COMMERCE MAKEOVER

FINANCIAL MANAGEMENT THEORY NOTES

UNIT-5 WORKING CAPITAL DECISION

𝐌𝐎𝐒𝐓 𝐈𝐌𝐏𝐎𝐑𝐓𝐀𝐍𝐓 𝐓𝐎𝐏𝐈𝐂:
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒄𝒚𝒄𝒍𝒆 , 𝒄𝒓𝒆𝒅𝒊𝒕 𝒑𝒐𝒍𝒊𝒄𝒚, 𝒍𝒊𝒒𝒖𝒊𝒅𝒊𝒕𝒚 𝒂𝒏𝒅 𝒑𝒓𝒐𝒇𝒊𝒕𝒂𝒃𝒍𝒊𝒍𝒚 𝒕𝒓𝒂𝒅𝒆 𝒐𝒇𝒇,
𝒗𝒂𝒓𝒊𝒐𝒖𝒅 𝒂𝒑𝒑𝒓𝒐𝒂𝒄𝒉𝒆𝒔, 𝒍𝒆𝒏𝒈𝒕𝒉𝒆𝒏𝒊𝒏𝒈 𝒔𝒉𝒐𝒓𝒕𝒆𝒏𝒊𝒏𝒈 𝒐𝒇 𝒄𝒓𝒆𝒅𝒊𝒕, 𝒇𝒂𝒄𝒕𝒐𝒓𝒔 𝒂𝒇𝒇𝒆𝒄𝒕𝒊𝒏𝒈
𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 , 𝒆𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝒐𝒓𝒅𝒆𝒓 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚)
Q1. Approaches of Financing Working Capital Requirements
Meaning of Working Capital

1. Gross Working Capital → Total Current Assets.

2. Net Working Capital → Current Assets − Current Liabilities.

3. Working Capital Management → Balancing liquidity vs. profitability.

4. Types of Working Capital:

o Permanent WC → Required all the time.

o Temporary WC → Required seasonally or occasionally.

Different Approaches of Financing Working Capital

1. Hedging / Matching Approach

• Permanent WC → financed by long-term sources.

• Temporary WC → financed by short-term sources.

• Objective: Match maturity of funds with use of funds.

• Risk level: Moderate.

2. Conservative Approach

• Major portion of WC (both permanent + part of temporary) → financed by long-term

funds.

• Short-term funds used very little.

• Ensures high liquidity and low risk.

• But profitability is generally lower.

3. Aggressive Approach

• Even a part of permanent WC is financed using short-term funds.

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• Aim: Higher profitability because short-term funds cost less.

• But results in high risk due to dependence on short-term borrowings.

Q2. Factors Affecting Working Capital Needs

1. Nature and Size of Business

• Trading & financial firms → Low fixed assets, high WC needs.

• Manufacturing & seasonal businesses (e.g., cigarettes, construction) → High inventory,

thus high WC.

• Service firms → High fixed assets, low WC.

2. Manufacturing / Operating Cycle

• Longer cycle → Higher WC needed.

• Shorter cycle → Lower WC required.

• Reason: More funds blocked in production process.

3. Frequency of Turnover of Sales & Debtors

• High sales turnover → Less inventory needed → Lower WC.

• High debtor turnover → Faster collections → Lower WC.

• Efficient credit management reduces WC needs.

4. Demand and Supply Conditions

• Seasonal demand fluctuations increase WC.

• Shortage of raw materials or irregular supply → Need for larger inventories → Higher
WC.

• Stable demand & smooth supply → Lower WC.

5. Overall Operating Efficiency

• Better utilisation of resources → Reduced cost → Lower WC requirement.

• Efficient production, inventory control, and collection processes improve WC

management.

• Depends heavily on skills of the finance manager.

Q3. “Liquidity and Profitability Are Competing Goals for a finance manager” comment.

Working capital management plays a vital role in ensuring smooth business operations. A
finance manager must maintain an optimum level of working capital, which directly affects
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the firm’s liquidity and profitability. However, these two objectives move in opposite
directions, making them competing goals.

• Liquidity refers to the firm’s ability to meet short-term obligations and maintain
smooth operations.

• Profitability refers to the firm’s ability to earn adequate returns by efficiently using
its resources.

A balance between these two is essential because both are important for long-term survival.

High Liquidity Reduces Profitability

If a firm maintains excessive current assets, such as large cash balances, high inventories
or liberal credit terms:

• Funds remain idle

• Cost of holding inventory increases

• Return on investment declines

Thus, higher liquidity leads to lower profitability.

Example:
A company holding large stocks to avoid production delays reduces the funds available for
profitable investments, lowering its overall return.

High Profitability Reduces Liquidity

If a firm follows an aggressive working capital policy by keeping:

• Low cash

• Minimum inventory

• Strict credit collection

Its profitability may increase because more funds are invested in productive assets.
However, liquidity declines, increasing the chances of:

• Cash shortages

• Inability to pay creditors

• Production stoppage

• Higher insolvency risk

Thus, higher profitability leads to lower liquidity.

Inverse Relationship
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Liquidity and profitability move in opposite directions:

• More liquidity → less profitability

• More profitability → less liquidity

This creates a continuous conflict for the finance manager.

The Role of the Finance Manager

The finance manager must:

• Avoid excessive liquidity

• Avoid excessive risk

• Maintain a balanced level of working capital

This balanced point ensures adequate liquidity without sacrificing profitability.

Risk–Return Trade Off

Every financial decision involves:

• Risk (uncertainty of returns)

• Return (benefits expected)

There is a direct relationship:

• Higher risk → possibility of higher return

• Lower risk → lower return

In working capital:

• Conservative policy = Low risk, low return

• Aggressive policy = High risk, high return

The firm must select a working capital level where both risk and return are optimally
balanced, known as the Risk–Return Trade Off.

➔Liquidity and profitability are competing objectives.

The primary aim of working capital management is to achieve a judicious balance between
them so that the firm maintains smooth operations while maximizing shareholder value.

Q4. Short Note On Cash Management

Meaning of Cash Management

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● Cash management refers to planning, controlling and handling cash and near-cash items.
● It ensures that the firm always has sufficient cash—neither too much nor too little.
● Shortage of cash affects liquidity, while excess cash leads to opportunity cost.

Importance of Cash Management

● Required for all daily payments and smooth operations.

● Adequate cash prevents delays in wages, bills, suppliers, etc.
● Excess cash reduces profitability because idle funds do not earn returns.
● Hence, optimum cash level must be maintained.

Objectives of Cash Management

● Ensure timely and adequate liquidity.

● Avoid excess idle cash to minimize opportunity cost.
● Maintain a proper balance between inflows and outflows.
● Invest surplus cash profitably.
● Arrange short-term finance during shortages.

Q5. Factors Determining Cash Needs Of A Firm

Cash Cycle / Operating Cycle

● Longer cash cycle → more time blocked in production and sales → higher cash needs.
● Shorter cycle → lower cash requirement.

Non-synchronization of Cash Flows

● Inflows and outflows rarely match in timing.

● Mismatch increases need to hold cash.

Cost of Holding Cash

● Higher opportunity cost pushes firms to minimize idle cash.

● Firms prefer holding less cash when returns elsewhere are attractive.

Volume of Business Operations

● Larger scale → higher purchases, wages, expenses → more cash required.

Business Fluctuations

● Seasonal variations create need for additional temporary cash.

Credit Policy

● Liberal credit to customers → money blocked in debtors → higher cash needs.

● Strict credit policy → lower cash requirement.

Inventory Policy
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● Large inventory → more cash blocked → higher cash needs.

Managerial Efficiency

● Efficient operations reduce wastage and improve cash turnover → lower cash requirement.

Q6. SHORT COSTS IN CASH FLOW MANAGEMENT

Short costs arise due to shortage of cash.

● Transaction Costs → cost of converting marketable securities into cash (brokerage).

● Borrowing Costs → interest paid on overdrafts or emergency loans.
● Loss of Cash Discounts → inability to take early-payment discounts.
● Deterioration of Credit Rating → delays harm reputation; suppliers may reduce credit.
● Penalty Costs → fines for delayed tax, bills, or statutory payments.
● Production Interruptions → shortage delays purchase of materials and disrupts
operations.
● Higher Risk of Frequent Shortages → frequent or long shortages increase overall short
costs.

Q7. TECHNIQUES TO CONTROL INFLOW OF CASH

Speeding Up Cash Receipts

● Send invoices promptly and accurately.

● Offer cash discounts to encourage quicker payment.
● Use self-addressed envelopes for easy customer return.
● Send reminders to slow-paying customers.

Speeding Up Conversion into Usable Cash

● Deposit all receipts immediately and daily.

● Reduce processing time of cheques.
● Use decentralised collection centres to reduce transit time.
● Reduce float using electronic payments and fast clearance options.

Q8. NON-SYNCHRONISATION OF CASH FLOWS & SHORT COSTS

Non-Synchronization of Cash Flows

● Inflows (from sales/debtors) and outflows (for materials, wages, bills) rarely match
perfectly.
● When outflows occur before inflows, temporary cash shortage arises.

Resulting Short Costs

● Transaction cost of converting securities.

● Borrowing cost due to emergency loans.
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● Loss of cash discounts.

● Lower credit rating and loss of goodwill.
● Penalties for delay.
● Interruptions in production and operations.

Q9. MOTIVES FOR HOLDING CASH

● Transaction Motive → for routine, expected payments like wages, materials, bills.
● Precautionary Motive → for emergencies and unexpected situations.
● Speculative Motive → to take advantage of profitable opportunities.
● Compensation Motive → minimum balance required by banks for services like overdraft.

Here are proper, exam-ready, fully organised notes for Q10–Q13, written in points with
dots (●) only.
Format is perfect for 6–9 marker answers.

Q10. DIFFERENCE BETWEEN PERMANENT & TEMPORARY WORKING CAPITAL

Permanent Working Capital (PWC)

● Minimum level of working capital required at all times to run day-to-day business smoothly.
● Refers to constant investment in current assets like minimum stock, minimum cash, and
receivables.
● It remains in the business permanently, just like fixed assets.
● It does not fluctuate with changes in sales volume.
● It ensures uninterrupted operations and supports the base level of production.
● Also known as Fixed Working Capital.

Temporary Working Capital (TWC)

● Additional working capital required over and above PWC during peak periods or seasonal
demand.
● Rises with fluctuations in sales, production or market conditions.
● Needed to maintain extra inventory or meet sudden increase in demand.
● Temporary in nature and reduces once demand returns to normal.
● Mainly used for short-term operational fluctuations.
● Also known as Fluctuating Working Capital.

Q11. SOURCES OF WORKING CAPITAL FINANCE

Long-Term Sources (for Permanent Working Capital)

● Shares (Equity and Preference)

● Debentures
● Term loans from banks/financial institutions
● Retained earnings
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Short-Term Sources (for Temporary Working Capital)

Bank Credit

● Important and widely used source.

● Can be short-term or medium-term.
● Given against security with interest charges.
Forms include:
● Demand loan
● Advances
● Overdraft facility
● Cash credit
● Letter of credit
● Bill discounting

Trade Credit

● Suppliers allow the firm to buy goods on credit.

● Firm can use this credit as a short-term source of working capital.

Advances from Customers

● Customers sometimes pay in advance.

● This advance helps the firm finance its operations.

Cash Credit

● A secured loan similar to overdraft.

● Firm can withdraw up to a fixed limit.
● Interest charged only on used amount.

Discounting of Bills

● When goods are sold on credit, the firm receives bills receivable.
● Banks can discount these bills and give money immediately.
● Helps avoid waiting till maturity.

Q12. Float: Meaning, Types & Objective Of Float Management

Meaning of Float

● Difference between the balance shown in firm's books and balance in bank’s books due to
time gap in cheque processing.

Payment Float

● Cheques issued by the firm but not yet cleared by the bank.
● Firm’s books show reduced balance, but bank balance is still higher.
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Collection Float

● Cheques received and deposited by the firm but not yet realised by bank.
● Firm’s books show increase, but bank balance has not yet increased.

Net Float

● Difference between payment float and collection float.

● Positive net float gives temporary benefit, but it is risky.

Components of Float

● Mail time
● Processing time
● Collection time

Objective of Float Management

● To reduce the time gap between inflow and outflow of cash.

● To ensure funds are available as quickly as possible.
● To reduce cash requirements by speeding up collections and delaying payments within
permissible limits.

Q13. SHORT NOTES

(a) Concentration Banking

● Firm opens collection centres in important locations where customers are concentrated.
● Customers pay at the nearest collection centre instead of sending payment to head office.
● Collection centres deposit the money in local banks.
● Surplus funds are periodically transferred to head office bank account.
● Helps reduce mail and processing time, thus speeding up collections.
● Earlier widely used, now less relevant due to digital banking.

(b) Lock-Box System

● Firm hires a post office box where customers mail their cheques directly.
● Bank collects cheques from this lock-box several times a day.
● Bank deposits the collected cheques directly into firm's account.
● Eliminates delays in receiving and depositing cheques.
● Reduces collection cost and shortens collection float.
● Useful when collections are spread across various cities.

(c) Cash Budget

● A cash budget is an estimate of expected cash receipts and payments for a future period.
● Shows surplus or shortage of cash at the end of the period.
● Generally prepared monthly due to short-term nature.
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Objectives of Cash Budget

● Ensure sufficient cash to meet all obligations on time.

● Help plan short-term loans in case of shortage.
● Assist in investing surplus cash in profitable options.
● Support financial planning and control.
● Helps decide whether capital expenditure can be financed internally.

D) Baumol’s model of cash management.

Baumol’s Model of Cash Management explains how a firm can determine the optimum cash
balance it should maintain to minimise the total cost of holding and converting cash.

This model is similar to the EOQ (Economic Order Quantity) model used for inventory
management.

Objective of the Model

To minimise total cost, which includes:

1. Transaction Cost – cost of converting securities into cash

2. Opportunity Cost – interest lost by holding idle cash

Assumptions of Baumol’s Model

1. Cash payments are certain and uniform over time.

2. Cash is spent at a constant rate.

3. Firm can convert marketable securities into cash instantly.

4. Transaction cost per conversion is fixed.

5. Opportunity cost (interest rate) is constant.

6. No uncertainty in cash flows.

e) Stock Out

Stock-out refers to a situation in which a firm runs out of inventory and is unable to meet
customer demand at the required time. In simple words, when required stock is not available,
a stock-out occurs.

Causes of Stock-out:

• Poor demand forecasting

• Delay in supply or transportation

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• Inadequate inventory planning

• Sudden increase in demand

• Inefficient inventory control system

Prevention of Stock-out:

• Maintaining safety stock

• Accurate demand forecasting

• Efficient inventory management techniques (EOQ, reorder level)

• Reliable suppliers and timely procurement

f) EOQ Model ( Economic order quantity)

EOQ is the optimal quantity of inventory that should be ordered each time so that total
inventory cost is minimum.

Objective

To balance:

• Ordering cost and carrying cost

2𝐴𝐵
𝐸𝑂𝑄 = √
𝐶𝑆

Here A is annual consumption

B is buying cost per order
c is cost per uniT
S is storage

Assumptions of EOQ Model

1. Demand is known and constant

2. Lead time is zero or constant

3. Ordering cost is fixed

4. Carrying cost is constant

5. No stock-outs are allowed

6. Purchase price per unit remains unchanged

Q14. Operating Cycle

Meaning
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● Operating Cycle refers to the total time period taken by a firm to convert its
investment in raw materials into cash receipts from sales.
● It starts with procurement of raw materials / goods and ends with realisation of cash
from customers.
● In simple terms, it is the time gap between purchase and collection of cash.
● The length of the operating cycle differs from firm to firm depending upon:
● Nature of business
● Size of the firm
● Credit policy
● Production process

Stages of Operating Cycle

(a) Procurement of raw materials and services

(b) Conversion of raw materials into Work-in-Progress (WIP)
(c) Conversion of WIP into finished goods
(d) Sale of finished goods (cash or credit)
(e) Conversion of receivables (debtors) into cash

Significance

● Longer operating cycle → More funds blocked → Higher working capital requirement
● Shorter operating cycle → Faster cash recovery → Lower working capital requirement

Q15 Credit Policy & Role of Credit Terms

Meaning of Credit Policy

● Credit policy refers to the guidelines framed by a firm to decide:

● Whether credit should be granted to a customer or not
● How much credit should be extended
● It has a direct impact on sales, debtors, risk and profitability.

Dimensions of Credit Policy

(i) Credit Standards

● Criteria used to decide the eligibility of customers for credit.

● Strict standards → Low sales, low risk
● Liberal standards → High sales, high risk

(ii) Credit Analysis

● Process of evaluating creditworthiness of customers.

● Based on past payment record, financial position and reputation.
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Role of Credit Terms in Credit Policy

After fixing credit standards, the firm decides the credit terms.

Credit terms consist of the following three components:

1. Credit Period
● Time allowed to customers to make payment.

2. Cash Discount
● Reduction in amount payable if payment is made early.

3. Cash Discount Period

● Period within which discount can be availed.

Example: 3/10, Net 40

● 3% discount if payment is made within 10 days
● Full payment must be made within 40 days

Q16. Consequences of Lengthening and Shortening of Credit Period

Lengthening of Credit Period

Benefits
● Increase in sales volume
● Higher contribution and profit
● Attraction of more customers

Costs
● Increase in investment in debtors
● Higher funds blocked → Higher financing cost
● Increase in bad debts
● Increase in collection and administrative expenses

Shortening of Credit Period

Benefits
● Faster cash inflow
● Reduction in debtors
● Lower bad debt risk
● Lower working capital requirement

Costs
● Reduction in sales
● Loss of customers
● Lower profits
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Decision Criterion

● Firm should compare incremental costs and incremental benefits.

● The credit policy giving maximum net profit should be selected.

Q17. RECEIVABLES MANAGEMENT

Receivables management is concerned with deciding the amount of credit to be
extended, the terms of credit and the collection policy, so as to maximise profitability
and maintain liquidity.

OBJECTIVES OF RECEIVABLES MANAGEMENT

The main objectives are as follows:

1. To Increase Sales

• Credit sales attract more customers.

• Liberal credit policy helps in increasing sales and market share.

2. To Minimise Investment in Receivables

• Excessive receivables block funds.

• The objective is to keep optimum level of receivables, not too high and not too
low.

3. To Ensure Timely Collection

• Speedy collection improves cash flow.

• Proper follow-up and collection procedures are required.

4. To Reduce Bad Debts

• Proper credit evaluation of customers reduces chances of default.

• Strict credit control helps in minimising losses due to bad debts.

5. To Maintain Liquidity

• Faster collection ensures availability of cash.

• Helps the firm meet its short-term obligations on time.

6. To Balance Profitability and Risk

• More credit increases sales but also increases risk.

• Receivables management aims to strike a balance between risk and return.

7. To Improve Overall Efficiency

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• Efficient receivables management reduces collection costs.

• Improves working capital turnover.

UNIT-4 DIVIDEND DECISION

Q.1 Stability of Dividends and Its Significance

Meaning of Stability of Dividends

• Stability of dividends means consistency or regularity in dividend payments over time.

• It implies absence of wide fluctuations in dividends from year to year.

• Sometimes stability refers only to regular payment, even if the amount varies.

Forms of Stable Dividend Policy

1. Constant Dividend per Share (DPS)

o Same amount of dividend paid every year.

o Possible when earnings are stable.

o Requires creation of Dividend Equalisation Reserve.

2. Constant Pay-out Ratio

o Fixed percentage of earnings paid as dividend.

o Dividend amount fluctuates with earnings.

3. Stable Cash Dividend plus Bonus Shares

o Minimum cash dividend paid regularly.

o Extra dividend paid through bonus shares.

o Suitable for companies with fluctuating earnings.

Significance of Stability of Dividends

• Preferred by investors needing regular income (retired persons, widows).

• Signals financial strength and good future prospects.

• Helps maintain or increase market price of shares.

• Improves goodwill and reputation of the company.

• Facilitates raising funds from capital market.

• Preferred by institutional investors.

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SCRIP DIVIDEND

A Scrip Dividend (or Stock Dividend) is a form of dividend in which a company distributes
additional shares to its existing shareholders instead of paying cash. It represents
capitalisation of reserves and surplus and involves no cash outflow.

Key Features

• Dividend paid in the form of shares

• Issued proportionately to existing shareholders

• No dilution of ownership

• Increases share capital but not shareholders’ wealth immediately

• No effect on company’s liquidity

Advantages

• Helps company maintain liquidity

• No immediate tax burden on shareholders

• Increases number of shares held by shareholders

Disadvantages

• No immediate cash income to shareholders

• Market price per share may decline

• Not suitable for investors needing regular cash income

Scrip dividend is suitable for companies with strong reserves but limited cash. It balances
shareholders’ expectations with long-term financial stability of the firm.

Q.2 Determinants of Dividend Policy

Meaning of Dividend Policy

• Dividend policy determines how profits are divided between dividends and retained
earnings.

• It directly affects shareholders’ wealth and firm’s growth.

External Factors

1. General Economic Environment

o During uncertainty or recession, firms retain more profits.

2. Legal and Contractual Restrictions

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o Loan agreements may restrict dividend payments.

3. Capital Market Conditions

o Ease or difficulty in raising external funds affects dividend decisions.

Internal Factors

1. Shareholders’ Expectations

o Preference for current income vs. future capital gains.

2. Financial Requirements of the Firm

o Growing firms prefer retention of profits.

3. Nature and Stability of Profits

o Stable profits support higher dividends.

4. Liquidity Position

o Availability of cash is essential for dividend payment.

5. Inflation

o Higher inflation increases need for retained earnings.

Q.3 Stock Dividend and Its Rationale

Meaning of Stock Dividend

• Dividend paid in the form of shares instead of cash.

• Also called bonus shares or scrip dividend.

• Issued to existing shareholders in proportion to holdings.

• Represents capitalisation of reserves.

Rationale of Stock Dividend

• Tax advantage over cash dividend.

• Conserves cash of the company.

• Provides psychological satisfaction to shareholders.

• Projects strong financial position of the company.

Q.4 Difference Between Bonus Shares and Stock Split

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Basis Bonus Shares Stock Split

Meaning Issue of additional shares by Sub-division of shares into smaller

capitalising reserves denominations

Consideration Issued free of cost No consideration involved

Face Value Remains unchanged Reduced

Number of Increases Increases

Shares

Share Capital Increases Remains same

Purpose Align capital with reserves Improve liquidity and affordability

Bonus shares are additional shares issued free of cost to existing shareholders by
capitalising the reserves and surplus of the company. No cash is involved in the issue of
bonus shares.

Example

If a shareholder holds 100 shares of ₹10 each and the company declares a 1:1 bonus
issue, the shareholder will receive 100 additional shares free.

• Total shares = 200

• Face value per share remains ₹10

Stock split refers to the sub-division of existing shares into shares of smaller face value.
It does not involve the capitalisation of reserves.

Example

Before split:

• 100 shares of ₹10 each

After stock split (₹10 → ₹2):

• 500 shares of ₹2 each

Total investment value remains the same.

Q.8 Gordon’s Model of Dividend DecisiOn

Meaning

• Proposed by Myron Gordon.

• States that dividend policy is relevant.

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• Affects value of firm and market price of shares.

Assumptions

• Firm has constant rate of return and cost of capital.

• Growth rate g = b × r.

• Cost of capital is greater than growth rate (k > g).

• Investors prefer current dividends.

Implication

• Higher dividends increase share value.

• Investors are risk-averse.

• Dividend policy affects firm value.

Q.9 Gordon’s Model vs Walter’s Model

Similarities

• Both consider dividend policy as relevant.

• Both relate dividend decision to firm value.

• Both assume constant return and cost of capital.

Differences

Basis Gordon’s Model Walter’s Model

Focus Dividend growth and investor Relationship between r and

preference k

Growth g=b×r No explicit growth formula

Assumption

Investor Behaviour Risk-averse Emphasises profitability

Q10. M&M Approach to Dividend Irrelevance

Meaning

• Proposed by Modigliani and Miller.

• States that dividend policy does not affect firm value.

Assumptions
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• Perfect capital market.

• No taxes.

• No transaction or flotation costs.

• Fixed investment policy.

• No uncertainty.

Explanation

• Firm value depends on earnings and risk, not dividends.

• Investors are indifferent between dividends and capital gains.

Limitations

• Unrealistic assumptions.

• Taxes and transaction costs exist.

• Investors may prefer dividends.

• Dividends act as signals of firm’s health.

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UNIT-3 COST OF CAPITAL AND FINANCING STRUCTURE

Q1. Explicit and Implicit Cost of Capital

Explicit Cost of Capital

Explicit cost of capital refers to the direct and clearly identifiable cost paid by a firm
to the suppliers of funds. It involves an actual cash outflow.

Features:

• Involves explicit payment of return

• Easily measurable

• Shown in company accounts

Examples:

• Interest paid on debentures and loans

• Fixed dividend on preference shares

• Expected dividend on equity shares

Implicit Cost of Capital

Implicit cost of capital refers to the opportunity cost of using internally generated
funds, especially retained earnings. There is no actual cash payment, but shareholders
forego income.

Explanation:

When profits are retained in the business instead of being distributed as dividends,
shareholders lose the opportunity to invest that money elsewhere and earn returns. This
foregone return is the implicit cost.

Example:

If retained earnings could earn 12% elsewhere, then 12% is the implicit cost to the
firm.

Difference between Explicit and Implicit Cost of Capital

Basis Explicit Cost Implicit Cost

Nature Direct cost Opportunity cost

Cash Outflow Yes No

Accounting Record Recorded Not recorded

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Example Interest, dividends Retained earnings

Q2. Why Cost of Preference Share Capital is Lower than Cost of Equity

The cost of preference share capital is generally lower than the cost of equity due to
the following reasons:

1. Fixed Rate of Dividend: Preference shareholders receive dividend at a fixed rate,

whereas equity shareholders receive variable dividends.

2. Priority in Dividend Payment: Preference dividend is paid before equity dividend.

3. Priority in Repayment of Capital: In case of liquidation, preference shareholders

are paid before equity shareholders.

4. Lower Risk: Equity shareholders bear the maximum business risk; hence they
expect higher returns.

Due to lower risk and fixed return, the cost of preference capital is less than equity
capital.

Q3. Trading on Equity

Trading on Equity refers to the use of fixed-cost debt capital in the capital structure
with the objective of increasing earnings per share (EPS) of equity shareholders.

It exists when Return on Investment (ROI) is higher than cost of debT

Limitations of Trading on Equity

1. Double-Edged Sword: If ROI exceeds cost of debt, EPS increases; otherwise

EPS decreases.

2. Increase in Financial Risk: Higher debt increases financial risk and interest
burden.

3. Harmful during Fluctuating Earnings: Fixed interest must be paid even when
earnings are low.

4. Restrictions by Financial Institutions: Excessive debt invites restrictions and

monitoring.

Q4. Leverage

Leverage refers to the use of fixed cost sources of funds or assets to magnify returns
to shareholders. It helps a firm earn higher profits with a smaller investment.

Types of Leverage
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(A) Operating Leverage

Operating leverage arises due to the presence of fixed operating costs.

Meaning:

It measures the effect of change in sales on EBIT.

Formula:

Operating Leverage (OL) = % Change in EBIT / % Change in Sales

Example:

A firm with high fixed costs will experience larger changes in EBIT with small changes
in sales.

(B) Financial Leverage

Financial leverage arises due to fixed financial charges like interest on debt.

Meaning:

It measures the effect of change in EBIT on EPS.

Formula:

Financial Leverage (FL) = % Change in EPS / % Change in EBIT

(C) Combined Leverage

Combined leverage reflects the total risk of the firm (business risk + financial risk).

Formula:

Combined Leverage (CL) = Operating Leverage × Financial Leverage

OR

CL = % Change in EPS / % Change in Sales

Q5. Net Income (NI) Approach vs Net Operating Income (NOI) Approach

Net Income (NI) Approach

Meaning:

According to NI approach, capital structure affects firm value. Higher debt lowers
overall cost of capital and increases firm value.

Assumptions:
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1. No corporate tax

2. Cost of debt is less than cost of equity

3. Risk perception remains unchanged

Conclusion:

• Capital structure is relevant

• More debt → lower WACC → higher firm value

Net Operating Income (NOI) Approach

Meaning:

According to NOI approach, capital structure is irrelevant. Firm value depends on EBIT
and overall cost of capital.

Assumptions:

1. Investors capitalize total earnings

2. Overall cost of capital is constant

3. Cost of debt is constant

4. No tax

Conclusion:

• Capital structure does not affect firm value

• WACC remains constant

Comparison between NI and NOI Approaches

Basis NI Approach NOI Approach

Capital Structure Relevant Irrelevant

WACC Changes Constant

Firm Value Affected Not affected

View Traditional Modern

Q6. factors affecting cost of capital (IMP)

1. Nature of Business / Business Risk – Riskier business → higher cost of capital.

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2. Capital Structure / Financial Leverage – More debt increases financial risk →

higher cost of equity.

3. Dividend Policy – High dividend payout reduces retained earnings → increases

reliance on external funds → higher cost.

4. Market Conditions / Interest Rates – Higher interest rates or investor required

returns → higher cost of capital.

5. Tax Rate – Higher taxes make debt more attractive (tax-deductible interest) →
reduces after-tax cost of debt.

UNIT-2 CAPITAL BUDGETING

Q1. Net Present Value (NPV)

Meaning

Net Present Value is the difference between the present value of cash inflows and the present
value of cash outflows discounted at the firm’s cost of capital.

Decision Rule:

• Accept the project if NPV > 0

• Reject if NPV < 0

Advantages

• Considers time value of money

• Uses all cash flows of the project

• Directly measures increase in shareholders’ wealth

• Best method for maximisation of firm value

Disadvantages

• Difficult to calculate

• Requires accurate estimation of discount rate

• Not easily understood by non-finance people

Q2. Internal Rate of Return (IRR)

Meaning
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IRR is the discount rate at which NPV of a project becomes zero. It represents the project’s
expected rate of return.

Decision Rule:

• Accept if IRR > Cost of Capital

Advantages

• Considers time value of money

• Easy to understand as a percentage

• Considers entire cash flows

Disadvantages

• Difficult computation

• Multiple IRRs may arise

• Assumes reinvestment at IRR (unrealistic)

• May give wrong ranking in mutually exclusive projects

Q3. Profitability Index (PI)

Meaning

Profitability Index is the ratio of present value of cash inflows to present value of cash outflows.

PI = PV of Cash Inflows / PV of Cash Outflows

Decision Rule:

• Accept if PI > 1

Advantages

• Considers time value of money

• Useful in capital rationing

• Relative measure of profitability

Disadvantages

• May give incorrect ranking in mutually exclusive projects

• Does not show absolute value creation

Q4. Accounting Rate of Return (ARR)

Meaning

ARR is the ratio of average accounting profit to average investment.

Decision Rule:
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• Accept if ARR is higher than required rate

Advantages

• Simple to calculate

• Uses accounting data

• Easy to understand

Disadvantages

• Ignores time value of money

• Uses accounting profits, not cash flows

• No clear decision rule

Q5. Payback Period (PBP)

Meaning

Payback Period is the time required to recover the initial investment from cash inflows.

Decision Rule:

• Shorter payback is preferred

Advantages

• Simple and quick method

• Emphasises liquidity

• Useful for risk-prone projects

Disadvantages

• Ignores time value of money

• Ignores cash flows after payback period

• Not a measure of profitability

[Link] BETWEEN METHODS – WHICH SHOULD BE CHOSEN?

NPV vs IRR Conflict

• Occurs in mutually exclusive projects

• Different project sizes or cash flow timings cause conflict

Final :
NPV should be preferred because it maximises shareholders’ wealth.

NPV vs PI Conflict

• PI is relative, NPV is absolute

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• In case of conflict, NPV is preferred

ARR & PBP vs Discounted Methods

• ARR and PBP are secondary methods

• They should not be used for final decision

Among all capital budgeting techniques, NPV is considered the best method because it considers
time value of money, risk and maximises the value of the firm. IRR and PI are supportive techniques,
while ARR and PBP are only preliminary screening tools.

Q7. Why do NPV and IRR techniques lead to conflicting project ranking?

NPV (Net Present Value) is the present value of cash inflows minus the present value of cash
outflows, discounted at the cost of capital.
IRR (Internal Rate of Return) is the discount rate at which the NPV of a project becomes zero. It
represents the earning rate of the project.

Conceptually, both NPV and IRR are related and normally give the same decision when projects are
independent and have conventional cash flows. However, conflicts arise in certain situations.

Reasons for Conflict between NPV and IRR:

1. Difference in size of projects:

A larger project may have a higher NPV but a lower IRR, while a smaller project may show a
higher IRR but a lower NPV.

2. Difference in timing of cash flows:

Projects with early cash inflows are favoured by IRR, whereas projects with larger but later
cash inflows are favoured by NPV.

3. Unequal life of projects:

Projects having different economic lives may result in different rankings under NPV and IRR.

4. Mutually exclusive projects:

When acceptance of one project excludes the other, NPV and IRR may suggest different
choices.

5. Unconventional cash flows:

Projects with alternating positive and negative cash flows may result in multiple IRRs or no
IRR.

Which method should be preferred and why?

In case of conflict, NPV should be preferred because:

• It is consistent with the objective of maximisation of shareholders’ wealth.

• It measures absolute value addition to the firm.

• It uses the cost of capital as the discount rate, which is realistic.

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• IRR assumes reinvestment at the same IRR, which is often unrealistic.

Conclusion:
Whenever NPV and IRR give conflicting rankings, the decision should be based on NPV, as it leads to
value maximisation for the firm.

Q8. Risk-Adjusted Discount Rate (RAD) vs Certainty Equivalent Approach (CEA):

Incorporating Risk in Capital Budgeting

1. Risk-Adjusted Discount Rate (RAD) Approach

• Definition: Incorporates project risk by adjusting the discount rate used in present value
calculations.

• How it works:

o Riskier projects → higher discount rate

o Safer projects → lower discount rate

• Example:

o Treasury bill → very low RAD

o New product in untested market → high RAD

• Usage: Widely used due to simplicity.

• Limitation: May not precisely measure project-specific risk.

2. Certainty Equivalent Approach (CEA)

• Definition: Adjusts the project’s expected cash flows for risk rather than the discount rate.

• How it works:

o Converts risky expected cash flows into risk-free equivalents.

o Smaller cash flows for inflows, larger for outflows to reflect risk.

o Discounted at risk-free rate.

• Advantage:

o Measures risk more accurately.

o Conservative estimation of cash flows.

o Different projects → different certainty equivalent factors.

• Theoretical superiority: Yes, because it directly adjusts cash flows, not the discount rate.

3. Similarities

• Both are used to incorporate risk into capital budgeting decisions.

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• Both adjust the NPV of a project to account for uncertainty.

• Both require estimation of risk magnitude (high-risk vs low-risk projects).

4. Differences

Aspect RAD Approach Certainty Equivalent Approach

Method Adjusts discount rate Adjusts cash flows

Rate used Risk-adjusted discount rate Risk-free rate

Cash flow Cash flows remain unchanged Cash flows converted to certainty
treatment equivalents

Accuracy Less precise for project-specific More precise, theoretically superior

risk

Complexity Simple to use More complex to estimate certainty

equivalents

Conservative? Less conservative More conservative

UNIT-1
Q1. Responsibilities of a Financial Manager

• Responsible for raising funds and allocating them efficiently across the enterprise.

• Connected with all functions: Production, Marketing, etc.

• Main Functions:

1. Raising funds.

2. Proper allocation of funds.

• Other Functions:

o Evaluating financial performance (profit & wealth maximisation).

o Efficiently dealing with providers of funds (banks, shareholders, institutions).

o Monitoring stock market and company share price behavior.

Q2. Roles of a Finance Manager

• Investment Decisions: Allocation of funds to short-term or long-term assets.

• Financing Decisions: Choosing appropriate sources of funds (debt/equity) keeping risk in mind.

• Dividend Decisions: Determining proportion of profit to distribute or retain, focusing on

shareholder wealth maximisation.
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Q3. Systematic vs Unsystematic Risk

• Risk: Variation between actual and expected return.

A. Systematic Risk (Market/Non-diversifiable Risk)

• Due to economy-wide factors: political, economic, social.

• Types:

1. Market Risk: Variability in stock prices due to market expectations.

2. Interest Rate Risk: Price change due to market interest rate changes.

3. Purchasing Power/Inflation Risk: Returns affected by inflation.

B. Unsystematic Risk (Diversifiable Risk)

• Firm-specific factors: labor strikes, management changes, product demand changes.

• Categories:

1. Business Risk: Variability in actual earnings vs expected earnings.

▪ Internal: Production disruption, labor strike, etc.

▪ External: Market demand, raw material price changes.

2. Financial Risk: Due to debt in capital structure. Fixed interest obligation → risk of
insolvency.

Q4. PROFIT MAXIMISATION AND WEALTH MAXIMATION

Aspect Profit Wealth Maximisation

Maximisation

Focus Total profit Market value of shares (shareholder wealth)

Considers risk? No Yes

Considers time value of No Yes

money?

EPS/DPS considered? No Yes

Better for finance manager? No Yes, because it aligns with shareholder

interest

Conclusion: Wealth maximisation is a superior operational guide.

[Link] Problem

• Occurs due to separation of ownership and management.

• Conflict: Managers (agents) may pursue personal goals over shareholders’ (principals) goals.

• Solutions:
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1. Shareholders monitor managers’ activities.

2. Employee Stock Option Plans (ESOPs).

3. Performance-based compensation.

Q6. Basic Financial Decisions & Risk-Return Tradeoff

1. Funds Requirement Decision: Long-term & short-term capital needs.

2. Financing Decision: Choice of debt & equity → trade-off between risk & return.

3. Investment Decision: Capital budgeting & working capital allocation → risk-return evaluation.

4. Dividend Decision: Distribution policy impacts retained earnings & future growth → risk-
return consideration.
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