained appropriately to cater to various needs
of the business on time. To provide timely payment there should be regular inflow of
cash. There should be proper balance of cash inflow and outflow for efficient operations
in business.
6. Implementation of financial controls
Proper control is essential for efficient system of financial management. Various control
devices such as return on investment, budgetary control, break even analysis, cost
control, ratio analysis etc. can be used as a measure to analyse the performance.
7. Proper use of surplus
A judicious use of surpluses is essential for expansion and diversification plans and also
in protecting the interest of shareholders. The ploughing back of profits is the best policy
of further financing but it clashes with the interests of shareholders.
GOALS OF FINANCIAL MANAGEMENT
Following are the objectives of financial management
1) Profit Maximization

2) Wealth Maximization

3) Other/General Objectives
Profit Maximization
Profit earing is the main aim of every economic activity. A business being an economic
institution must earn profit to cover its costs and provides funds for growth. No business
can survive without earning profit.
Profit Maximization refers to the process whereby companies focus on maximizing their
profit or getting the best possible profit in their particular kind of business.
Arguments in Favour of Profit Maximization
1. Profit is a barometer through which the performance of a business unit can be
measured

2. Profit ensures maximum welfare to the shareholders, employees, and prompt

payment to creditors of a company.

3. Profit Maximization increases the confidence of management in expansion and

diversification programmes of a company.

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4. Profit Maximization attracts the investors to invest their savings in securities of
time.

5. Profit indicates the efficient use of funds for different requirements

Arguments Against Profit Maximization

1. Profit is a not a clear term. Is it accounting profit? Economic profit? Profit before
tax? After tax? Net profit? Gross Profit or EPS?
2. It encourages corrupt practices to increase the profits.
3. Profit Maximization does not consider the element of risks.
4. It does not consider the impact of time value of money.
5. The true and fair picture of the organization is not reflected through Profit
Maximization Profit Maximization attracts cut-throat competition.
6. Huge number of profits attracts government intervention.
7. A huge profit invites problem from workers. They demand high salary and fringe
benefits.
8. The modern concept of marketing does not encourage Profit Maximization.
9. Profit Maximization is a narrow concept, later it affects the long-term liquidity of a
company.
To conclude, Profit Maximization criterion is inappropriate and unsuitable as an
operational objective of investment, financing and dividend decisions of the firm because
it ignores the two important dimensions of financial analysis namely risk and time value
of money.
Wealth Maximization
Wealth Maximization refers to the gradual growth of the value of assets of the firm in
terms of benefits it can offer. Wealth Maximization attained by an organization is
reflected by the market value of shares.
Significance of Wealth Maximization
• Investors/ Shareholders.

• Financial lenders

• Workers/Employees.

• Management.

• Public/Society.

1) Investors/ Shareholders: Share holders’ interest is protected by increased market

value of their holdings in the firm.
2) Financial lenders: It provides security to the financial lenders, who supply funds to
the business enterprise.

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3) Workers/Employees: Workers are the backbone of every organization. Wealth
Maximization must also ensure the interest of the workers through handsome and
regular payment of salary and other amenities.
4) Management: The overall success of the organization depends on the decision taken
by the management; hence Wealth Maximization should protect the interest of the
management.
5) Public/Society: It ensure to provide right quality and quantity of goods and services
to the public at reasonable prices.
Advantages of Wealth Maximization
 The concept of Wealth Maximization is a clear term
 It considers the time value of money
 Wealth Maximization concept is universally accepted.
 It guides the management in formulating a consistent strong dividend policy to
reach maximum return to the equity holders
 It studies the impact of risk factors.
Disadvantages of Wealth Maximization
• Wealth Maximization is the indirect name of profit maximization.

• Wealth Maximization can be activated only with the help of profitable position of the
business concern.
Wealth Maximization is superior to Profit Maximization
Profit Maximization Wealth Maximization
It is a vague concept It is a clear term and not vague
It ignores the time value of money It considers the time value of money
It does not consider the element of risks. It considers the element of risks.
It ignores the interest of the community It considers the interest of the community
It does not show the true and fair picture of It shows the true and fair picture of the
the organization organization
It is a short-term objective It is a long-term objective
Financial decision
Financial decision refers to decisions concerning the main financial matters of a
business concern. The decision as to the amount of funds to be invested the kinds of
assets to be acquired, the pattern of capitalization, the pattern of distribution of the
profit of the concern and other similar financial matters are included in financial
decisions.
Types of Financial decision
1) Financing decision.

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2) Investment decision.
3) Dividend decision.
1) Financing decisions.
 It is a major function of financial management. It deals with the procurement of
capital funds through internal and external sources.
 Financing decision is with the financing mix or capital mix or leverage or capital
structure.
 The term leverage or capital structure deals with the proportion of debt and equity
capital mix in the total capital of the firm.
 The debt –equity ratio should be fixed in such a way that it helps in maximising
the profitability of the concern. The raising of more debts will involve fixed interest
liability and dependence upon outsiders.
 It may help in increasing the return on equity but will also enhance the risk. The
raising of funds through equity will bring permanent funds to the business but the
shareholders will expect higher rate of earnings. The finance manager has to strike
a balance between the various sources so that the overall profitability of the
concern improves.
 If the capital structure is able to minimise the risk and raise the profitability then
the market prices of the shares will go up maximising the wealth of shareholders.
2) Investment decisions.
 It refers to the allocation of capital funds on the acquisition of fixed assets and
current assets. This decision is also known as Asset mix decision since the
investment is made on the acquisition of both fixed assets and current assets.
 The investment decision to allocate capital funds on the acquisition of fixed assets
are known as ‘capital budgeting’ and the decision which relates to acquisition of
currents assets is known as ‘working capital management.
 The fixed asset acquisition decision has a long period effect. Hence careful analysis
is required in choosing the best asset is crucial through the application of different
capital budgeting techniques like PBP, ARR, NPV, IRR and PI.
 The second component of investment decision is ‘working capital management.
Which is concerned with the management of current assets and current liabilities?
Working capital management is important and integral part of financial
management discipline, as short-term survival of pre-requisite of long-term
success. Hence there should be a trade-off between profitability and liquidity is
necessary.
3) Dividend decisions

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This decision relates to the dividend policy of the organisation. Dividend decisions deals
with the profits of the organisation, which has two aspects- dividend and reserve.
a) What proportion of profits is distributed to the shareholders as dividend? i.e. dividend
pay -out ratio
b) What proportion of profits should be retained as reserves to meet contingencies?
The final decision will depend up on the preference of the shareholders and the
investment opportunities available within the firm and also the factors which determines
the dividend policy of the organization.
Risk-Return Tradeoff
The risk-return tradeoff states that the potential return rises with an increase in risk.
Using this principle, individuals associate low levels of uncertainty with low potential
returns, and high levels of uncertainty or risk with high potential returns.
The following figure shows the relationship between various financial decisions and the
risk-return tradeoff and market value of the firm.
Financial Manager
A finance manager is a person who is responsible for all the important financial
functions of an organization. The decisions taken by finance manager will affect the
profitability, growth and goodwill of the firm.
Role /Functions of finance manager
1)Raising of funds
2)Allocation of funds
3)Profit planning
4)Understanding capital markets
As against the traditional role played by finance manager, there are challenges faced by
finance manager to adapt to the changes in the emerging economy, the role played by
financer manager too is changing.
1) The finance manager has to know more about the core financial activities in terms of
globalization, liberalization and privatization (LPG).
2) The finance manager has to guide the management in adopting tax planning
technique.
3) Finance manager should have requisite knowledge of export and import.
4) Finance manager has to know about the various application of information
technology.
5) It is important to deliver training to personnel about the modern techniques of
financial management.
6) He should also concentrate on stress management techniques.

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Financial Planning
Financial Planning is the process of estimating the capital required and determining its
composition. It is the process of framing financial policies in relation to procurement,
investment and administration of funds of an enterprise.
Principles of Sound Financial Planning
1) Principle of Simplicity.
2) Principle of Foresight.
3) Principle of Flexibility.
4) Principle of Liquidity.
5) Principle of Economy
6) Principle of Contingencies
7) Principle of optimum use.
8) Principle of Long-term view.
9) Investor’s Preference
1. Principle of simplicity
Simplicity principle should be kept in mind while preparing financial plan. It states that
financial plan should be easily understandable about its contents and implementation. t
plan should not lead to complications, suspicions and ambiguity.
2. Principle of foresight.
Present and future needs of the organisation should be kept in mind while framing
financial plan though it is too difficult to forecast the future fund requirements due to
change in business environment.
3. Principle of flexibility.
Financial plan should not be rigid. There may be a scope for raising additional funds if
fresh opportunities occur. Similarly, idle funds if any maybe invested in short-term and
low-risk bearing securities.
4. Principle of liquidity.
The firm should incorporate the liquidity factor in its structure, where sufficient amount
of current assets should be maintained to repay the current liabilities. Because the
liquidity ensures credit worthiness and goodwill to the firm.
5. Principle of Economy.
It states that, the financial funds should be raised at minimal cost. Hence while
formulating financial plan cost of procurement of capital funds should be kept in mind.
6. Principle of contingency.

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Maximum utilization of funds depends on how best we manage these future obstacles.
Hence the financial plan should be coupled with the principle of provision for
contingency and risk.
7. Principle of optimum use.
Financial plan should incorporate neither excess funds nor deficit funds, it should have
required fund or optimum fund or balanced fund.
8. Principle of long-term view.
The financial plan should be formulated keeping in view the long-term needs of an
organisation. This is because the original financial plan would continue to operate for
long period of time even after the formulation of organisation.
9. Investor’s preference.
The preference of the investors is different. Investors who are bold and venturesome,
prefer equity shares, Investors who are not very bold have a liking for preference shares.
Investors, who are very cautious, go for debentures. As such the financial plan should
keep in mind the temperament or the preference of the investors.
Factors Influencing Financial Planning
1) Nature of the industry.
A financial plan should be framed keeping in mind the type/ nature of industry.
For instance, Capital intensive industry need more capital than labour intensive
industry needs to give priority to labour force than capital and other factors, which helps
to decide the quantum of capital and the sources of procurement of labour force.
2) Status of the company in the industry.
Status of the industry in terms of age, that the number of years of its existence, size of
its activities, the extend of goodwill it earns, its area of operation/the nature of product
and the promoters of management etc., is very important in attracting the capital.
3) Future plans.
The financial plan should be designed keeping in view the future plans of the business.
For instance, an organisation planning for expansion or diversification in near future will
require flexible financial plan. The sources of funds should facilitate required funds
without any difficulty.
4) Availability of Sources.
There are various sources by which an organization can raise funds. The pros and cons
of all available sources should be properly analysed for making a final decision making
on the sources. The selected sources should be able to provide adequate and regular
funds to meet the various needs of the business.
5) General economic conditions.

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The prevailing economic conditions at the national level and international level will
influence a decision about financial plan. These conditions should be considered before
taking any decision about the sources f funds. A favourable economic environment will
help in raising funds without any difficulty. On the other hand, uncertain economic
conditions may make it difficult for even a good concern to raise sufficient funds.
6) Government Policy.
Nature of government Policy, financial controls and other provisions should be
considered in formulating financial plan, since they have an influence on the decision of
the organization on profits, tax, dividends, investments and acquisitions etc.
7) Management attitude towards control
Financial plan should also incorporate the attitude management towards its policies and
procedures in deciding the extent of capital through equity or debt control, project
control, profit and the dividend decisions.
8) Types of Capital Structure.
Debt-Equity proportion /leverage decision has an influence on the maximization of EPS
to equity shareholders and the extent of operational and financial risk factor of the
organization. Hence the type of capital mix is an important factor in formulating
financial plan of an organization.
9) Magnitude of external sources of finance.
The extent to which the external sources of finance like borrowings from financial
institutions, issue of debentures and other short-term borrowings is also play an
important role in managing fixed and working capital require.
10) Extent of relationship with neighbouring industries.
Financial plan should give due weightage to the nature and type of relationship that an
organization has to maintain decides its competitive advantage in its activities.
Steps in Financial planning
Financial planning involves the following steps
1) Estimating the capital requirements.
2) Determination of the form and the proportionate number of securities to be issued.
3) Setting financial objectives.
4) Formulation of financial policies.
5) Formulation of financial Procedure.
1) Estimating the capital requirements.
a) The cost of fixed assets like land, buildings, plant & machinery, furniture & fittings
required to be acquired.
b) The cost of intangible assets like patents, goodwill etc to be acquired.

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c) The amount required to be invested in current assets.
d) The Cost of Promotion.
e) The cost of financing.
2) Determination of the form and the proportionate number of securities to be
issued.
a) Determining the Capital structure
b) Determining the Debt-Equity ratio
c) Selecting the types of securities to be issued to raise the funds.
3) Setting financial objectives.
a) Short- term Objectives.
b) Long-term Objectives.
4) Formulation of financial policies.
a) Policy regarding the size of capitalization.
b) Policy governing the capital structure.
c) Policy regarding collection and credit.
d) Dividend policy
e) Policy regarding management of fixed & current assets.
5) Formulation of financial Procedure
a) Formulation of financial Procedures are required to execute the financial plan.
b) They are very helpful to the middle level executives to know their responsibility.
Limitations Financial planning
Financial plan guides the management in taking varied decisions, but this function will
be restricted or failed due to some drawbacks, namely:
1) Difficulty in forecasting: Future conditions cannot be forecasted accurately, which
makes adoptability of financial plan a very difficult task.
2) Difficulty in formulating plans: Formulation of future plans is tedious task for the
management since it involves huge time, money and man power.
3) Difficulty in Changing plan: Once financial plan is prepared then it becomes difficult
to change.
4) Problem of coordination: There is lack of coordination among different functions. Even
indecision among personnel disturbs the process of plan.
5) Rapid Changes in economy: Drastic changes in government rules and regulations
about the economic environment can affect financial plans adversely.

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Module No. 2: Time Value of Money

Theory
Time Value of Money MEANING
Time value of money (TVM) is the idea that money that is available at the present time is
worth more than the same amount in the future, due to its potential earning capacity.
This core principle of finance holds that provided money can earn interest, any amount
of money is worth more the sooner it is received.
DEFINITION
“The time value of money (TVM) is the concept that money you have now is worth more
than the identical sum in the future due to its potential earning capacity. This core
principle of finance holds that provided money can earn interest, any amount of money
is worth more the sooner it is received. TVM is also sometimes referred to as present
discounted value”.
NEED OF TIME VALUE OF MONEY
• Re-investment opportunities:
Fundamental principal behind time value of money is that, a sum of money received
today, is worth more than if the same is received after a certain period of time.
• Uncertainty:
Future is always uncertain and risky. Outflow of cash is in our control but there is no
certainty of future cash inflows.
• Inflation:
In an inflationary economy, the money received today, has more purchasing power than
the money to be received in future.
• Personal consumption preference:
People consider present needs as more important than their future needs. Purchase of
clothes, television, car and luxurious articles for their present use feels more urgent
than saving for tomorrow. Therefore, people consider the value of money today as more
than its value as of tomorrow.
Problems on Compound Interest (future Value) and Simple Interest
Formulas

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Simple Interest = P x T x I / 100
Calculation of Future Value of Single Cash Flow
If Interest is Compounded annually
Future Value =
FV = PV × CVIFn.i

1.

Solution:
Future Value =
=
= 20000(1.12)5
= 20000 (1.7623)
Future Value = Rs. 35246.83
2.

Solution:
Future Value =
At the end of First Year
Future Value =
= 35000(1.12)1
= Rs.39200
Interest = 39200 – 35000 = 4200
At the end of Second Year
Future Value =
= 35000(1.12)2
= 35000 (1.2544)
= Rs.43904
Interest = 43904 – 35000 = 8904
If Interest is Compounded Half Yearly / Quarterly
Future Value =

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P= Principal ; n= Time period ; I = Rate of Interest ; M- Quarterly – 4 ; Half yearly -2
1.

Solution:
a) Compunded annually
Future Value =
FV = 30000 (1+0.08)5
FV = 30000 (1.08)5
FV = 30000 (1.469)
FV = Rs.44080
b) Compunded half yearly
Future Value =

Future Value =

Future Value =
FV = 30000 (1+0.04)10
FV = 30000 (1.48)
FV = Rs.44407
c) Compunded quaterly
Future Value =

Future Value =
FV = 30000 (1+0.04)10
FV = 30000 (1.486)
FV = Rs.44578
Exercise
1.

2.

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3.

4.

1.

If Cash Flow happens at the end of year

= 40000 (6.1051)

FV = Money at the end of 5 of years = 244204

Or

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Beginning of Year Amount Interest (10%) End of year
1 - - 40000
2 40000 4000 44000+40000
3 84000 8400 92400+40000
4 132400 13240 145640+40000
5 185460 18564 204024+40000
At end of 5 years = 204024+40000 = 244024
Exercise
1

Problems on Present Value

Present value of Ordinary Annuity

PVAn = FV PVIFA I.n
1.

Solution:
Calculation of Present Value
End Year Cash Flow PVDF(8%) PVCF
1 30000 0.926 27780
2 30000 0.857 25710
3 30000 0.794 23820
4 30000 0.735 22050
5 30000 0.681 20430
6 30000 0.630 18900
4.623 138690
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Present Value = Rs.138690
OR
PVAn = FV x PVIFA I.n
PV = 30000 x 4.623 = Rs.138690
2.

Calculation of Present Value

End Year Cash Flow PVDF(12%) PVCF

1 10000 0.8928 8929

2 12000 0.7971 9566
3 14000 0.7117 9965
4 16000 0.6355 10168
5 18000 0.5671 10214
3.605 48842
Present Value = Rs. 48842
3.

End of Year Cash Flow PVDF(8%) PVCF

1 40000 0.9259 37037

2 55000 0.8573 47154
3 60000 0.7938 47630
4 78000 0.7350 57332
5 38000 0.6806 25862
3.993 215015
Present Value = Rs. 215015
4.

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End Cash
PVDF(14%) PVCF
Year Flow
1 5000 0.877 4386
2 5000 0.769 3847
3 5000 0.675 3375
4 5000 0.592 2960
5 8000 0.519 4155
6 10000 0.456 4556
3.433 23279
Present Value = Rs. 215015
Exercises
1.

2.

3.

4.

5.

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6.

7.

8.

Loan Amortisation
1.

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PV= Annuity x PVAF

12,29,000 = Annuity x 6.145
Annuity/ Annual Installment = 12,29,000 / 6.145
= Rs. 200000
Loan Amortisation Schedule
Principal Outstanding
Year Installment Interest
Paid Prinicpal
0 0 0 0 1229000
1 200000 122900 77100 1151900
2 200000 115190 84810 1067090
3 200000 106709 93291 973799
4 200000 97380 102620 871179
5 200000 87118 112882 758297
6 200000 75830 124170 634126
7 200000 63413 136587 497539
8 200000 49754 150246 347293
9 200000 34729 165271 182022
10 200000 18202 182022 0

2.

PV= Annuity x PVAF

12,00,000 = Annuity x 6.671
Annuity/ Annual Installment = 12,00,000 / 6.71
= Rs. 178838

Principal Outstanding
Year Instalment Interest
Paid Prinicpal
0 0 0 0 1200000
1 178838 96000 82838 1117162
2 178838 89373 89465 1027697
3 178838 82216 96622 931075
4 178838 74486 104352 826723
5 178838 66138 112700 714023
6 178838 57122 121716 592306
7 178838 47385 131453 460853
8 178838 36868 141970 318883
9 178838 25511 153327 165556

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10 178838 13244 165556 0

Excercises
1.

2.

3.

4.

5.

6.

7.

8.

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9.

10.

11.

12.

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Module No. 3: Financing Decision

Meaning and Definition of Capital Structure
Capital structure refers to the amount of debt and/or equity employed by a firm to fund
its operations and finance its assets. A firm’s capital structure is typically expressed as a
debt-to-equity or debt-to-capital ratio.
In the words of P. Chandra, ‘capital structure is essentially concerned with how the firm
decides to divide its cash flows into two broad components, a fixed component that is
earmarked to meet the obligations toward debt capital and a residual component that
belongs to equity shareholders’.
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Optimal Capital Structure
Optimal capital structure is referred to as the perfect mix of debt and equity financing
that helps in maximising the value of a company in the market while at the same time
minimises its cost of capital.
Capital structure varies across industries. For a company involved in mining or
petroleum and oil extraction, a high debt ratio is not suitable, but some industries like
insurance or banking have a high amount of debt as part of their capital structure.
Factors affecting the Capital Structure
Several factors affect a company’s capital structure, and it also determines the
composition of debt and equity portions within this structure. Some of these factors are
as follows:
Business Size – The size and scale of a business affect its ability to raise finance. Small-
sized companies face difficulty in raising long-term borrowings. Creditors are hesitant to
give them loans because of the scale of their business operations. Even if they do get
these loans, they have to accept high-interest rates and stringent repayment conditions.
It limits their ability to grow their business.
Earnings – Firms with relatively stable revenues can afford a more significant amount of
debt in their capital structure. Since debt repayment is periodical with fixed interest
rates, businesses with higher income prospects can bear these fixed financial charges.
On the other hand, companies that face higher fluctuations in their sales, like consumer
goods, rely more on equity shares to finance their operations.
Competition: If a company operates in a business environment with more competition,
it should have more equity shares in its capital structure. Their earnings are prone to
more fluctuation compared to businesses facing lesser competition.
Stage of the life cycle: A business in the early stage of its life cycle is more susceptible
to failure. In that case, they should use a more significant proportion of ordinary share
capital to finance their operations. Debt comes with a fixed interest rate, and it is more
suitable for companies with stable growth prospects.
Creditworthiness: Any company that has a reputation for paying back its loans on time
will be able to raise funds on less stringent terms and at lower interest rates. It allows
them to pay back their loans on time. The opposite is true for firms that don’t have a
good credit standing in the market.
Risk Aptitude of the Management: The attitude of a company’s management also
affects the proportion of debt and equity in the capital structure. Some managers prefer
to follow a low-risk strategy and opt for equity shares to raise finances. Other managers

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are confident of the company’s ability to repay big loans, and they prefer to undertake a
higher proportion of long term debt instruments.
Control: A management that wants outside interference in its operations may not raise
funds through equity shares. Equity shareholders have the right to appoint directors,
and they also dilute the stake of owners in the company. Some companies may prefer
debt instruments to raise funds. If the creditors get their instalments on loans and
interest on time, they will not be able to interfere in the workings of the business. But if
the company defaults on their credit, the creditors can remove the present management
and take control of the business.
State of Capital Market: The tendencies of investors and creditors determine whether a
company uses more debt or equity to finance their operations. Sometimes a company
wants to issue ordinary shares, but no one is willing to invest due to the high-risk
nature of their business. In that case, the management has to raise funds from other
sources like debt markets.
Taxation Policy: The government’s monetary policies in terms of taxation on debt and
equity instruments are also crucial. If a government levies more tax on gains from
investing in the share market, investors may move out of equities. Similarly, if the
interest rate on bonds and other long-term instruments is affected due to the
government’s policy, it will also influence companies’ decisions.
Cost of Capital: The cost of raising funds depends on the expected rate of return for the
suppliers. This rate depends on the risk borne by investors. Ordinary shareholders face
the maximum risk as they don’t get a fixed rate of dividend. They get paid after
preference shareholders receive their dividends. The company has to pay interest on
debentures under all circumstances. It attracts more investors to opt for debentures and
bonds.

Leverage:
The word ‘leverage’, borrowed from physics, is frequently used in financial management.
Leverageresultsfromusingborrowedcapitalasafundingsourcewheninvestingto expand the
firm's asset base and generate returns on risk capital.
Leverageisaninvestmentstrategyofusingborrowedmoney—specifically,the use of various
financial instruments or borrowed capital—to increase the potential return of an
investment.
According to Ezra Solomon:
“Leverage is the ratio of net returns on shareholders equity and the net rate of return on
capitalisation”.

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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.”
Types of Leverage:
Leverage are the three types:
(i) Operating leverage
(ii) Financial leverage and
(iii) Combined leverage
1. Operating Leverage: Operating leverage refers to the use of fixed operating costs
such as depreciation, insurance of assets, repairs and maintenance, property taxes etc.
in the operations of a firm. But it does not include interest on debt capital. Higher the
proportion of fixed operating cost as compared to variable cost, higher is the operating
leverage, and vice versa.
Operating leverage may be defined as the “firm’s ability to use fixed operating cost to
magnify effects of changes in sales on its earnings before interest and taxes.”
Operating Leverage = Contribution / EBIT
2. 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.
Financial Leverage = EBIT / EBT
3. 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.
Combined Leverage = Contribution / EBT
Combined Leverage = Operating Leverage x Financial Leverage
Basics of EBIT-EPS Approach
It is important to understand what EBIT and EPS mean to understand what the analysis
is meant to be.

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EBIT refers to earnings before interest and tax. The metric makes interest and taxes
irrelevant. Therefore, an investor can understand how the company is performing out of
the balance sheet’s composition which essentially makes interest and taxes the focal
point of consideration. In terms of EBIT, there is no difference if a company has huge
debt or no debt at all. The repercussions will be the same.
EPS or earnings per share is the metric that shows a company’s earnings including
interests and taxes. It is an important metric because it shows the earnings on a per-
share basis which helps the investors understand how a company performs on an
overall basis. If a company’s overall profit soars high but the payment to investors is low,
it is a bad gesture for investors owning a fixed number of shares. EPS shows this
dynamic rule simply and in a clear manner.
The ratio between these two metrics can show how the bottom line results, the
company’s EPS, are related to its performance irrespective of its capital structure, the
EBIT.
INDIFFERENCE POINT:
When two alternate financial plans do produce the level of EBIT where EPS is the same,
this situation is referred to as indifference point.
In case, the expected level of EBIT exceeds th0e indifference point, the use of debt
financing would be advantageous to maximise the EPS. the indifference point may be
defined as the level of EBIT beyond which the benefit of financial leverage begins to
operate with respect to earning per share.
The indifference point can be explained with the help of following figure:

Problems on Leverages
Particulars Amount(Rs.)
Sales XXX
Less: Variable Cost XXX
Contribution XXX
Less: Fixed Cost XXX
Profit Before Interest and Tax (EBIT) XXX

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Less: Interest XXX
Profit Before Tax(EBT) XXX
Less: Tax XXX
Profit After Tax(EAT) XXX
Less: Preference Dividend XXX
Earnings Available to Equity Share Holders XXX
Operating Leverage = Contribution / EBIT
Financial Leverage = EBIT / EBT
Combined Leverage = Contribution / EBT
Or
Combined Leverage = Operating Leverage x Financial Leverage
1.

Solution:
Particulars Amount(Rs.)
Sales (200000x50) 10000000
Less: Variable Cost (200000x32.5) 6500000
Contribution 3500000
Less: Fixed Cost 1000000
Profit Before Interest and Tax (EBIT) 2500000
Less: Interest (10000000 x 8/100) 800000
Profit Before Tax(EBT) 1700000
Less: Tax(35%) 595000
Profit After Tax(EAT) 1105000
Less: Preference Dividend (3250000 x 10/100) 325000
Earnings Available to Equity Share Holders 780000
(EATESH)

Operating Leverage(OL) = Contribution / EBIT

= 3500000 / 2500000
= 1.4 times
Financial Leverage(FL) = EBIT / EBT
= 2500000 / 1700000
= 1.47 times
Combined Leverage = OL x FL
= 1.4 x 1.47

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= 2.06 times
Earning Per share = EATESH / No. of Equity Shares
= 780000 / 100000
= Rs.7.8 per share

2.

Solution:
Particulars Existing Planned
200000 units 250000 units
(Rs.) (Rs.)
Contribution Rs.40 per unit 8000000 10000000
Less: Fixed Cost 1000000 1000000
Profit Before Interest and Tax (EBIT) 7000000 9000000
Less: Interest (6000000 x 10/100) 600000 600000
Profit Before Tax(EBT) 6400000 8400000
Less: Tax(30%) 1920000 2520000
Profit After Tax(EAT) 4480000 5880000
Less: Preference Dividend (3250000 x 10/100) 0 0
Earnings Available to Equity Share Holders 4480000 5880000
(EATESH)
No. of Equity Shares =2000000/10 =2000000/10
=200000 =200000
EPS = EATESH / No. of Equity Shares =4480000/200000 =5880000/200000
=22.4 per share =29.4 per share
Operating Leverage(OL) = Contribution / EBIT =8000000 =10000000
7000000 9000000
=1.143 times =1.111 times
Financial Leverage(FL) = EBIT / EBT =7000000 =9000000
6400000 8400000
=1.094 times 1.071 times
Combined Leverage = OL x FL =1.143 x 1.094 =1.111 x 1.071
=1.25 times =1.190 times

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Existing units = 200000 units

Planned units = 200000 + 25% of 200000
= 200000 + 50000
= 250000 units
3.

Particulars Existing Planned

5000 units (Rs.) 6000 units (Rs.)
Sales Rs.150 per unit 750000 900000
Less: Variable Cost Rs. 70 per unit 350000 420000
Contribution 400000 480000
Less: Fixed Cost 50000 50000
Profit Before Interest and Tax (EBIT) 350000 430000
Less: Interest (500000 x 12/100) 60000 60000
Profit Before Tax(EBT) 290000 370000
Less: Tax(30%) 87000 111000
Profit After Tax(EAT) 203000 259000
Less: Preference Dividend 0 0
Earnings Available to Equity Share Holders 203000 259000
(EATESH)
No. of Equity Shares =400000/100 =400000/100
=4000 =4000
EPS = EATESH / No. of Equity Shares =203000/4000 =259000/4000
= Rs.50.75/Share = Rs.64.75/Share
Operating Leverage(OL) = Contribution / EBIT =400000/350000 =480000/430000
=1.143 times 1.116times
Financial Leverage(FL) = EBIT / EBT =350000/290000 =430000/370000
=1.207 times =1.162 times
Combined Leverage = OL x FL = 1.143 x 1.207 =1.116 x 1.162

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1.379 times =1.297 times

Existing units = 5000 units

Planned units = 5000 + 20% of 5000
= 5000 + 1000
= 6000 units
4

Solution :
Particulars A Ltd B Ltd. C Ltd
Units Sold 20000 10000 3000
Selling Price 20 50 100
Sales 400000 500000 300000
Variable Cost per unit 15 30 40
Less: Variable Cost 300000 300000 120000
Contribution 100000 200000 180000
Less: Fixed Cost 40000 70000 100000
Profit Before Interest and Tax (EBIT) 60000 130000 80000
Less: Interest 10000 20000 40000
Profit Before Tax(EBT) 50000 110000 40000
Less: Tax(25%) 12500 27500 10000
Profit After Tax(EAT) 37500 82500 30000
Less: Preference Dividend 0 0
Earnings Available to Equity Share Holders 37500 82500 30000
(EATESH)

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No. of equity Shares 10000 12000 15000
EPS = EATESH / No. of Equity Shares =3.75/share =6.875/share =2/share
Operating Leverage(OL) = Contribution / EBIT =1.67 times =1.54 times =2.25times
Financial Leverage(FL) = EBIT / EBT = 1.2 times =1.18 times =2 times
Combined Leverage = OL x FL =2 times =1.82 times =4.5 times

5.

Particulars Existing New

Units Sold 400000 500000
Selling Price 10 10
Sales 4000000 5000000
Variable Cost per unit 6 6
Less: Variable Cost 2400000 3000000
Contribution 1600000 2000000
Less: Fixed Cost 500000 500000
Profit Before Interest and Tax (EBIT) 1100000 1500000
Less: Interest (2000000 x 20/100) 400000 400000
Profit Before Tax(EBT) 700000 1100000
Less: Tax(50%) 350000 550000
Profit After Tax(EAT) 350000 550000
Less: Preference Dividend 0 0
Earnings Available to Equity Share Holders 350000 550000
(EATESH)
No. of Equity shares =2000000/10 =2000000/10
=200000 =200000
EPS = EATESH / No. of Equity Shares 1.75 2.75
Operating Leverage(OL) = Contribution / EBIT 1.454545455 1.333333333
Financial Leverage(FL) = EBIT / EBT 1.571428571 1.363636364
Combined Leverage = OL x FL 2.285714286 1.818181818
6.

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Solution
Particulars Existing New
Units Sold 10000 12000
Selling Price 10 10
Sales 100000 120000
Variable Cost per unit 6 6
Less: Variable Cost 60000 72000
Contribution 40000 48000
Less: Fixed Cost 20000 20000
Profit Before Interest and Tax (EBIT) 20000 28000
Less: Interest (100000 x 20/100) 10000 10000
Profit Before Tax(EBT) 10000 18000
Less: Tax(50%) 3000 5400
Profit After Tax(EAT) 7000 12600
Less: Preference Dividend 0 0
Earnings Available to Equity Share Holders 7000 12600
(EATESH)
No. of Equity shares 1000 1000

EPS = EATESH / No. of Equity Shares 7 12.6

Operating Leverage(OL) = Contribution / EBIT 2 1.714285714
Financial Leverage(FL) = EBIT / EBT 2 1.555555556
Combined Leverage = OL x FL 4 2.666666667

Percentage increase in EPS = (12.6 -7 ) x 100

7
=5.6 x 100 = 70%
7
Exercises
1.

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2.

3.

4.

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5.

6.

7.
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8.

9.

10.

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EBIT – EPS Analysis

1

Particulars Plan A Plan B Plan C

Equity
Existing 3000000 3000000 3000000
(30000) (30000) (30000)
New 5000000 Nil Nil
(50000)
Debentures Nil 5000000(10%) Nil
Preference Shares Nil Nil 5000000(10%)
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EBIT 1600000 1600000 1600000

Less: Interest 0 500000 0
EBT 1600000 1100000 1600000
Tax(50%) 800000 550000 800000
EAT 800000 550000 800000
Less: Pref. 0 0 500000
Dividend
EATESH 800000 550000 300000
EPS = EATESH / No. of Equity Shares
No. of Equity 80000 30000 30000
Shares
EPS = 800000 = 550000 = 300000
80000 30000 30000
= Rs.10 / Share = Rs. 18.33 / Share = Rs. 10 / Share

Plan B is Best alternative because the EPS of Plan B (Rs.18.33) is More than other
plans.
2.

Plan A Plan B Plan C Plan D

Equity
Existing 5000000 5000000 5000000 5000000
(50000) (50000) (50000) (50000)
New 3000000 Nil 1000000 1500000
(30000) (10000) (15000)
Debentures Nil 3000000(10%) 2000000(10%) Nil
Preference Shares Nil NIl Nil 1500000(10%)

EBIT 800000 800000 800000 800000

Less: Interest 0 300000 100000 0
EBT 800000 500000 700000 800000
Tax(50%) 400000 250000 350000 400000
EAT 400000 250000 350000 400000

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Less: Pref. Dividend 0 0 0 150000
EATESH 400000 250000 350000 250000
EPS = EATESH / No. of Equity Shares
No. of Equity 80000 50000 60000 65000
Shares
EPS 5 5 5.833333 3.846154

Plan C is Best alternative because the EPS of Plan B (Rs.5.83) is More than other
plans.
3.

Particulars EBIT 25% Increase 25% Decrease

Equity Rs.4000000 Rs.4000000 Rs.4000000
(400000) (400000) (400000)
Debentures Rs.10000000(15%) Rs.10000000(15%) Rs.10000000(15%)
Preference Shares Rs.6000000(12%) Rs.6000000(12%) Rs.6000000(12%)
480000+120000 480000-120000
EBIT 4800000 6000000 3600000
Less: Interest 1500000 1500000 1500000
EBT 3300000 4500000 2100000
Tax(40%) 1320000 1800000 840000
EAT 1980000 2700000 1260000
Less: Pref. Dividend 720000 720000 720000
EATESH 1260000 1980000 540000
EPS = EATESH / No. of Equity Shares
No. of Equity 400000 400000 400000
Shares
EPS 3.15 4.95 1.35

4.

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Particulars A B C
Equity 1000000(100000) 500000(50000) 500000(50000)
Debentures Nil Nil 500000(8%)
Preference Shares Nil 500000(8%) Nil

EBIT 200000 200000 200000

Less: Interest 0 0 40000
EBT 200000 200000 160000
Tax(30%) 60000 60000 48000
EAT 140000 140000 112000
Less: Pref. Dividend 0 40000 0
EATESH 100000 100000 112000
EPS = EATESH / No. of Equity Shares
No. of Equity 100000 50000 50000
Shares
EPS 1 2 2.24

5.

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Particulars A B C
Equity Rs.1000000(25000) Rs.600000(15000) Rs.200000(5000)
Debentures Rs.200000(10%) Rs.600000(12%) Rs.1000000(15%)

EBIT 200000 200000 200000

Less: Interest 20000 72000 150000
EBT 180000 128000 50000
Tax(40%) 72000 51200 20000
EAT 108000 76800 30000
Less: Pref. Dividend 0 0 0
EATESH 108000 76800 30000
EPS = EATESH / No. of Equity Shares
No. of Equity
25000 15000 5000
Shares
EPS 4.32 5.12 6
6.

Particulars A B
Equity
Existing Rs.3000000(30000) Rs.3000000(30000)
New Rs.3000000(30000) Rs.500000(5000)
Preference shares Rs.1500000(10%) Rs.3000000(11%)
Debentures Rs.500000(10%) Rs.1500000(10%)

EBIT 3000000 3000000

Less: Interest 50000 150000
EBT 2950000 2850000
Tax(25%) 737500 712500
EAT 2212500 2137500
Less: Pref. Dividend 150000 330000
EATESH 2062500 1807500
EPS = EATESH / No. of Equity Shares

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No. of Equity 60000 35000
Shares
EPS 34.375 51.6429
7.

Particulars Plan I Plan II

Equity Rs.500000- Rs.40/Share (12500) Rs.750000 Rs.50 /Share(15000)
Debentures Rs.500000(8%) Rs.250000(6%)

EBIT 200000 200000

Less: Interest 40000 15000
EBT 160000 185000
Tax(30%) 48000 46250
EAT 112000 138750
Less: Pref. Dividend 0 0
EATESH 112000 138750
EPS = EATESH / No. of Equity Shares
No. of Equity
12500 15000
Shares
EPS 8.96 9.250

8.

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Particulars A B C
Equity Rs.5000000(50000) Rs.2500000(25000) Rs.1250000(12500)
Debentures Nil Rs.2500000(15%) Rs.3750000(14%)

EBIT 750000 750000 750000

Less: Interest 0 375000 525000
EBT 750000 375000 225000
Tax(30%) 225000 112500 67500
EAT 525000 262500 157500
Less: Pref. Dividend 0 0 0
EATESH 525000 262500 157500
EPS = EATESH / No. of Equity Shares
No. of Equity
50000 25000 12500
Shares
EPS 10.5 10.5 12.6

9.

Particulars A B C
Equity
Existing Rs.100000(10000) Rs.100000(10000) Rs.100000(10000)
New Rs.36000(3600) 42000(4200) Rs.60000(6000)
Debentures Nil Rs.18000(10%) 0
Preference Shares Rs.24000(7%) 0 0

EBIT 30000 30000 30000

Less: Interest 0 1800 0
EBT 30000 28200 30000
Tax(30%) 9000 8460 9000
EAT 21000 19740 21000
Less: Pref. Dividend 1680 0 0
EATESH 19320 19740 21000
EPS = EATESH / No. of Equity Shares
No. of Equity 13600 14200 16000

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Shares
EPS 1.421 1.390 1.313

10.

Particulars EBIT-180000 EBIT-220000

Equity Rs.450000- Rs.30 each(15000) Rs.450000- Rs.30 each(15000)
Debentures Rs.250000(12%) Rs.250000(12%)
Preference Shares Rs.300000(10%) Rs.300000(10%)

EBIT 180000 220000

Less: Interest 30000 30000
EBT 150000 190000
Tax(30%) 45000 57000
EAT 105000 133000
Less: Pref. Dividend 30000 30000
EATESH 75000 103000
EPS = EATESH / No. of Equity Shares
No. of Equity
15000 15000
Shares
EPS 5.000 6.867

Indifference Point
11.

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Financial Plan
Plan 1 Plan 2
Equity Share
Existing Rs. 1000000(Rs.50 each) Rs. 1000000(Rs.50 each)
20000 Shares 20000 Shares

New Rs. 500000(Rs.50 each) Nil

10000 Shares
Debentures Nil Rs.500000 (9%)

Indifference point
EPS(Plan 1) = EPS (plan 2)
(EBIT – Interest)(1- T)–Pref Dividend = (EBIT – Interest)(1- T)–Pref Dividend
Number of equity shares Number of equity shares

(EBIT – 0 ) (1-0.3) – 0 = (EBIT – 45000 ) (1-0.3) – 0

30000 20000
EBIT x 0.7 = (EBIT – 45000) x 0.7
3 2
2 ( 0.7 EBIT ) = 3 (0.7 EBIT – 31500)
1.4 EBIT = 2.1 EBIT – 94500
2.1 EBIT - 1.4 EBIT = 94500
0.7 EBIT = 94500
EBIT = 94500 / 0.7
EBIT = 135000
Indifference point = Rs.135000

12.

Exercise
1

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2.

3.

4.

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5.

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Capital Budgeting
Capital Budgeting is defined as the process by which a business determines which fixed
asset purchases or project investments are acceptable and which are not. Using this
approach, each proposed investment is given a quantitative analysis, allowing rational
judgment to be made by the business owners.
Capital budgeting is a process of evaluating investments and huge expenses in order to
obtain the best returns on investment.

Features of Capital Budgeting

Capital Budgeting is characterized by the following features:
 There is a long duration between the initial investments and the expected returns.
 The organizations usually estimate large profits.
 The process involves high risks.
 It is a fixed investment over the long run.
 Investments made in a project determine the future financial condition of an
organization.
 All projects require significant amounts of funding.
 The amount of investment made in the project determines the profitability of a
company.

Capital Budgeting Process

The process of capital budgeting is as follows:

Step 01 Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to

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purchasing a new asset. For example, a company finds two new products that they can
add to their product line.
Step 02 Evaluating investment proposals
Once an investment opportunity has been recognized an organization needs to evaluate
its options for investment. That is to say, once it is decided that new product/products
should be added to the product line, the next step would be deciding on how to acquire
these products. There might be multiple ways of acquiring them. Some of these products
could be:
 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or
 Purchased from the market

Step 03 Choosing a profitable investment

Once the investment opportunities are identified and all proposals are evaluated an
organization needs to decide the most profitable investment and select it. While selecting
a particular project an organization may have to use the technique of capital rationing to
rank the projects as per returns and select the best option available. In our example, the
company here has to decide what is more profitable for them. Manufacturing or
purchasing one or both of the products or scrapping the idea of acquiring both.
Step 04 Capital Budgeting and Apportionment
After the project is selected an organization needs to fund this project. To fund the
project, it needs to identify the sources of funds and allocate it accordingly. The
sources of these funds could be reserves, investments, loans or any other available
channel.
Step 05 Performance Review
The last step in the process of capital budgeting is reviewing the investment. Initially, the
organization had selected a particular investment for a predicted return. So now, they
will compare the investments expected performance to the actual performance.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of
investment proposal will help the company to decide upon the desirability of an
investment proposal depending upon their; relative income generating capacity
and rank them in order of their desirability. These methods provide the company a
set of norms on the basis of which either it has to accept or reject the investment
proposal. The most widely accepted techniques used in estimating the cost-returns
of investment projects can be grouped under two categories.

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1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods These methods are based on the principles to determine the
desirability of an investment project on the basis of its useful life and expected returns.
These methods depend upon the accounting information available from the books of
accounts of the company. These will not take into account the concept of ‘time value of
money’, which is a significant factor to determine the desirability of a project in terms of
present value.
A. Pay-back period method: It is the most popular and widely recognized traditional
method of evaluating the investment proposals. It can be defined, as ‘the number of
years required to recover the original cash out lay invested in a project’.
Payback period = 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒍𝒂𝒚 (𝑶𝑹)𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒑𝒓𝒐𝒋𝒆𝒄𝒕 / 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘
Merits:
1. It is one of the earliest methods of evaluating the investment projects. 2. It is simple
to understand and to compute. 1. It dose not involve any cost for computation of the
payback period 2. It is one of the widely used methods in small scale industry sector 3.
It can be computed on the basis of accounting information available from the books.
Demerits
1. This method fails to take into account the cash flows received by the company after
the payback period.
2. It doesn’t take into account the interest factor involved in an investment outlay.
3. It doesn’t take into account the interest factor involved in an investment outlay.
4. It is not consistent with the objective of maximizing the market value of the
company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash
inflows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the
financial statements to measure the probability of an investment proposal. It can be
determine by dividing the average income after taxes by the average investment i.e., the
average book value after depreciation.
According to ‘Soloman’, accounting rate of return on an investment can be calculated as
the ratio of accounting net income to the initial investment, i.e.,
ARR= 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙𝒆𝒔 / 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 ×𝟏𝟎𝟎
Average income after taxes= 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 / 𝑛𝑜.𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

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Average investment =𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 / 2
On the basis of this method, the company can select all those projects who’s ARR is
higher than the minimum rate established by the company. It can reject the projects
with an ARR lower than the expected rate of return. This method can also help the
management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.
Merits
1. It is very simple to understand and calculate.
2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested
II: Discounted cash flow methods:
The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The DCF methods are
based on the concept that a rupee earned today is more worth than a rupee earned
tomorrow. These methods take into consideration the profitability and also time value of
money.
A. Net present value method (NPV)
The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this the
net cash inflows of various period are discounted using required rate of return which is
predetermined.
According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”
NPV is the difference between the present value of cash inflows of a project and the
initial cost of the project.
According the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be
rejected. If there are more than one project with positive NPV’s the project is selected
whose NPV is the highest.
The formula for NPV is NPV= Present value of cash inflows – investment.
Merits:

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1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the useful life of the asset
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the
present value.
Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the concept
of cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
4. It does not give correct answer to a question whether alternative projects or limited
funds are available with unequal lines.
B. Internal Rate of Return Method (IRR)
The IRR for an investment proposal is that discount rate which equates the present
value of cash inflows with the present value of cash out flows of an investment. The IRR
is also known as cutoff or handle rate. It is usually the concern’s cost of capital.
If the obtained present value is higher than the initial cost of the project one has to try
with a higher rate. Like wise if the present value of expected cash inflows obtained is
lower than the present value of cash flow. Lower rate is to be taken up. The process is
continued till the net present value becomes Zero.
As this discount rate is determined internally, this method is called internal rate of
return method.
Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return
projects are selected, it satisfies the investors in terms of the rate of return an capital 4.
It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.

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Problems on capital Budgeting

1.

Calculation of Cash flow

Year CFBDT Depreciation CFBT Tax(30%) CFAT CFATBD
1 500000 400000 100000 30000 70000 470000
2 650000 400000 250000 75000 175000 575000
3 600000 400000 200000 60000 140000 540000
4 800000 400000 400000 120000 280000 680000
5 1000000 400000 600000 180000 420000 820000
1085000
Depreciation= Cost - Salvage/ Estimated life
= 2000000-0/ 5
= Rs. 400000

Year CFATBD Cumulative PVF(12%) PVCF

1 470000 470000 0.893 419642.9
2 575000 1045000 0.797 458386.5
3 540000 1585000 0.712 384361.3
4 680000 2265000 0.636 432152.3
5 820000 3085000 0.567 465290
2159833
Pay Back Period (PBP) = 3 years (2000000-1585000 / 680000)x 12
=3 years 7.32 Months

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ARR= (Average Profit after tax / Average Investment )x100
= (217000/1000000)x100
= 21.70%
Average profit = 1085000/5 = 217000
average Investment = (2000000 )/2 = 1000000
NPV= PVCF - Investment
=2159833-2000000
NPV= +159833
Profitability Index= PVCF / Investment
=2159833 / 2000000
= 1.0799
2.

Year CFBDT Depreciation CFBT Tax(30%) CFAT CFATBD

1 1000000 600000 400000 120000 280000 880000
2 1040000 480000 560000 168000 392000 872000
3 1100000 384000 716000 214800 501200 885200
4 1260000 307200 952800 285840 666960 974160
5 1300000 245760 1054240 316272 737968 983728
2578128
Deprecation Written down value method
Cost 3000000
I year 600000
2400000
II year 480000
1920000
III Year 384000

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1536000
IV year 307200
1228800
V year 245760
Year CFATBD Cumulative PVF(12%) PVCF
1 880000 880000 0.909 800000
2 872000 1752000 0.826 720661.2
3 885200 2637200 0.751 665063.9
4 974160 3611360 0.683 665364.4
5 983728 4595088 0.621 610817.7
3461907
PBP= 4 years (3000000-2637200 / 974160)x 12
= 4 years 4.469
NPV= PVCF - Investment
3461907-3000000
NPV= 461907.1
Profitability Index= PVCF / Investment
= 3461907/ 3000000
= 1.153969
3.

Calculation of Cash flow

Year Depreciation PADAT PATBD
1 36000 38000 74000
2 36000 48000 84000
3 36000 58000 94000
4 36000 68000 104000
5 36000 78000 114000
290000

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Depreciation= Cost - Salvage/ Estimated life
= 200000-20000/ 5
= 36000
Year CFATBD Cumulative PVF(12%) PVCF
1 74000 74000 0.909 67272.73
2 84000 158000 0.826 69421.49
3 94000 252000 0.751 70623.59
4 104000 356000 0.683 71033.4
5 114000 470000 0.621 70785.03
349136.2
PBP= 2 years (200000-158000 / 94000) x 12
= 2 years 5.36 months
ARR= (Average Profit after tax / Average Investment) x100
= (58000/1000000) x100 = 52.73%
Average profit = 290000/5 = 58000
average Investment = (200000 + 20000) / 2 = 110000
NPV= PVCF - Investment
= 349136-200000
NPV= 149136.2
Profitability Index= PVCF / Investment
= 349136 / 200000
= 1.746
4.

Year CFAT CFATBD

1 1400000 1400000
2 1300000 1300000
3 1500000 1500000
4 1800000 1800000
5 1200000 1200000

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7200000
Year CFATBD Cumulative PVF(12%) PVCF
1 1400000 1400000 0.893 1250000
2 1300000 2700000 0.797 1036352
3 1500000 4200000 0.712 1067670
4 1800000 6000000 0.482 868055.6
5 1200000 7200000 0.567 680912.2
4902990
PBP= 3 years (5000000-4200000 / 1800000) x 12
= 3 years 5.333333
ARR= (Average Profit after tax / Average Investment) x100
= (1440000/2500000) x100
= 57.60%
Average profit = 7200000/5 = 1440000
Average Investment = (5000000+0)/ 2 = 2500000
NPV= PVCF - Investment
= 4902990-5000000
NPV= -97009.8
Profitability Index = PVCF / Investment
= 4902990 / 5000000
= 0.980598

Problem on IRR
1.

NPV = PVCF – Inverstment

PVCFa (14%)= 25000 x 3.432
= 85800
NPVa(14%) = 85800 – 80000 = +5800
PVCFb (18%)= 25000 x 3.127
= 78175
NPVa(14%) = 78175 – 80000 = - 1825
IRR = 14 + 5800 x (18-14)
5800-(-1825)
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IRR = 14 + 5800 x4
7625
IRR = 14 + (0.7605 x 4)
IRR = 14 + 3.043
IRR = 17.043
Exercises
1.

2.

3.

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4.

5.

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7.

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Module 5: Working Capital Management

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Working Capital
Working capital is defined as the excess of current assets over current liabilities. It forms
a part of the aggregate capital of the business. Now, a business needs working capital to
fund its short term obligations. Typically, firms with an optimum level of working capital
indicate efficiency in managing its operations. This further enables the firm to pay for its
short-term dues and day-to-day operational expenses.
Therefore, working capital is a measure of business’ liquidity position, operational
efficiency, and short-term financial soundness.
Hence, working capital can be put into the following equation:
Working Capital = Current Assets – Current Liabilities
Types Of Working Capital
The types of working capital are mainly divided into different parts:
Gross Working Capital
Gross working capital is the total value of the company’s current assets. Current assets
include cash, receivables, short-term investments, and especially market securities.
The Gross working capital does not showcase the current liabilities. Gross working
capital can be executed by calculating the difference between the existing assets and
current liabilities.
The difference remaining is the actual working capital that the company has to meet its
obligations.
Net Working Capital
Networking capital is the difference between the current assets and current liabilities of
the company. If the company’s assets are more than current liabilities, it indicates a
positive working capital, and the company is in a financial position to meet its
obligations.
However, if the company’s assets are less than current liabilities, it indicates a negative
working capital, and the company is facing financial distress.
The key difference between gross and net working capital is that gross working capital
will always be a positive value. In contrast, networking capital can either be a negative or
positive value.
Permanent Working Capital
Permanent working capital is the minimum amount of capital required to carry on the
operations without interruption or difficulty.
For example, a company will need minimum cash to keep the operations smooth and
running; here, the minimum amount of money required will act as permanent working
capital.

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Regular Working Capital
Regular working capital is the amount of funds businesses require to fund its day to day
operations. For example, cash needed for making payment of wages, raw materials,
salaries comes under regular working capital.
Reserve Margin Working Capital
Apart from conducting day-to-day activities, a business may need some amount of
capital to face unforeseen circumstances. Reserve margin working capital is nothing, but
the money kept aside apart from the regular working capital. These funds are held
separately against unexpected events like floods, natural calamities, storms, etc.
Variable Working Capital
Variable working capital can be defined as the capital invested for a temporary period in
the business. Variable working capital is also called fluctuating working capital. Such
capital differs with respect to changes in the business assets or the size of the business.
Furthermore, variable capital is subdivided into two parts:
1)Seasonable Variable Working Capital
Seasonable variable working capital is the amount of capital kept aside to meet the
seasonal demand if the business is running seasonally.
2) Special Variable Working Capital
Special variable working capital is the temporary rise in the working capital due to any
unforeseen or occurrence of a special event.

Operating cycle

An operating cycle(OC) refers to the period of time it takes businesses to buy goods, sell
out the goods, and receive cash/money from the customers in exchange for the goods. In
simple words, it is the estimation of the time takes a company to turn its inventories into
cash.

The flow of the operating cycle is as follows:

1. Purchase goods or raw materials

2. Produce goods or services for sale
3. Sell goods or services
4. Collect cash from customers

The similar words to the OC that most people get confused about are the cash-to-cash
cycle, net operating cycle, and cash conversion cycle. All these terms come in the context
of the operating cycle.

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Net operating cycle- The time period between paying for inventory and cash collected
from a sale of inventory.

Cash conversion cycle– it measures how long a firm will be deprived of cash if it
increases its investment in inventory in order to expand customers’ sales.

Cash-to-cash cycle- The time period between the business paying for the supplies for
inventory and receiving cash from its customers.

Factors Affecting the Working Capital

1. Nature of Business
The first factor which helps in determining the requirement of working capital is the type
of business in which the company is involved. A trading company or a retail shop
requires less working capital as the length of the operating cycle of these types of

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businesses is small. However, the wholesalers require more working capital, as they
have to maintain a large stock and generally sell goods on credit, increasing the length of
the operating cycle. Besides, a manufacturing company requires a huge amount of
working capital as it has to convert its raw material into finished goods, sell the goods on
credit, maintain the inventory of raw materials and finished goods.
2. Scale of Operation
The firms that are operating at a large scale need to maintain more debtors, inventory,
etc. Hence, these firms generally require a large amount of working capital. However, the
firms that are operating at a small scale require less working capital.
3. Business Cycle Fluctuation
A market flourishes during the boom period which results in more demand, more stock,
more debtors, more production, etc., ultimately leading to the requirement for more
working capital. However, the depression period results in less demand, less stock, fewer
debtors, less production, etc., which means that less working capital is required.
4. Seasonal Factors
The companies which sell goods throughout the season require constant working capital.
However, the companies selling seasonal goods require a huge amount of working capital
during the season, as at that time there is more demand and the firm has to maintain
more stock and supply the goods at a fast speed, and during the off-season, it requires
less working capital as the demand is low.
5. Technology and Production Cycle
A company using labour-intensive techniques requires more working capital because it
has to maintain enough cash flow for making payments to labour. However, a company
using capital-intensive techniques requires less working capital because the investment
made by the company in machinery is a fixed capital requirement, and also there will be
less operating expenses.
6. Credit Allowed
The average period for collection of the sale proceeds is known as the Credit Policy. The
credit policy of a company depends on various factors like the client’s creditworthiness,
industry norms, etc. A company following a liberal credit policy will require more
working capital, as it is giving more time to the creditors to pay for the sale made by the
company. However, if a company follows a strict or short-term credit policy then it will
require less working capital.
7. Credit Avail
The time period that a company is getting credit from its suppliers also affects the
requirement for working capital. If a company is getting long-term credit on raw

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materials from its supplier, then it can manage well with less working capital. However,
if a company is getting a short period of credit from its suppliers, then it will require
more working capital.
8. Operating Efficiency
If a company has a high degree of operating efficiency then it will require less working
capital; however, if a company has a low degree of operating efficiency then it will require
more working capital. (Operating cycle of a firm is the time period from the purchase of
raw material to the realisation from debtors). Hence, it can be said that the length of the
operating cycle directly affects the requirements of the working capital of an
organisation.
9. Availability of Raw Materials
If the raw material is easily available to the firm and there is a ready supply of inputs
and raw material, then the firm can easily manage with less working capital. Also, as the
firm does not need to maintain any stock of raw materials, they can manage with less
stock, and hence less working capital. However, if there is a rough supply of raw
materials, then the firm will have to maintain a large inventory to carry on the operating
cycle smoothly. Therefore, the firm will require more working capital.
10. Level of Competition
If there is competition in the market, then the company will have to follow a liberal credit
policy for supplying goods on time. For this, it will have to maintain higher inventories,
resulting in more working capital requirements. However, if there is less competition in
the market or a company is in a monopoly position, then it will require less working
capital, as it can dictate its own terms according to its requirements.
11. Inflation
A rise in the price increases the price of raw materials and the cost of labour, resulting
in the increasing requirement for working capital. However, if a company is able to
increase the price of its goods also, then it will face less problem with working capital. A
rise in price has a different effect on the working capital of different businesses.
12. Growth Prospects
If a firm is planning on expanding its activities then it will require more working capital,
as it needs to increase the scale of production for expansion, resulting in the
requirement of more inputs, raw materials, etc., ultimately increasing the need for more
working capital.

Requirement for More Working Requirement for Less

Name of the Factor Capital Working Capital

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Requirement for More Working Requirement for Less
Name of the Factor Capital Working Capital

Manufacturing Concern Trading Concern because

Nature of Business
because of processing work of no production

Small Scale of Operation

Large Scale of Operation
Scale of Operation because of small
because of huge inventory
inventories

During the boom period During the depression

Business Cycle because there is more period because there is
production less production

Peak season because there is Lean season because there

Seasonal Factors
more demand is less demand

Credit allowed to
Sales on Credit Basis Sales on Cash Basis
Customers

Credit availed from

Purchase on Cash Basis Purchase on Credit Basis
Suppliers

During inflation because of

During deflation because
Inflation v/s Deflation high price levels for wages, raw
of the low price level
materials, etc.

Operating
Cycle/Turnover of Long Operating Cycle Short Operating Cycle
Working Capital

Growth Prospects Higher growth prospects Lower growth prospects

Availability of Raw
Higher Lead Time Lower Lead Time
Material

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Requirement for More Working Requirement for Less
Name of the Factor Capital Working Capital

Level of Competition High competition Low competition

Productive Cycle Long Production Cycle Short Production Cycle

Disadvantages or Dangers of Inadequate Working Capital:

1. A concern which has inadequate working capital cannot pay its short-term liabilities
in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies,
increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of
liquid funds.
6. The rate of return on investments also falls with the shortage of working capital.
Advantages of adequate working capital
i) Helps in maintaining goodwill of the firm.
ii) Helps in maintaining solvency of the firm.
iii) Helps the firm in getting regular supply if raw material.
iv) Helps the firm in getting regular return on investment.
v) Helps the firm in getting payment.
vi) Helps the firm to face the crisis.
Vii) Helps the firm in getting loan easily from the banks.
Viii) Helps the firm in getting cash discount.

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Sources of Working Capital

Spontaneous Sources of Working Capital Finance

The word ‘spontaneous’ itself explains that this source of working capital is naturally
available to the business in the normal course of business affairs. It refers to the funds
that a business can generate through its day-to-day operations without any external
borrowing or investment. The following are the spontaneous sources of working capital
finance that are available to a company:
Trade Credit
Trade credit is the extension of credit by suppliers of raw materials to their buyers who
purchase goods or services on credit terms. It acts as a source of working capital
financing for businesses as it provides them with an interest-free credit period for
making the payment. This allows businesses to use the cash they would have otherwise
paid for the purchases for other short-term needs.
Sundry Creditors
Sundry creditors are also similar to trade credit when it comes to sources of working
capital financing. The difference is that it is the extension given by the suppliers of other
goods and services for making payments.
Accrued Expenses
Accrued expenses are those which are incurred by the business but not yet paid.
All of the above-mentioned sources are a way of delaying immediate cash payments. By
delaying payment to suppliers, businesses can free up cash to use for other working
capital needs. Each supplier will have a maximum credit limit defined for the buyer
depending on the business capacity and creditworthiness of the buyer. Similarly,

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the credit period is defined say 30 days, 45 days, etc. If the buyer makes payment
immediately on buying the materials, he can avail of a discount on cash payment. Else,
this discount turns out as an opportunity cost to the buyer.
Short-Term Sources of Working Capital Finance
These can be further divided into internal and external sources of working capital
finance.
Short-term Internal Sources of Working Capital
The following are the two short-term sources of working capital financing:
Tax Provisions
The tax provision is the amount that a business has set aside for making the payment of
taxes. It is a form of self-financing, as the business is effectively borrowing from itself to
pay its taxes, rather than relying on external sources.
Dividend Provisions
Similar to tax provision, dividend provision is the amount kept aside for paying
dividends to shareholders.
While these amounts are kept for future payments, they can be used by the company to
fund its short-term operations. The fund that would have been used in paying these
provisions act as working capital till the point these are not paid.
Short-term External Sources of Working Capital
Short-term external sources of working capital financing are generally obtained from the
banks and include:
Bank Overdrafts
A bank overdraft is an extension of credit from a bank that allows businesses to
overdraw their account up to a certain limit. It is convenient as a business can quickly
access additional funds to cover short-term expenses without having to go through the
process of applying for a loan.
Also Read: Types of Working Capital – Gross and Net, Temporary and Permanent
Cash Credits
Cash credit is a form of short-term financing in which a business borrows money from a
bank by using its assets of higher value than the loan amount as collateral.
Trade Deposits
Trade deposits refer to advance payments made by customers for goods or services to be
delivered in the future. These advance payments provide a business with an immediate
infusion of cash that can be used to finance current operations.
Bills Discounting

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Bills discounting is a tool that acts as a source of working capital financing for a
business. It provides businesses with immediate access to cash, allowing them to cover
their short-term cash needs without having to wait for their customer to pay before the
end of their credit period.
Short-term Loans or Working Capital Loans
As the name suggests, working capital loans are short-term loans designed to meet the
working capital financing requirement of the business.
Commercial Paper
Commercial paper is a short-term debt instrument that can provide businesses with
access to low-cost, short-term financing.
Vendor Financing
Vendor financing is the financing provided by a supplier to its customer to help them
purchase goods or services. This help businesses maintain a stable supply chain while
also ensuring access to the working capital.
Short-term working capital finance availed from banks and financial institutions are
costly compared to spontaneous and long-term sources in terms of rate of interest but
has great time flexibility. Due to time flexibility, the finance manager can use the funds
and pay interest on the money his business utilizes and can pay them anytime when
cash is available. Overall, in comparison to long-term sources where you have to hold
funds even when not required, these facilities prove cheaper.
Long-Term Sources of Working Capital Financing
Long-term sources can also be divided into internal and external sources. The internal
sources of finance include retained profits and provision for depreciation, whereas
external sources include share capital, long-term loans, and debentures.
Long-term internal sources of working capital financing include:
Retained Profits
Retained earnings are a source of working capital financing for a business. It provides
access to internal funds that can cover short-term working capital requirements.
Provision for Depreciation
Similar to tax and dividend provisions, a company creates provision for depreciation
regularly. Therefore, the company can use this amount to finance its working capital
needs.
Retained profits and accumulated depreciation are as good as funds available to the
business without any explicit cost. The business earns and owns these funds
completely. The utilization of these funds is for expansion as well as working capital
finance.

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Long-term External Sources of Working Capital
The following are the long-term external sources of working capital financing:
 Share Capital
 Long-term Loan
 Debentures
CASH MANAGEMENT
Cash flow management is a very important area and is very critical for survival of an
organisation. It entails management of cash for day to day activities, as well as
maintaining cash for meeting the desired medium/long term objectives of the
organisation. Objectives of cash flow management are to reduce the liquidity risks, make
cash available for day to day activities, minimise the cash, invest surplus cash in the
best possible manner and maintain optimum cash balance in the system125 Cash Flow
Management at all times. For this, various tools and techniques are used which include
cash forecasting, managing cash collection, disbursement and optimum cash balance
Cash management is concerned with the managing of:
 cash flows into and out of the firm,
 cash flows within the firm, and
 cash balances held by the firm at a point of time by financing deficit or investing
surplus cash
FOUR FACETS OF CASH MANAGEMENT
 Cash planning (Cash budget)
 Managing the cash flows (accelerate inflows, decelerate outflows)
 Optimum cash level
 Investing surplus cash (bank deposits, marketable securities, inter-corporate
lending)
MOTIVES FOR HOLDING CASH
 The transactions motive
 The precautionary motive
 The speculative motive
 The compensating motive
The Transaction Motive: A firm needs cash for making transactions in the day to day
operation. For example, cash payments have to be made for purchases, wages, operating
expenses, financial charges and so on. Similarly, there is a regular inflow of cash to the
firm from sales, returns on investments etc. Thus, the transaction motive mainly refers
to holding cash to meet anticipated payments whose timing is not perfectly matched
with cash receipts.

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The Precautionary Motive: A firm is required to keep cash for meeting various
contingencies in future. It provides a cushion to withstand some unseen emergencies.
The more unpredictable are the cash flows, the larger is the need for such balances.
Precautionary balance should, thus, be held more in marketable securities and relatively
less in cash.
The Speculative Motive: The speculative motive relates to holding of cash investing in
profitable opportunities as and when they arise. Here, firms aim to exploit profitable
opportunities and will hold cash in reserves to do so. The
Compensating Motive: Compensating balances are also required by some loan
agreements between a bank and its customers. Of the four primary motives of holding
cash balances, the two most important are transactions and precautionary motives.

MANAGEMENT CASH COLLECTION AND DISBURSEMENT

The cash budget explained as we have seen above throws light on the cash position of
the firm for a time horizon. Let us now try to understand the broad strategies of cash
management.126 Record to Report (R2R) Broad cash management strategies are linked
to the cash cycle of a firm. Cash cycle of a typical manufacturing can be depicted as
under:

Cash cycle reflects the total time elapsed in the process by which the cash is used for
making payments to suppliers for raw material and expenses which results in raw
materials inventory. The inventory is then converted into work-in-progress during the
manufacturing process and is finally transformed into finished goods inventory. The
finished goods are then sold to customers to whom credit is offered. Cash is again
received on realization from customers.
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This is a continuous process and the cycle repeats itself again and again. Cash turnover
means the number of times cash is used each year.
Cash turnover is calculated as
Cash Turnover = 360/Cash cycle in number of days
Importance of Cash Management
 Effective cash management is crucial for businesses as it ensures sufficient
liquidity to meet daily operational needs, pay bills, and invest in growth
opportunities.

 Ensuring sound cash management practices is the best way to ensure financial
stability and make strategic decisions for growth. Fintech solutions today have
automated, tech-first offerings that make banking for businesses easier than ever.

Receivable management

Account receivables refer to the outstanding invoices or money which is yet to be paid by
your customers. Until it is paid, such invoices or money is accounted as accounts
receivables. Also known as bills receivables. You need cash all the time to keep your
business running smoothly and ensuring the accounts receivables are paid on time is
essential to manage cash flow efficiently.

And as the term suggests, management of your accounts receivable is called receivable
management. Basically, the entire process of defining the credit policy, setting payment
terms, sending payment follow ups and timely collection of the due payments can be
defined as receivables management. Management of Receivables is also known as:

 Payment Collection
 Collection Management
 Accounts Receivables

Objectives of receivable management

Helps improve cash flow

Reduces losses incurred due to bad debts
Improved customer satisfaction
Boost up sales volume
Importance & benefits of receivable management

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Management of receivables refers to planning and controlling of debt owed to the
customer on account of credit sales. In simple words, the successful closure of your
order to sales is determined only when you convert your sales into cash. Till your sales
are converted into cash, you need to manage ‘how much you need to receive? from
whom? And when?

To do this, you need accounts receivables management, popularly known as a credit

management system in place.

Another reason, accounts receivables are one of the key sources of cash inflow and given
the volume of credit sales, a large amount of money gets tied-up in accounts receivables.
This simply implies that so much of money is not available till it is paid. If these are not
managed efficiently, it has a direct impact on the working capital of the business and
potentially hampers the growth of the business.

Scope of receivable management

When you do sales on credit, you would certainly need to keep track of the due amounts
that your parties owe you. All such dues from your parties will be your outstanding
receivables. Managing the outstanding receivables can be critical to your business
because it not only helps to understand how much your parties owe you, but also helps
you to recover the dues on time and use it for your business, as needed.

 Record and track dues

 Use credit period
 Keep a close eye on long-pending bills
 Payment performance of your customer

Inventory Management
Nature of Inventory
Stocks of manufactured products and the material that make up the product.
Components:
 Raw materials
 work-in-process
 finished goods
 stores and spares (supplies)
Inventory management is not an isolated activity; it requires coordination among the
production, purchasing and marketing departments. Decisions regarding of the
purchase raw material are taken by the purchasing and production department,
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whereas work in process inventory is influenced by the production department.
Finished goods inventory levels are decided by both the production and marketing
departments. Since these entire decision ends up in tying of resources the financial
manager has the responsibility to ensure that the inventories are properly monitored
and controlled.
REASONS FOR HOLDING INVENTORY
1) Inventory of raw material are held to ensure that the production process is not
disrupted due to shortage of raw material. The amount of raw material inventory would
depend upon the speed at which the raw material can be procured; the greater the
speed, lower would be the level of raw material inventory. Higher the uncertainty in the
supply of raw material, higher would be the level of raw material inventory.
2) Work in process (WIP) inventories arises in the process of production. These type of
inventories are also referred to as “Process Inventories”. In case of simple products the
WIP inventories would be less, whereas in case of complex products requiring various
sub-processes and sub-assemblies the work in process inventory would be high.
3) Finished goods inventories are held to meet customers requirement promptly. The
quantum of finished goods inventory would depend upon: time required to fill an order
from the customer. If the products is of such nature that any unexpected demand can
be met at short notice the level of inventories would be lower, and diversity of the
product line: Firms selling a wide range of products generally need to invest more
in finished goods.
4) Inventories are also held, so that the order cost is reduced.
5) Spares: An inventory of spare items which are required for the smooth running of
business is also kept.
6) Transaction/Precautionary and Speculative Motives: Inventories which are held for
conducting normal day to day business are known as transaction inventory.
Precautionary inventories are those inventories which are held to ensure that in case of
shortage or adverse price movement, the production process will not be stopped due to
the lack of inventory.

OBJECTIVES OF INVENTORY MANAGEMENT

Operating Objectives
1) to ensure continuous supply of materials
2) to ensure uninterrupted production
3) to minimize risks and losses
4) to ensure better customer service

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5) to avoiding stock out danger.
Financial Objectives
1) to minimize investment
2) to minimize inventory related costs and
3) to ensure economy in purchasing
Factors Affecting Level of Inventory
The quantum of inventory depends upon several factors, some of the important factors
are mentioned below:
 Nature of Business
 Inventory Turnover
 Nature and Type of Product
 Market Structure
 Economies of Production
 Inventory Costs
 Financial Position
 Period of Operating Cycle
 Attitude of Management

Techniques of Inventory Management

1. Just-in-Time (JIT)
With just-in-time inventory management, companies maintain the lowest inventory
levels possible to reduce costs and improve efficiency. Ordering new inventory to arrive
“just in time” allows businesses to avoid overstocking and reduce waste while achieving
high production volume.
2. Economic Order Quantity (EOQ)
Businesses use the economic order quantity inventory management technique to
maximize reorders while minimizing holding and other inventory costs. When companies
calculate EOQ, they determine how much inventory to order in each batch to reduce its
total inventory costs, including holding and setup costs. A company using the EOQ
method is considering what order quantity would be most economical for them to order
and store.

3. Minimum Order Quantity (MOQ)

Another inventory management model that helps businesses determine when to reorder
products is minimum order quantity. MOQ is the minimum amount of each unit a
supplier is willing to fulfill in an order. When a supplier uses MOQ, it may turn away

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customers because their order doesn’t meet the required minimum. MOQ helps
companies maintain a certain sale margin.

4. ABC Analysis
One of the most-used inventory management techniques is ABC analysis. This model
tells a business which products are the most profitable, costly, and fast-moving.
Companies using ABC analysis order products by importance to determine which are
most critical to their success.
ABC analysis evaluates products by their demand, costs, and associated risks, classing
them accordingly:
Class A products bring in the most profit, cost the least to store, and are therefore the
most valuable. A products also move the fastest.
Class B products are midrange items that are still valuable but less so than Class A. B
products move slower than A products but faster than C products.
Class C items have the lowest value, are the slowest moving, and may be costly to store.

Problems On Working Capital Requirement

Format

Estimation of Working Capital Requirements

Particulars Amount Amount
I. Current Assets
1. Stock of Raw materials
2. Stock of Work in progress
a. Raw materials
b. Wages / Labour (50%)
c. Overheads (50%)
3. Stock of finished goods
Total Cost
4. Debtors
Total cost(credit sales)
5. Cash in hand
Total Current Assets (I)
II. Current Liabilities
1. Creditors
2. Lag in payment of wages
3. Lag in payment of overheads

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Total Current liabilities (II)
Net Working capital (I-II)
Add: Contingency
Working capital requirements

1.

Estimation of Working Capital Requirements

Particulars Amount Amount
I. Current Assets
1. Stock of Raw materials- 1 month (3520000 x 1 / 12) 293333
2. Stock of Work in progress - 1/2 Month
a. Raw materials 0.5 month (3520000 x 0.5 / 12) 146666.667
b. Wages / Labour (50%) (880000 x 0.5 / 12) x 50/100 18333.3333
c. Overheads (50%) (2640000 x 0.5 / 12) x 50/100 55000 220000
3. Stock of finished goods - 6 weeks
Total Cost (7040000 x 1.5 / 12) 880000
4. Debtors - 2 months
Total cost(credit sales) (7040000 x 2 / 12) 1173333
5. Cash in hand 15000
Total Current Assets (I) 2581667
II. Current Liabilities

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1. Creditors- 1 month - Raw materials - (3520000 x 1 / 12) 293333
2. Lag in payment of wages- 1/2 month (880000 x 0.5/12) 36667
3. Lag in payment of overheads 0
Total Current liabilities (II) 330000
Net Working capital (I-II) 2251667
Add: Contingency 0
Working capital requirements 2251667
Working Note

No. of Units 22,000

Particualrs Per unit Total
Raw materials 160 3520000
Direct labour / Wages 40 880000
overhead 120 2640000
total cost 320 7040000
* 6 weeks = 1.5 months

Estimation of Working Capital Requirements

Particulars Amount Amount

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I. Current Assets
1. Stock of Raw materials- 8 weeks (27750000 x 8 / 52) 4269231
2. Stock of Work in progress - 4 weeks
a. Raw materials 4 month (27750000 x 4 / 52) 2134615
b. Wages / Labour (50%) (10500000 x 4/ 52) x 50/100 403846
c. Overheads (50%) (21000000 x 4/ 52) x 50/100 807692 3346154
3. Stock of finished goods - 6 weeks 6836538
Total Cost (59250000 x 6/ 52)
4. Debtors - 8 weeks 6836538
Total cost(credit sales) (59250000 x 8/ 52) x 3/4
5. Cash in hand 100000
Total Current Assets (I) 21388462
II. Current Liabilities
1. Creditors- 6 weeks - Raw materials - (27750000 x 6 / 52) 2134615
2. Lag in payment of wages- 4 weeks (10500000 x 4/52) 807692
3. Lag in payment of overheads - 2 weeks (2100000 x 2/52) 807692
Total Current liabilities (II) 3750000
Net Working capital (I-II) 17638462
Add: Contingency 0
Working capital requirements 17638462
Working Note
No. of Units 1,50,000
Particulars Per unit Total
Raw materials 185 27750000
Direct labour / Wages 70 10500000
overhead 140 21000000
Total cost 395 59250000
3.

Estimation of Working Capital Requirements

Particulars Amount Amount

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I. Current Assets
1. Stock of Raw materials- 4 weeks – 416000 x 4/52 32000
2. Stock of Work in progress - 2 weeks
a. Raw materials - 416000 x 2/52 16000
b. Wages / Labour (50%) - 104000 x 2/52 x 50/100 2000
c. Overheads (50%) - 312000 x 2/52 x 50/100 6000 24000
3. Stock of finished goods - 6 weeks
Total Cost - 832000 x 6/52 96000
4. Debtors – 8 weeks 128000
Total cost(credit sales) 832000 x 8/52
5. Cash in hand 50000
Total Current Assets (I) 330000
II. Current Liabilities
1. Creditors- 4 weeks - Raw materials – 416000x 4/52 32000
2. Lag in payment of wages- 104000 x 6/12 12000
3. Lag in payment of overheads – 312000 x 6/52 36000
Total Current liabilities (II) 80000
Net Working capital (I-II) 250000
Add: Contingency 0
Working capital requirements 250000
Working Note

No. of Units 5,200

Particualrs Per unit Total
Raw materials 80 416000
Direct labour / Wages 20 104000
overhead 60 312000
total cost 160 832000
4 weeks = 1 month
4.

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Estimation of Working Capital Requirements

Particulars Amount Amount
I. Current Assets
1. Stock of Raw materials- 525000
2. Stock of Work in progress -
a. Raw materials 262500
b. Wages / Labour (50%) 26250
c. Overheads (50%) 61250 350000
3. Stock of finished goods - 1312500
Total Cost
4. Debtors - 700000
Total cost(credit sales)
5. Cash in hand 35000
Total Current Assets (I) 2922500
II. Current Liabilities
1. Creditors - Raw materials - 787500
2. Lag in payment of wages- 0
3. Lag in payment of overheads - 0
Total Current liabilities (II) 787500
Net Working capital (I-II) 2135000
Add: Contingency 0
Working capital requirements 2135000
Working Note

No. of Units 70,000

Particulars Per unit Total
Raw materials 45 3150000
Direct labour / Wages 9 630000

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overhead 21 1470000
total cost 75 5250000
5.

Estimation of Working Capital Requirements

Particulars Amount Amount
I. Current Assets
1. Stock of Raw materials- 30000
2. Stock of Work in progress -
a. Raw materials 15000
b. Wages / Labour (50%) 1250
c. Overheads (50%) 2500 18750
3. Stock of finished goods - 67500
Total Cost
4. Debtors - 67500
Total cost(credit sales)
5. Cash in hand 20000
Total Current Assets (I) 203750
II. Current Liabilities
1. Creditors - Raw materials - 30000
2. Lag in payment of wages- 2500
3. Lag in payment of overheads - 5000
Total Current liabilities (II) 37500
Net Working capital (I-II) 166250
Add: Contingency 16625
Working capital requirements 182875
Working Note
Selling Price 5

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No. of Units 60,000
Sales 3,00,000
Particulars % Total
Raw materials 60% 180000
Direct labour / Wages 10% 30000
overhead 20% 60000
total cost 90% 270000

Exercises

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