Corporate Finance

Course Aim/s:
 To give an overview of the problems facing a financial manager in the commercial
world.
 It will introduce the concepts and theories of corporate finance that underlie the
techniques that are offered as aids for the understanding, evaluation and resolution of
financial manager’s problems.
Learning Outcome/s:
 Provides support for decision making.
 It enables to monitor their decisions for any potential financial implications and for
 Lessons to be learned from experience and to adapt or react as needed.
 To ensure the availability of timely, relevant and reliable financial and nonfinancial
 Information. FM helps in understanding the use of resources efficiently, effectively and
Economically.

Unit-I: The Finance Function

Introduction to Finance: Nature and Scope - Finance Function - It’s Role in the Contemporary Scenario
- Goals of Finance Function - Maximizing vs. Satisfying - Profit vs. Wealth vs. Welfare - The Agency
Relationship and Costs - Risk-Return Trade Off.
Time Value of Money: Concept - Future Value and Present Value and the Basic Valuation Model.

Unit-II: The Investment Decision

Investment Decision Process: Project Generation - Project Evaluation - Project Selection and Project
Implementation - Developing Cash Flows - Data for New Projects.
Capital Budgeting Techniques: Traditional and DCF methods - The NPV vs. IRR Debate. (Theory &
Problems)
Cost of Capital: Concept and Measurement of Cost of Capital - Debt vs. Equity - Cost of Equity -
Preference Shares - Equity Capital and Retained Earnings - Weighted Average Cost of Capital and
Marginal Cost of Capital (Theory & Problems) - Importance of Cost of Capital in Capital Budgeting
Decisions.

Unit-III: Capital Structure Decisions

Capital Structure vs. Financial Structure: Capitalization - Financial Leverage - Operating Leverage
and Composite Leverage. (Theory & Problems)
EBIT-EPS Analysis: Indifference Point/Break-Even Analysis of Financial Leverage.
Capital Structure Theories: The Modigliani Miller Theory - Net Income - Net Operating Income
Theory and Traditional Theory (Theory & Problems) - A Critical Appraisal.

Unit-IV: Dividend Decisions

Major Forms of Dividends: Cash and Bonus Shares.
Dividends and Value of the Firm: Relevance of Dividends - The MM Hypothesis - Factors
Determining Dividend Policy - Dividends and Valuation of the Firm - The Basic Models.
Dividend Theories: Major Theories centred on the works of GORDON, WALTER and LITNER.
(Theory & Problems)

Unit-V: Management of Current Assets

Working Capital Management: Components of Working Capital - Gross vs. Net Working Capital -
Determinants of Working Capital Needs - The Operating Cycle Approach - Planning of Working
Capital - Financing of Working Capital through Bank Finance and Trade Credit;
Management of Cash: Basic Strategies for Cash Management - Cash Budget (Problems) - Cash
Management Techniques/Processes;
Management of Receivables & Inventory.
REFERENCES:
 IM Pandey, Financial Management, 10th Edition, Vikas.
 M.Y Khan, P K Jain: “Financial Management-Text and Problems”, 6th Edition, TMH.
 Prasanna Chandra, “Financial Management Theory and Practice”, 8th Edition, TMH.
 Shashi K. Gupta, R. K. Sharma, “Financial Management” Kalyani Publishers.
 Rajiv Srivastava, Anil Mishra, Financial Management” Oxford University Press, New Delhi.
 James C Van Horne, Sanjay Dhamija, “Financial Management and Policy” Pearson
Education.
 UNIT 1
MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the provision
of money at the time when it is needed. Finance function is the procurement of
funds and their effective utilization in business concerns

Definition:
According to GUTHMANN and DOUGALL, business finance may be broadly
defined as “the activity concerned with the planning, raising, controlling and
administering the funds used in the business.”

Financial decisions refer to decisions concerning financial matters of a business

firm. There are many kinds of financial management decisions that the firm makers
in pursuit of maximizing shareholder‟s wealth, viz., kind of assets to be acquired,
pattern of capitalization, distribution of firm‟s income etc. We can classify these
decisions into three major groups:

 Investment decisions
 Financing decision.
 Dividend decisions.
 Working capital decisions.

NATURE OF FINANCE FUNCTION:

I. In most of the organizations, financial operations are centralized. This
results in economies.
II. Finance functions are performed in all business firms, irrespective of
their sizes /legal form of organization.
III. They contribute to the survival and growth of the firm.

IV. Finance function is primarily involved with the data analysis for use in
decision making.

V. Finance functions are concerned with the basic business activities of a firm,
in addition to external environmental factors which affect basic business
activities, namely, production and marketing.

VI. Finance functions comprise control functions also

VII. The central focus of finance function is valuation of the firm. Finance
makes use of economic tools. From Micro economics it uses theories and
assumptions. From Macro economics it uses forecasting models. Even
though
 finance is concerned with individual firm and economics is concerned with
forecasting of an industry.

SCOPE OF FINANCIAL MANAGEMENT:

The main objective of financial management is to arrange sufficient finance for meeting short term
and long term needs. A financial manager will have to concentrate on the following areas offinance
function.
1. Estimating financial requirements:
The first task of a financial manager is to estimate short term and long term financial requirements
of his business. The amount required for purchasing fixed assets as well as needs for working
capital will have to be ascertained.
2. Deciding capital structure:
Capital structure refers to kind and proportion of different securities for raising funds. After
deciding the quantum of funds required it should be decided which type of securities should be
raised. A decision about various sources for funds should be linked to the cost of raising funds.
3. Selecting a source of finance: An appropriate source of finance is selected after preparing a
capital structure which includes share capital, debentures, financial institutions, public deposits
etc. If finance is needed for short term periods then banks, public deposits and financial institutions
may be the appropriate. On the other hand, if long term finance is required then sharecapital and
debentures may be the useful.
4. Selecting a pattern of investment: When funds have been procured then a decision about
investment pattern is to be taken. A decision will have to be taken as to which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an appropriate portion
will be retained for working capital and for other requirements.

5. Proper cash management: Cash management is an important task of finance manager. He has
to assess various cash needs at different times and then make arrangements for arranging cash.
Cash may be required to purchase of raw materials, make payments to creditors, meet wagebills
and meet day to day expenses. The idle cash with the business will mean that it is not properly
used.
6. Implementing financial controls: An efficient system of financial management necessitates
the use of various control devices. They are ROI, break even analysis, cost control, ratio analysis,
cost and internal audit. ROI is the best control device in order to evaluate the performance of
various financial policies.

7. Proper use of surpluses: The utilization of profits or surpluses is also an important factor in
financial management. A judicious use of surpluses is essential for expansion and diversification
plans and also in protecting the interests of shareholders. A balance should be struck in using funds
for paying dividend and retaining earnings for financing expansion plans.
EVOLUTION OF FINANCE FUNCTION:
Financial management came into existence as a separate field of study from finance function in
the early stages of 20th century. The evolution of financial management can be separated into three
stages:
1. Traditional stage (Finance up to 1940): The traditional stage of financial management
continued till four decades. Some of the important characteristics of this stage are:

i) In this stage, financial management mainly focuses on specific events like formation
expansion, merger and liquidation of the firm.
ii) The techniques and methods used in financial management are mainly illustrated and
in an organized manner.
iii) The essence of financial management was based on principles and policies used in
capital market, equipment’s of financing and lawful matters of financial events.
iv) Financial management was observed mainly from the prospective of investment
bankers, lenders and others.
2. Transactional stage (After 1940): The transactional stage started in the beginning years of
1940‟s and continued till the beginning of 1950‟s. The features of this stage were similar to the
traditional stage. But this stage mainly focused on the routine problems of financial managers in
the field of funds analysis, planning and control. In this stage, the essence of financial management
was transferred to working capital management.
3. Modern stage (After 1950): The modern stage started in the middle of 1950‟s and observed
tremendous change in the development of financial management with the ideas from economic
theory and implementation of quantitative methods of analysis. Some unique characteristics of
modern stage are:
i) The main focus of financial management was on proper utilization of funds so that
wealth of current share holders can be maximized.
ii) The techniques and methods used in modern stage of financial management were
analytical and quantitative.
Since the starting of modern stage of financial management many important developments
took place. Some of them are in the fields of capital budgeting, valuation models, dividend policy,
option pricing theory, behavioral finance etc.

ROLE OF FINANCIAL MANAGEMENT IN CONTEMPORARY SCENARIO:

GOALS OF FINANCE FUNCTION
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.

1 .Profit Maximization
Main aim of any kind of economic activity is earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizing the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows
the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.

Unfavorable Arguments and Drawbacks for Profit Maximization

The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.
Profit maximization objective consists of certain drawback also:
 (i) It is vague: In this objective, profit is not defined precisely or correctly. It creates
some unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It leads certain differences
between the actual cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the business
concern.

Wealth Maximization
Wealth maximization is one of the modern approaches. The term wealth means shareholder wealth
or the wealth of the persons those who are involved in the business concern. Wealth maximization
is also known as value maximization or net present worth maximization. This objective is an
universally accepted concept in the field of business .
Stockholder‟s current wealth in a firm = (Number of shares owned) x(Current Stock Price share)

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim
of the business concern under this concept is to improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the
business operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv)Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
(ii) Wealth maximization creates ownership-management controversy.
(iii) Management alone enjoy certain benefits.
(iv) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(v) Wealth maximization can be activated only with the help of the profitable position of the
business concern.

MAXIMIZING VS SATISFYING
As share holders are the real owners of the organization, they appoint managers to take important
decisions with the objective of maximizing share holder‟s wealth. Though organizations have
many more objectives, but maximizing stock price is considered to be an important objective of
all for many firms.
1) Stock price maximization and social welfare: It is advantageous for society, if
firm maximize its stock price. But, firm must not have any intentions of forming
monopolistic market, creating pollution and avoiding safety measures. When stock prices
are maximized, it benefits society by:
 i) To greater extent the owners of stock are society: In past, ownership of stock was
with wealthy people in society. But now, with the tremendous growth of pension funds,
life insurance companies and mutual funds, large group of people in society have
ownership of stock either directly or indirectly. Hence, when stock price is increased, it
ultimately improves the quality of life for many people in society.

ii) Consumers benefit: It is necessary to have effective low-cost businesses which

manufacture good quality of goods and services at the cheapest cost possible to maximize
stock price. Companies which are interested in maximizing stock price must satisfy all
requirements of customers, provide good services and innovate new products finally; it
must increase its sales by creating value for customers. Some people believe that firms
increase the prices of goods while maximizing stock price. But it is not true;in order to
survive in competitive market firms does not increase prices otherwise they may lose their
market share.

iii) Employees benefit: In past years, it was an exception that decreases in level of
employees lead to increase in stock price, but now a successful company which can
increase stock price can develop and recruit more employees which ultimately benefits
the society. Successful companies take advantage of skilled employees and motivated
employees are an important source of corporate success.

2) Managerial Actions to Maximize Shareholder’s Wealth: In order to identify the

steps taken by managers to maximize shareholder‟s wealth, the ability of the organization
to generate cash must be known. Cash flows can be determined in three ways, they are:
i) Unit Sales: In first determinant, managers can increase the level of their sales either by
satisfying customers or by luck, but which will not continue in long run.
ii) After Tax Operating Margins: In second determinant, managers can generate cash
flows by increasing operating profit which is not possible in competitive environment or
by decreasing direct expenses.
iii) Capital Requirements: In third determinant, managers can increase cash flows by
decreasing assets requirements which ultimately results in increase of stock price.
Investment and financing decisions have an impact on level, timing and
risk of the cash flow of firm and finally on stock price. It is necessary for manager
to make decisions which can maximize the stock price of the firm.
3) Maximizing Earnings Per Share is Beneficent or Not: In order to maximize
stock price, many analyst focus on cash flows by evaluating the performance of
the company and also focus of EPS as an accounting measure. Along with cash
flow, EPS also plays an important role in identifying stockholder‟s value.
DIFFERENCE BETWEEN PROFIT AND WEALTH MAXIMIZATION

Goal Objective Advantages Disadvantages

Profit Large amount of profits -Easy to calculate profits. -Emphasizes the short term.
maximization
-Easy to determine the link -Ignores risk oruncertainty.
between financial decisions
-Ignores the timing of
and profits.
Returns.
-Requires immediate
Resources.

Stockholder Highest market value of -Emphasizes the long term. -Offers no clear relationship
wealth common stock -Recognizes risk or between financial decisions
maximization Uncertainty. and stock price.
-Consider stockholders -Can lead to management
return. anxiety and frustration.
PROFIT VS. WEALTH VS. WELFARE

S.NO. PROFITMAXIMIZATION WEALTH MAXIMIZATION WELFARE

MAXIMIZATION

1) Profits are earned Wealth is maximized, so that Welfare maximization is

maximized, so that firm wealth of share-holders can be done with the help of micro
can over-come future risks maximized. economic techniques to
which are uncertain. examine a locative
distribution.

2) Profit maximization is a In wealth maximization In welfare maximization,

yards stick for calculating stockholders current wealth is social welfare is evaluated
efficiency and economic evaluated in order to maximize by calculating economic
prosperity of the concern. the value of shares in the activities of individuals in
market. the society.

3) Profit is measured in terms Wealth is measured in terms of Welfare can be measured in

of efficiency of the firm. market price of shares. two ways, either by pare to
efficiency or in units or
Rupees.

4) Profit maximization Wealth maximization involves Wealth maximization

Involves problem of problems related to involves problem of
uncertainty because profits maximizing shareholder‟s combining the utilities of
are uncertain. wealth or wealth of the firm different people.
AGENCY RELATIONSHIP AND COST:
The relationship that exists in an organization between share holders and management
known as agency relationship. Agency relationship results when a principal hires an agent
to perform part of his duties.
Agency Problem: In this type of relationship there is a chance of conflicts to occur between
the principal and the agent. This conflict is termed as agency problem.
Agency Costs: The costs incurred by stockholders in order to minimize agency problem
and maximize the owner‟s wealth are called agency costs.
The two primary agency relationships exists in a business concern are:

1) Shareholders Vs Bondholders
2) Manager Vs Share holders
1) Agency conflict-I (Shareholders Vs Bondholders): Shareholders are the real
owners of the concern, they pay fixed and agreed amount of interest to
bondholders till the duration of bond is finished but bondholders have a
proceeding claim over the assets of the company. Since equity investors are
the owners of the company they possess a residual claim on the cash flows of
the company. Bondholders are the only sufferers if decisions of the company
are not appropriate.
When a company invest in project by taking amount from bondholders and if the
project is successful, fixed amount is paid to bondholders and rest of the profits are for
shareholders and suppose if project fails then sufferers will be the bondholders as their
money have been invested.

2) Agency conflict-II (Managers Vs Shareholders): Profits generated from

investments in projects can be utilized for reinvestment or provided back to shareholders
as dividends. If dividends are increased, it may leads to decrease in the resources which
are under the manager‟s control and also strict its growth. As managers are evaluated on
the basis of growth they might go for unproductive projects which cannot generate
appropriate returns, which make the shareholders, feel shocked. This is the main cause of
conflicts between managers and shareholders.

RISK RETURN TRADE-OFF

The Risk-Return Trade-Off is an essential concept in finance theory. Risk
implies the changes in expected return like sales, profits or cash flow and it also
includes probability that problem.
Risk analysis is a procedure of calculating and examining the risk which
is related to financial and investment decision of the company. Finance managers
must focus on expected rate of return by comparing the level of risks involved in
investment decision. When it is expected that rate of return will be high then it
involves high level of risk and vice versa.
TIME VALUE OF MONEY AND MATHEMATICS OF FINANCE

Concept
We know that 100 in hand today is more valuable than 100 receivable after a year.
We will not part with 100 now if the same sum is repaid after a year. But we might part with
100 now if we are assured that 110 will be paid at the end of the first year. This “additional

Compensation” required for parting 100 today, is called “interest” or “the time value of
money”. It is expressed in terms of percentage per annum.

Money should have time value for the following reasons:

□ Money can be employed productively to generate real returns;
□ In an inflationary period, a rupee today has higher purchasing power than a rupee in the
future;
□ Due to uncertainties in the future, current consumption is preferred to
future Consumption.

The three determinants combined together can be expressed to determine the rate of
interest as follows :

Nominal or market interest rate

= Real rate of interest or return (+) Expected rate of inflation (+) Risk premiums to
compensate for uncertainty.
Time Value of Money and mathematics
(1) Compounding: We find the Future Values (FV) of all the cash flows at the end of the time
period at a given rate of interest.
(2) Discounting: We determine the Time Value of Money at Time “O” by comparing the initial
outflow with the sum of the Present Values (PV) of the future inflows at a given rate of interest.
Time Value of Money
Compounding Discounting

(Future Value) (Present Value)

(a) Single Flow (a) Single Flow
(b) Multiple Flows (b) Uneven Multiple Flows

(c) Annuity (c) Annuity

Future Value of a Single Flow
It is the process to determine the future value of a lump sum amount invested at one point
of time.

FVn = PV (1+i) n

Where,FVn = Future value of initial cash outflow after n years

PV = Initial cash outflow,i = Rate of Interest p.a. , n = Life of the Investment and (1+i)n =
Future Value of Interest Factor (FVIF)

Example
The fixed deposit scheme of Punjab National Bank offers the following interest rates :
Period of Deposit Rate Per Annum
46 days to 179 days 5.0
180 days < 1 year 5.5

1 year and above 6.0

An amount of Rs. 15,000 invested today for 3 years will be compounded too :
FVn = PV (1+i) n

= PV × FVIF (6, 3)
= PV × (1.06)3
= 15,000 (1.191)
= 17,865

Present Value of a Single Flow:

PV= FVn

Where, PV = Present Value, FVn = Future Value receivable after n years, i = rate of interest, n =
time period

Example
Calculate P.V. of 50,000 receivable for 3 years @ 10%
P.V. = Cash Flows × Annuity @ 10% for 3
years.
= 50,000 × 2.4868 = 1,24,340/-
 UNIT 2
Investment Definition:

The term "investment" can be used to refer to any mechanism used for the purpose of generating
future income. In the financial sense, this includes the purchase of bonds, stocks or real estate
property. Additionally, the constructed building or other facility used to produce goods can be seen
as an investment.

Capital Definition:

The word Capital refers to be the total investment of a company money in , tangible and intangible
assets
Investment decision is the process of making investment decisions in capital expenditure.

A capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over period of time exceeding one year.

The main characteristic of a capital expenditure is that the expenditure is incurred at one point of
time whereas benefits of the expenditure are realized at different points of time in future.

Capital Budgeting

The process through which different projects are evaluated is known as capital budgeting. Capital
budgeting is defined “as the firm‟s formal process for the acquisition and investment of capital. It
involves firm‟s decisions to invest its current funds for addition, disposition, modification and
replacement of fixed assets”.

DEFINITION
Capital budgeting (investment decision) as, “Capital budgeting is long term
Planning for making and financing proposed capital outlays.” Charles T.Horngreen

NEED AND IMPORTANCE OF CAPITAL BUDGETING

1. Huge investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control
its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent in nature.

Therefore financial risks involved in the investment decision are more. If higher risks are
involved, it needs careful planning of capital budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose
of those assets without involving huge losses.
 4. Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by
avoiding over or more investment or under investment. Over investments leads to be
unable to utilize assets or over utilization of fixed assets. Therefore before making the
investment, it is required carefully planning and analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process as it involves decisions relating to the investment of current
funds for the benefit to the achieved in future and the future is always uncertain.However the
following procedure may be adopted in the process of capital budgeting:

Screening or
Identification of Evaluation of
matching the
various investments proposals
available resources

Implementation Final Approval Fixing property

PROJECT GENERATION
1. Identification of Investment Proposals:
The proposal or the idea about potential investment opportunities may originate
from the top management or may come from the rank and file worker of any department
or from any officer of the organization.

2. Screening the Proposals:

The expenditure planning committee screens the various proposals received from
different departments. The committee views these proposals from various angels to
 ensure that these are in accordance with the corporate strategies or a selection criterion‟s
of the firm and also do not lead to departmental imbalances.

PROJECT EVALUATION

3. Evaluation of Various Proposals:

The next step in the capital budgeting process is to evaluate the profitability of
various proposals. There are many methods which may be used for this purpose such as
payback period method, rate of return method, net present value method, internal rate of
return method etc.

PROJECT SELECTION
4. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals may
be rejected straight ways. But it may not be possible for the firm to invest immediately in
all the acceptable proposals due to limitation of funds. Hence, it is very essential to rank
the various proposals and to establish priorities after considering urgency, risk and
profitability involved therein.

5. Final Approval and Preparation of Capital Expenditure Budget:

Proposals meeting the evaluation and other criteria are finally approved to be
included in the Capital expenditure budget.

PROJECT EXECUTION
6. Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a particular
proposal in the budget does not itself authorize to go ahead with the implementation of
the project. A request for authority to spend the amount should further be made to the
Capital Expenditure Committee.
Further, while implementing the project, it is better to assign responsibilities for
completing the project within the given time frame and cost limit so as to avoid
unnecessary delays and cost over runs by applying Network techniques PERT and CPM.

7. Performance Review:
The last stage in the process of capital budgeting is the evaluation of the performance of
the project. The evaluation is made through post completion audit by way of comparison
of actual expenditure of the project with the budgeted one, and also by comparing the
actual return from the investment with the anticipated return. The unfavorable variances,
if any should be looked into and the causes of the same are identified so that corrective
action may be taken in future.
DEVOLOPING CAH FLOW DATA (cash inflow and cash outflow)
The process of cash flow estimation is problematic because it is difficult to
accurately forecast the costs and revenues associated with large, complex projects that are
expected to affect operations for long periods of time. Forecasting project cash inflows
involves numerous variables and many participants in this exercise.
Capital outlays are estimated by engineering and product development
departments, revenue projections are provided by marketing group and operational cost
are estimated by production people, cost accountants, purchase managers, personal
executives, and tax experts and so on.

Calculation of cash inflow

Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx

PROJECT EVALUATION TECHNIQUES (OR) CAPITAL BUDGETING

TECHNIQUES
There are many methods of evaluating profitability of capital investment proposals. The various
commonly used methods are as follows:

(A) Traditional methods:

(1) Pay-back Period Method or Pay out or Pay off Method.
 (2) Improvement of Traditional Approach to pay back Period Method.(post
payback method)
(3) Accounting or Average Rate of Return Method.

(B) Time-adjusted method or discounted methods:

(4) Net Present Value Method.
(5) Internal Rate of Return Method.
(6) Profitability Index Method.

Traditional Discounted
methods methods

Pay-back Period Net Present

Method Value Method

post payback Internal Rate of

method Return Method

Accounting or
Average Rate of Profitability
Return Method Index Method

(A) TRADITIONAL

METHODS:

1. PAY-BACK PERIOD ETHOD

The „pay back‟ sometimes called as pay out or pay off period method represents the period in
which the total investment in permanent assets pays back itself. This method is based on the
principle that every capital expenditure pays itself back within a certain period out of the additional
earnings generated from the capital assets.

ACCEPT /REJECT CRITERIA

Under this method, various investments are ranked according to the length of their payback period
in such a manner that the investment within a shorter payback period is preferred to the one which
has longer pay back period. (It is one of the non-discounted cash flow methods of capital
budgeting).
PAY BACK PERIOD = INITIAL INVESTMENT / ANNUAL CASH INFLOWS

MERITS
The following are the important merits of the pay-back method:

1. It is easy to calculate and simple to understand.

2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.

DEMERITS
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.

AVERAGE RATE OF RETURN:

This method takes into account the earnings expected from the investment over their
whole life. It is known as accounting rate of return method for the reason that under this
method, the Accounting concept of profit (net profit after tax and depreciation) is used
rather than cash inflows.

ACCEPT /REJECT CRITERIA

According to this method, various projects are ranked in order of the rate of earnings or
rate of return. The project with the higher rate of return is selected as compared to the one
with lower rate of return. This method can also be used to make decision as to accepting
or rejecting a proposal. Average rate of return means the average rate of returnor profit
taken for considering.

2. Average Rate of Return Method (ARR):

Under this method average profit after tax and depreciation is calculated and then it is
divided by the total capital outlay or total investment in the project. The project evaluation.
This method is one of the traditional methods for evaluating

The project proposals

ARR = (Total profits (after dep & taxes))/ (Net Investment in the project X
No. of years of profits) x 100
OR

ARR = (Average Annual profits)/ (Net investment in the project) x 100

(b) Average Return on Average Investment Method:
This is the most appropriate method of rate of return on investment Under this method,
average profit after depreciation and taxes is divided by the average amount of investment;
thus:

Average Return on Average Investment = (Average Annual Profit after

depreciation and taxes)/ (Average Investment) x 100

Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.

Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in
the calculation of the project.

(B) TIME – ADJUSTED OR DISCOUNTED CASH FLOW METHODS: or

MODERN METHOD

The traditional methods of capital budgeting i.e. pay-back method as well as

accounting rate of return method, suffer from the serious limitations that give equal weight
to present and future flow of incomes. These methods do not take into consideration the
time value of money, the fact that a rupee earned today has more valuethan a rupee earned
after five years.
1. NET PRESENT VALUE
Net present value method is one of the modern methods for evaluating the project
proposals. In this method cash inflows are considered with the time value of the money.
Net present value describes as the summation of the present value of cash inflow and
present value of cash outflow. Net present value is the difference between the total present
values of future cash inflows and the total present value of future cash outflows.

NPV = Total Present value of cash inflows – Net Investment

 If offered an investment that costs $5,000 today and promises to pay you $7,000 two years
from today and if your opportunity cost for projects of similar risk is 10%, would you
make this investment? You
Need to compare your $5,000 investment with the $7,000 cash flow you expect in two
years. Because you feel that a discount rate of 10% reflects the degree of uncertainty
associated with the $7,000 expected in two years, today it is worth:

Present value of $7000to be received in two years

= $ 7000/(1+0.10)2 = $5785.12

By investing $5,000 today, you are getting in return a promise of a cash flow in the future
that is worth $5,785.12 today. You increase your wealth by $785.12 when you make this
investment.

Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash outflows, it would
be accepted. If not, it would be rejected.

Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders‟ wealth.
Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
2. INTERNAL RATE OF RETURN METHOD

This method is popularly known as time adjusted rate of return method/discounted rate of
return method also. The internal rate of return is defined as the interest rate that equates
the present value of expected future receipts to the cost of the investment outlay.This
internal rate of return is found by trial and error.

First we compute the present value of the cash-flows from an investment, using an
arbitrarily elected interest rate. Then we compare the present value so obtained with the
investment cost. If the present value is higher than the cost figure, we try a higher rate of
interest and go through the procedure again. Conversely, if the present value is lower than
the cost, lower the interest rate and repeat the process.
The interest rate that brings about this equality is defined as the internal rate of return. In
other words it is a rate at which discount cash flows to zero.

This rate of return is compared to the cost of capital and the project having higher
difference, if they are mutually exclusive, is adopted and other one is rejected. As the
determination of internal rate of return involves a number of attempts to make the present
value of earnings equal to the investment, this approach is also called the Trial and Error
Method. Internal rate of return is time adjusted technique and covers the disadvantages of
the Traditional techniques.

Accept/Reject criteria
If the present value of the sum total of the compounded reinvested cash flows is greater
than the present value of the outflows, the proposed project is accepted. If not it would be
rejected.
It is expected by the following ratio

Cash inflow / Initial Investment

Steps to be followed:

Step1. Find out factor. Factor is calculated as follows:

F = Cash outlay or Initial Investment / Cash Inflow

Step 2. Find out positive net present value

Step 3. Find out negative net present value
Step 4. Find out IRR

IRR= Base Factor + ( Positive NPV/ Difference in Positive and Negative NPV ) x DP

Base factor = Positive Discount Rate

DP= Difference in Percentage

Merits
1. It considers the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate of
return.

NPV vs. IRR Methods¶

Key differences between the most popular methods, the NPV (Net Present Value)
Method and IRR (Internal Rate of Return) Method, include:
• NPV is calculated in terms of currency while IRR is expressed in terms of
the percentage return a firm expects the capital project to return;

• Academic evidence suggests that the NPV Method is preferred over other
methods since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash
flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);

• However, the IRR Method does have one significant advantage -- managers tend to
better understand the concept of returns stated in percentages and find it easy to compare
to the required cost of capital; and, finally,

• While both the NPV Method and the IRR Method are both DCF models and can even
reach similar conclusions about a single project, the use of the IRR Method can lead to
the belief that a smaller project with a shorter life and earlier cash inflows, is preferable
to a larger project that will generate more cash.

• Applying NPV using different discount rates will result in different

recommendations. The IRR method always gives the same recommendation.

COST OF CAPITAL
The cost of capital of a firm is the minimum rate of return expected by its investors.
It is the weighted average cost of various sources of finance used by a firm. The capital
used by a firm may be in the form of debt, preference capital, retained earnings and equity
shares. The concept of cost of capital is very important in the financial management. A
decision to invest in a particular project depends upon the cost of capital of the firm or the
cut off rate which is the minimum rate of return expected by the investors.

DEFINITIONS
According to Solomon Ezra, “Cost of capital is the minimum required rate of earning or
the cut-off rate of capital expenditures”.

MEASUREMENT OF COST OF CAPITAL

The term cost of capital is an overall cost. This is the combination cost of the
specific cost associated with specific source of financing. The computation of cost capital
therefore, involves two steps: The computation of the different elements of the cost in
term of the cost of the different source of finance.
The calculation of the overall cost by combining the specific cost into a composite
cost. From the view point of capital budgeting decisions the long-termsources of fund are
relevant as the constitute the major source of financing of fixed cost. In calculating the
cost of capital, therefore, the focus is to be on the long-term funds.
In other words the specific cost has to be calculated for: 1) Long term debt 2)
Preference Shares 3) Equity Shares 4) Retained earnings

COST OF DEBT

Kdb= I/P
Where Kdb = before tax cost of debt, I = Interest, P = Principal
Dividend Price Approach:
This is also known as dividend valuation model. This model makes an assumption that
the market price of share is the present value of its future dividends stream.
As per this approach the cost of equity is the rate which equates the future dividends to
the current market price.
The cost of equity capital is calculated by dividing the expected dividend by market
price per share.
In this approach dividend is constant, which means there is no- growth or zero growth in
dividend.
The WACC represents the minimum rate of return at which a company produces value for
its investors.

Let’s say company produces a return of 20% and has WACC of 11%. By contrast, if the
company return is less than WACC, the company is shedding value, which indicates that
investors should put their money elsewhere.
 UNIT-III
Funds are the basic need of every firm to fulfill long term and working capital requirement.
Enterprise raises these funds from long term and short term sources. In this context, capital
structure and financial structure are often used. Capital Structure covers only the long term
sources of funds, whereas financial structure implies the way assets of the company arefinanced,
i.e. it represents the whole liabilities side of the Position statement, i.e. Balance Sheet, which
includes both long term and long term debt and current liabilities.

Definition of Capital Structure

The combination of long-term sources of funds, i.e. equity capital, preference capital, retained
earnings and debentures in the firm‟s capital is known as Capital Structure. It focuses on choosing
such a proposal which will minimize the cost of capital and maximize the earnings per share. For
this purpose a company can opt for the following capital structure mix:

 Equity capital only

 Preference capital only
 Debt only
 A mix of equity and debt capital.
 A mix of debt and preference capital.
 A mix of equity and preference capital.
 A mix of equity, preference and debt capital in different proportions.

There are certain factors which are referred while choosing the capital structure like, the pattern
opted for capital structure should reduce the cost of capital and increase the returns, the capital
structure mix should contain more of equity capital and less of debt to avoid the financial risk, it
should provide liberty to the business and management to adapt itself according to the changes and
so on.

Definition of Financial Structure

The mix of long term and short term funds employed by the company to procure the assets which
are required for day to day business activities is known as Financial Structure. Trend Analysis and
Ratio Analysis are the two tools used to analyze the financial structure of the company.

The composition of the financial structure represents the whole equity and liabilities side of the
Balance Sheet, i.e. it includes equity capital, preference capital, retained earnings, debentures,
short-term borrowings, account payable, deposits provisions, etc. The following factors are
considered at the time of designing the financial structure:

 Leverage: Leverage can be both positive or negative, i.e. a modest rise in the EBIT will
give a high rise to the EPS but simultaneously it increases the financial risk.
  Cost of Capital: The financial structure should focus on decreasing the cost of capital. Debt and
preference share capital are cheaper sources of finance as compared to equity share capital.
 Control: The risk of loss and dilution of control of the company should be low.
 Flexibility: Any firm cannot survive if it has a rigid financial composition. So the financial structure
should be such that when the business environment changes structure should also be adjusted to cope
up with the expected or unexpected changes.
 Solvency: The financial structure should be such that there should be no risk of getting insolvent.

Capitalization

Capitalization is an important constituent of financial plan. ln common parlance, the phrase

„Capitalization‟ refers to total amount of capital employed in a business. However, scholars are not
unanimous in so far as capitalization is concerned. The term capitalization connotes the process of determining
the quantum of funds that a firm would require to run its business. Capitalization is distinct from share capital
which refer only to the paid-up value of shares issued and definitely excludes bonds and other forms of
borrowings. Similarly, it should be distinguished form
„capital‟. The term capital refers to the total investment of a company in money, tangible assets like goodwill.
It is in a way the total wealth of a company. When used in the sense of net capital, it indicates the excess of
total assets over liabilities. Here, then, itincludes “the gains or profits from the use and investment of the
capital that has not been distributed to the stockholders” and excludes losses that have resulted from the use
of capital. Capitalization, on the other hand, refers only to the par value (i.e., face value indicated on the
security itself) of the long-term securities (shares and debentures) plus by any reserves which are meant to be
used for meting long-term and permanent needs of a company. Thus capital includes all the loans and reserves
of the concern but Capitalization includes only long-term loans and retained profits besides the capital.

Capitalization comprises of share capital, debentures, loans, free reserves,etc. Capitalization

represents permanent investment in companies excluding long-term loans. Capitalization can be
distinguished from capital structure. Capital structure is a broad term and it deals with qualitative
aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect.

Capitalization is generally found to be of following types-

 Normal
 Over
 Under

Overcapitalization

Overcapitalization is a situation in which actual profits of a company are not sufficient enough to
pay interest on debentures, on loans and pay dividends on shares over a period of time. This
situation arises when the company raises more capital than required. A part of capital always
remains idle. With a result, the rate of return shows a declining trend. The causes can be-

1. High promotion cost- When a company goes for high promotional expenditure, i.e.,
making contracts, canvassing, underwriting commission, drafting of documents, etc. and
the actual returns are not adequate in proportion to high expenses, the company is over-
capitalized in such cases.
2. Purchase of assets at higher prices- When a company purchases assets at an inflated rate,
the result is that the book value of assets is more than the actual returns. This situation gives
rise to over-capitalization of company.
 3. A company’s floatation n boom period- At times company has to secure it‟s solvency
and thereby float in boom periods. That is the time when rate of returns are less as compared
to capital employed. This results in actual earnings lowering down and earnings per share
declining.
4. Inadequate provision for depreciation- If the finance manager is unable to provide an
adequate rate of depreciation, the result is that inadequate funds are available when the
assets have to be replaced or when they become obsolete. New assets have to be purchased
at high prices which prove to be expensive.
5. Liberal dividend policy- When the directors of a company liberally divide the dividends
into the shareholders, the result is inadequate retained profits which are very essential for
high earnings of the company. The result is deficiency in company. To fill up the
deficiency, fresh capital is raised which proves to be a costlier affair and leaves the
company to be over- capitalized.
6. Over-estimation of earnings- When the promoters of the company overestimate the
earnings due to inadequate financial planning, the result is that company goes for
borrowings which cannot be easily met and capital is not profitably invested. This results
in consequent decrease in earnings per share.

Effects of Overcapitalization

1. On Shareholders- The over capitalized companies have following disadvantages to

shareholders:
a. Since the profitability decreases, the rate of earning of shareholders also decreases.
b. The market price of shares goes down because of low profitability.
c. The profitability going down has an effect on the shareholders. Their earnings
become uncertain.
d. With the decline in goodwill of the company, share prices decline. As a result shares
cannot be marketed in capital market.
2. On Company-
a. Because of low profitability, reputation of company is lowered.
b. The company‟s shares cannot be easily marketed.
c. With the decline of earnings of company, goodwill of the company declines and
the result is fresh borrowings are difficult to be made because of loss of credibility.
d. In order to retain the company‟s image, the company indulges in malpractices like
manipulation of accounts to show high earnings.
e. The company cuts down it‟s expenditure on maintainance, replacement of assets,
adequate depreciation, etc.
3. On Public- An overcapitalized company has got many adverse effects on the public:
a. In order to cover up their earning capacity, the management indulges in tactics
like increase in prices or decrease in quality.
b. Return on capital employed is low. This gives an impression to the public that
their financial resources are not utilized properly.
c. Low earnings of the company affects the credibility of the company as the
company is not able to pay it‟s creditors on time.
d. It also has an effect on working conditions and payment of wages and salaries
also lessen.

Undercapitalization
An undercapitalized company is one which incurs exceptionally high profits as compared to
industry. An undercapitalized company situation arises when the estimated earnings are very low
as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill,
high earnings and thus the return on capital shows an increasing trend. The causes can be-

1. Low promotion costs

2. Purchase of assets at deflated rates
3. Conservative dividend policy
4. Floatation of company in depression stage
5. High efficiency of directors
6. Adequate provision of depreciation
7. Large secret reserves are maintained.
Effects of Under Capitalization

1. On Shareholders
a. Company‟s profitability increases. As a result, rate of earnings go up.
b. Market value of share rises.
c. Financial reputation also increases.
d. Shareholders can expect a high dividend.
2. On company
a. With greater earnings, reputation becomes strong.
b. Higher rate of earnings attract competition in market.
c. Demand of workers may rise because of high profits.
d. The high profitability situation affects consumer interest as they think that the
company is overcharging on products.
3. On Society
a. With high earnings, high profitability, high market price of shares, there can be
unhealthy speculation in stock market.
b. „Restlessness in general public is developed as they link high profits with high
prices of product.
c. Secret reserves are maintained by the company which can result in paying lower
taxes to government.
d. The general public inculcates high expectations of these companies as these
companies can import innovations, high technology and thereby best quality of
product.

Bases of Capitalization:

The major problem faced by the financial manager is determination of value at which a firm should
be capitalized because it have to raise funds accordingly there are two theories that contain
guidelines with which the amount of capitalization can be summarized;

1. Cost Theory of Capitalization

According to this theory capitalization of a firm is regarded as the sun of cost actually incurred in
setting of the business. A film needs funds to acquire fixed assets, to defray promotional and
organizational expenses and to meet current asset requirements of the enterprise sum of the costs
of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to
provide with necessary working capital and to cover possible initial losses, it will capitalized under
this method more emphasis is laid on current investments. They are static in nature and do not have
any direct relationship with the future earning capacity. This approach is given as the value of
capital only at a particular point of time which would not reflect the future changes.

2. Earning Theory of Capitalization

According to this theory, firm should be capitalized on the basis of its expected earning A firm is
profit is seeking entity and hence its value is determiner according to What it earns. The probable
earning are forecast and them they are capitalized at a normal representative rate of return.
Capitalization of a company as per the earning theory can thus be determined with help following
formula.

Capitalization = Annual Net Earnings X Capitalization Rate

Thus for the purpose of determining amount of Capitalization in an enterprise the financial
manager has to fist estimate of annual net earnings of the enterprise where after he will have to
determine the capitalization rate. The future earning cannot be forecast exactly and depend to a
large extent on such external factors which are beyond the control of management.

LEVERAGES

Financial and Operating Leverage

Leverage is common term in financial management which entails the ability to amplify results at
a comparatively low cost. In business, company's managers make decisions about leverage that
affect profitability. According to James Horne, leverage is, "the employment of an asset or fund
for which the firm pays a fixed cost or fixed return". When they evaluate whether they can increase
production profitably, they address operating leverage. If they are expecting taking on additional
debt, they have entered the field of financial leverage. Operating leverage and financial leverage
both heighten the changes that occur to earnings due to fixed costs in a company's capital
structures. Fundamentally, leverage refers to debt or to the borrowing of funds to finance the
purchase of a company's assets. Business proprietors can use either debt or equity to finance or
buy the company's assets. Use of debt, or leverage, increases the company's risk of bankruptcy. It
also upsurges the company's returns, specifically its return on equity. It is a fact because, if debt
financing is used rather than equity financing, then the owner's equity is not diluted by issuing
more shares of stock. Investors in a business like for the business to use debt financing but only
up to a point. Investors get nervous about too much debt financing as it drives up the company's
default risk.

Types of leverage

There are many types of leverage. The company may use finance leverage or operating leverage,
to increase the EBIT and EPS.

Financial Leverage

The ability of a firm to use fixed financial charges to magnify the effect of changes in
EBIT/Operating profits, on the levels of EPS is knows as Financial Leverage.

Financial leverage measures the extent to which the fixed financing costs arise out of the use of
debt capital

A firm with high financial leverage will have relatively high fixed financing costs.

Formula for Degree of Financial Leverage

Financial Leverage Formula example is given below:

Degree of financial leverage= % Change in EPS/ % Change in EBIT

(OR)

EBIT/ EBT

Why financial leverage important?

 It provides a framework for financial decisions.

 It helps in choosing the best mixture of source of funds and helps to maintain a desirable
capital structure for the firm. The structure of the funds influences the shareholder‟s in
terms of return and risk.
 In order to quantify the risk-return relationship of various alternative capital structures,
firms use financial leverages.
 Financial Leverages help in making prudent investment decisions by providing an upper
limit of risk and by balancing the return on investment against charges of debt.

Limitations of Financial Leverages

In view of the limitations given below, financial decisions should not be solely based onfinancial
leverages. It should rather be used to support or supplement those decisions. Given below are
financial leverage limitations examples:

 Financial leverages do not take into account implicit costs of debt. It implies that as
long as the future earnings of the firm are greater than the interest payable on debt i.e.
explicit cost, the firm should rely on debt to raise additional funds. However, that may not
always help maximize the wealth of shareholders because it results in a decline in the
market price of the common stock as a result of increased financial risk.
 Financial Leverages are based on certain unrealistic assumptions. Financial leverages
assume that costs of debt remain constant irrespective of the degree of leverage of the firm.
That is an unrealistic assumption because as the amount of debt increases, the firmis
exposed to greater risk and therefore, the interest rate charged to the firm also increases
simultaneously.

Operating Leverage
Definition of Operating Leverage
 It measures the extent of the fixed operating costs of a firm. If the operating leverage of a
firm is high, it implies that it has high fixed costs in comparison to a firm with a low
operating leverage. It measures the effect of change in sales on the level of EBIT.
 Degree of operating leverage refers to a firm‟s ability to use fixed operating costs to
magnify effects of changes in sales on its earnings before interest and taxes.
 Formula for Degree of Operating Leverage

Sales- variable Cost/EBIT

An operating Leverage of 1.5 means that an increase in sales by 1% would cause the operating
profit to increase by 1.5%

Combined Leverage

The Combined Leverage measures the effect of percentage change in sales on the percentage
change in EPS. It indicates the effect that change in sales has on EPS. It helps to maintain a proper
balance between operating profit and sales without exposing the firm to too much risk.

Formula for Combined Leverage

Combined Leverage= Operating Leverage X Financial Leverage

Illustration 1: Calculate the Degree of Operating Leverage (DOL), Degree of Financial

leverage (DFL) and the Degree of Combined Leverage (DCL) for the following firms and interpret
the results.

Firm A Firm B Firm C

Output (units) 60,000 15,000 1,00,000
Fixed Costs (Rs) 7,000 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed funds 4,000 8,000 -----
Selling price per unit (Rs) 0.60 5.00 0.10

Solution:

Firm A Firm B Firm C

Output (units) 60,000 15,000 1,00,000
Selling price per unit (Rs) 0.60 5.00 0.10
Variable cost per unit (Rs.) 0.20 1.50 0.02
Contribution per unit 0.40 3.50 0.08
Total Contribution Rs.24,000 Rs.52,500 RS.8,000
Less fixed costs 7,000 14,000 1,500
EBIT 17,000 38,500 6,500
Less Interest 4,000 8,000 ---
Profit before Tax 13,000 30,500 6,500
Degree of Operating Leverage
Contribution/EBIT 24,000/17,000 52,500/38,000 8,000/6,500
= 1.41 =1.36 = 1.23
Degree of Financial Leverage
EBIT/PBT 17,000/13,000 38,500/30,500 6,500/6,500
= 1.31 = 1.26 = 1.00
Degree of Combined Leverage
Contribution/ EBIT 24,000/13,000 52,500/30,500 8,000/6,500
= 1.85 = 1.72 = 1.23
Illustration 2: A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of
Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating, financial and
combined leverages. If the firm wants to double its earnings before interest and tax (EBIT), how
much of a rise in sales would be needed on a percentage basis?
Solution:
Statement of Existing Profit

Sales Rs.10,00,000
Less Variable cost 7,00,000
Contribution 3,00,000
Less fixed cost 2,00,000
EBIT 1,00,000
Less Interest @ 10% on 5,00,000 50,000
Profit after Tax 50,000
Operating leverage Contribution/ EBIT = 3,00,000/1,00,000 = 3
Financial Leverage EBIT/PBT = 1,00,000/50,000 = 2
Combined Leverage = 3x 2= 6

Statement of sales needed to double EBIT

Operating Leverage is 3 times i.e. 33 – 1/3% increase in sales volume causes a 100%
increase in operating profit or EBIT. Thus, at the sales of Rs. 13,33,333, operating profit or EBIT
will become Rs. 2,00,000 i.e. double existing one.
 Verification:

Sales Rs.13,33,333
Variable cost (70%) 9,33,333
Contribution 4,00,000
Fixed Costs 2,00,000
EBIT 2,00,000

Illustration 3: The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amount

Equity share capital 60,000 Fixed Assets 1,50,000
Retained Earnings 20,000 Current Assets 50,000
10% long term debt 80,000
Current Liabilities 40,000 ------------
2,00,000 2,00,000

The company‟s total assets turnover ratio is 3, its fixed operating costs are Rs.1,00,000 and
its variable operating cost ratio is 40%. The income tax rate is 50%. Calculate the different types
of leverages given that the face value of share is Rs.10.
Solution: Total Assets Turnover Ratio = Sales / Total Assets
3 = Sales/2,00,000

Sales 6,00,000
Variable Operating Cost (40%) 2,40,000
Contribution 3,60,000
Less Fixed Operating Cost 1,00,000
EBIT 2,60,000
Less interest (10% of 80,000) 8,000
PBT 2,52,000
Tax at 50% 1,26,000
PAT 1,26,000
Number of shares 6,000
EPS Rs.21
Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT / PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage =1.38 x 1.03 = 1.42
Illustration 4: The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed Costs 7,00,000
Calculate % change in EPS if the sales are expected to increase by 5%.
Solution: In order to find out the % change in EPS as a result of % change in sales, the
combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs.11,20,000 + Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT / Profit before Tax
= Rs. 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/ Profit before Tax = OL x FL
= 1.625 x 3.5 = 5.69
The combined leverage of 5.69 implies that for 1% change in sales level, the % change in
EPS would be 5.69% So, if the sales are expected to increase by 5%, then the % increase in EPS
would be 5 x 5.69 = 28.45%.
Illustration 5: The data relating to two companies are as given below:

Company A Company B
Capital Rs.6,00,000 Rs.3,50,000
Debentures Rs. 4,00,000 6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Fixed costs per annum 7,00,000 14,00,000
Variable cost per unit 10 75
You are required to calculate the Operating leverage, Financial leverage and Combined Leverage
of two companies.
Solution: Computation of Operating leverage, Financial Leverage and Combined leverage

Company A Company B
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Sales Revenue 18,00,000 37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
on debentures 48,000 78,000
PBT 4,52,000 11,47,000
DOL = Contribution/EBIT 12,00,000/5,00,000 26,25,000/12,25,000
= 2.4 = 2.14
DFL = EBIT/ PBT 5,00,000/4,52,000 12,25,000/11,47,000
1.11 =1.07
DCL = DOL x DFL 2.14 x 1.11 = 2.66 2.14 x 1.07 = 2.2
Illustration 6: X Corporation has estimated that for a new product its break-even point is 2,000
units if the item is sold for Rs. 14 per unit, the cost accounting department has currently identified
variable cost of Rs. 9 per unit. Calculate the degree of operating leverage for sales volume of 2,500
units and 3,000 units. What do you infer from the degree of operating leverageat the sales volume
of 2,500 units and 3,000 units and their difference if any?
Solution:

Particulars 2500 units 3000 units

Sales @ Rs.14 per unit 35,000 42,000
Variable cost 22,500 27,000
Contribution 12,500 15,000
Fixed Cost (2,000 x (Rs.14 – 9) 10,000 10,000
EBIT 2,500 5,000
Operating Leverage
= Contribution/ EBIT 12,500/2,500 15,000/5,000
 =5 =3

Illustration 7: The following data is available for XYZ Ltd.

Sales Rs. 2,00,000
Less: Variable cost 60,000
Contribution 1,40,000
Fixed Cost 1,00,000
EBIT 40,000
Less Interest 5,000
Profit before tax 35,000
Find out:
(a) Using concept of financial leverage, by what percentage will the taxable income increase, if
EBIT increases by 6 %.
(b) Using the concept of operating leverage, by what percentage will EBIT increase if there is
10% increase in sales and,
(c) Using the concept of leverage, by what percentage will the taxable income increase if the
sales increase by 6%. Also verify the results in view of the above figures.

Solution:
(i) Degree of Financial Leverage:
FL = EBIT/Profit before Tax = 40,000/35,000 = 1.15
If EBIT increases by 6%, the taxable income will increase by 1.15 x 6 = 6.9% and it may be
verified as follows:
EBIT (after 6% increase) Rs. 42,400
Less Interest 5,000
Profit before Tax 37,400
Increase in taxable income is Rs. 2,400 i.e 6.9% of Rs. 35,000
(ii) Degree of Operating Leverage:
OL = Contribution / EBIT = 1,40,000/40,000 = 3.50
If sale increases by 10%, the EBIT will increase by 3.50 x 10 = 35% and it may be verified as
follows:
Sales (after 10% increase) Rs. 2,20,000
Less variable expenses @ 30% 66,000
 Contribution 1,54,000
Less Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e 35% of Rs. 40,000

(iii) Degree of Combined leverage

CL = Contribution/ Profit before tax = 1,40,000/35,000 = 4
If sales increases by 6%, the profit before tax will increase by 4x6= 24% and it maybe verified as
follows:
Sales (after 6% increase) Rs. 2,12,000
Less Variable expenses@ 30% 63,600
Contribution 1,48,400
Less Fixed cost 1,00,000
EBIT 48,400
Less Interest 5,000
Profit before tax 43,400
Increase in Profit before tax is Rs. 8,400 i.e 24% of Rs. 35,000

EBIT and EPS Analysis

One of the primary valuation metrics used by investors to assess a business' worth and financial
stability is earnings per share (EPS). EPS reflects a company's net income divided by the number
of common shares outstanding. EPS, of course, largely depends on a company's earnings. For the
purposes of EPS calculation, earnings before interest and taxes (EBIT) is used because it reflects
the amount of profit that remains after accounting those expenses necessary to keep the business
going. EBIT is also often referred to as operating income.

The relationship between EBIT and EPS is as follows:

EPS = (EBIT - Debt Interest) * (1 - Tax Rate) - Preferred Share Dividends / Number of Common
Shares Outstanding

When assessing the relative effectiveness leverage versus equity financing, companies look for the
level of EBIT where EPS remains unaffected, called the EBIT-EPS break-even point. This
calculation determines how much additional revenue would need to be generated in order to
maintain a constant EPS under different financing plans.

To calculate the EBIT-EPS break-even point, rearrange the EPS formula:

EBIT = (EPS * Number of Common Shares Outstanding) + Preferred Share Dividends / (1 - Tax
Rate) + Debt Interest

For example, assume a company generates $150,000 in earnings and is financed entirely by equity
capital in the form of 10,000 common shares. The corporate tax rate is 30%. The company's EPS
is ($150,0000 - 0) * (1 - 0.3) + 0 / 10,000, or $10.50. Now assume the company takes out a loan of
$10,000 with a 5% interest rate and sells an additional 10,000 shares. To calculate the level of
EBIT where EPS remains stable, simply input the debt interest, current EPSand updated shares
outstanding values and solve for EBIT: ($10.50 * 20,000) + 0 / (1 - 0.3) +
$500 = $300,500. Under this financing plan, the company must more than double its earnings to
maintain a stable EPS.

Effective business management requires careful planning and decision-making about the
balance of debt and equity used in financing the business. The EBIT-EPS approach is one method
available to managers to guide them in making decisions about capital structure. It refers to the
relationship between two numbers: earnings before interest and taxes, or EBIT, and earnings per
share, or EPS. To benefit from the EBIT-EPS approach, it helps to understand the basics of how it
works, as well as its advantages and drawbacks.

Business Capital Structure

Capital structure refers to a business's balance of debt and equity financing. Businesses have two
options for financing the purchases of equipment, expenses and materials necessary for their
operations. They can raise money from investors, which is equity financing, or they can borrow
from banks and creditors – leverage or debt financing. Most businesses engage in a degree of both,
paying careful attention to the costs associated with either source. Relying too heavily on equity
increases the cost to investors and cuts into return. But relying too much on debt puts the business
in a more precarious position and comes with the substantial costs of interest.

Understanding the EBIT-EPS Approach

The EBIT-EPS approach is one tool managers use to decide on the right mix of debt and equity
financing in a business's capital structure. In the EBIT-EPS approach, the business plots graphs
of its performance at different possible debt-to-equity ratios, such as 40 percent debt to 60 percent
equity. In a basic graph, the earnings per share as a data point is plotted for each level of earnings
before interest and taxes at different debt-to-equity ratios. The graph is then analyzed to determine
the ideal level of debt-to-equity for the business.

Analysis for Risk and Return

Once the relationship between EBIT and EPS is plotted for different capital structures, the investor
can analyze the graph, focusing on two key challenges. The level of EBIT where EPS is zero,
called the break-even point, and the graph's slope, which visually represents the company's risk. A
steeper slope conveys a higher risk – greater loss per share at at lower EBIT level. A steeper slope
also means a higher return, and that the company needs to earn less EBIT to
produce greater EPS. The breakeven point is also important because it tells the business how much
EBIT there must be to avoid losses, and varies at different proportions of debt to equity.

Drawbacks to the Approach

The EBIT-EPS approach is not always the best tool for making decisions about capital structuring.
The EBIT-EPS approach places heavy emphasis on maximizing earnings per share rather than
controlling costs and limiting risk. It's important to keep in mind that as debt financing increases,
investors should expect a higher return to account for the greater risk; this is known as a risk
premium. The EBIT-EPS approach does not factor this risk premium into the cost of financing,
which can have the effect of making a higher level of debt seem more advantageous for investors
than it actually is.

ABC Ltd. which is expecting the EBIT of Rs.1,50,000 per annum on an investment
Rs.5,00,000, is considering the finalization of the capital structure or the financial plan. The
company has access to raise funds of varying amounts by issuing equity share capital, 12%
preference share and 10% debenture or any combination thereof. Suppose, it analyzes the
following four options to raise the required funds of Rs.5,00,000.
1. By issuing equity share capital at par.
2. 50% funds by equity share capital and 50% funds by preference shares.
3. 5% funds by equity share capital, 25% by preference shares and 25% by issue of 10%
debentures.
4. 25% funds by equity share capital, 25% as preference share and 50% by the issue of 10%
debentures.
Assuming that ABC Ltd. belongs to 50% tax bracket, the EPS under the above four options can
be calculated as follows:

Option 1 Option 2 Option 3 Option 4

Equity share capital Rs.5,00,000 Rs.2,50,000 Rs.2,50,000 Rs.1,25,000

Preference share capital --- 2,50,000 1,25,00 1,25,000

10% Debentures --- --- 1,25,000 2,50,000

Total Funds 5,00,000 5,00,000 5,00,000 5,00,000

EBIT 1,50,000 1,50,000 1,50,000 1,50,000

- Interest --- --- 12,500 25,000

Profit before Tax 1,50,000 1,50,000 1,37,500 1,25,000

- Tax @ 50% 75,000 75,000 68,750 62,500
 Profit after Tax 75,000 75,000 68,750 62,500
- Preference Dividend --- 30,000 15,000 15,000
Profit for Equity shares 75,000 45,000 53,750 47,500
No. of Equity shares (of Rs.100 5000 2500 2500 1250
each)
EPS (Rs.) 15 18 21.5 38

In this case, the financial plan under option 4 seems to be the best as it is giving the highest
EPS of Rs.38. In this plan, the firm has applied maximum financial leverage. The firm is expecting
to earn an EBIT of Rs.1,50,000 on the total investment of Rs.5,00,000 resulting in 30% return. On
an after-tax basis, this return comes to 15% i.e., 30% x (1-.5). However, the after tax cost of 10%
debentures is 5% i.e., 10% (1- .5) and the after tax cost of preference sharesis 12% only. In the
option 4, the firm has employed 50% debt, 25% preference shares and 25% equity share capital,
and the benefits of employing 50% debt (which has after tax cost of 5% only) and 25% preference
shares (having cost of 12% only) are extended to the equity shareholders. Therefore the firm is
expecting an EPS of Rs.38.
In case, the company opts for all-equity financing only, the EPS is Rs.15 which is just equal
to the after tax return on investment. However, in option 2, where 5% funds are obtained by the
issue of 12% preference shares, the 3% extra is available to the equity shareholders resulting in
increase in of EPS from Rs.15 to Rs.18. In plan 3, where 10% debt is also introduced, the extra
benefit accruing to the equity shareholders increases further (from preference shares as well a from
debt) and the EPS further increases to Rs.21.50. The companyis expecting this increase in EPS
when more and more preference share and debt financing is availed because the after tax cost of
preference shares and debentures are less than the after tax return on total investment.
Hence, the financial leverage has a favourable impact on the EPS-only if the ROI is more
than the cost of debt. It will rather have an unfavourable effect if the ROI is less than the cost of
debt. That is why financial leverage is also called the twin-edged sword.

Break Even Analysis of Financial Leverage

Financial BEP is the amount EBIT at which net profit becomes zero and is calculated by the
following formula.

Financial BEP = EBIT= I+ PD/1-t

Capital Structure Theories

A corporate can finance its business mainly by 2 means i.e. debts and equity. However, the
proportion of each of these could vary from business to business. A company can choose to have
a structure which has 50% each of debt and equity or more of one and less of another. Capital
structure is also referred to as financial leverage, which strictly means the proportion of debt or
borrowed funds in the financing mix of a company.

Debt structuring can be a handy option because the interest payable on debts is tax deductible
(deductible from net profit before tax). Hence, debt is a cheaper source of finance. But increasing
debt has its own share of drawbacks like increased risk of bankruptcy, increased fixed interest
obligations etc.

For finding the optimum capital structure in order to maximize shareholder‟s wealth or value of
the firm, different theories (approaches) have evolved. Let us now look at the first approach

Modigliani and Miller (MM) Approach

Modigliani and Miller approach to capital theory, revised in the 1950s advocates capital structure
irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of
a company. Whether a firm is highly leveraged or has lower debt component, it has no bearingon
its market value. Rather, the market value of a firm is dependent on the operating profits ofthe
company.

The capital structure of a company is the way a company finances its assets. A company can
finance its operations by either debt or equity or different combinations of these two sources. The
capital structure of a company can have a majority of debt component or a majority of equity, only
one of the 2 components or an equal mix of both debt and equity. Each approach has its own set
of advantages and disadvantages. There are various capital structure theories, trying to establish a
relationship between the financial leverage of a company (the proportion of debt in the company‟s
capital structure) with its market value. One such approach is the Modigliani and Miller Approach.

Modigliani and Miller Approach

This approach was devised by Modigliani and Miller during 1950s. The fundamentals of
Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliani
and Miller advocate capital structure irrelevancy theory. This suggests that the valuation of a firm
is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower
debt component in the financing mix, it has no bearing on the value of a firm.

Modigliani and Miller Approach further states that the market value of a firm is affected by its
future growth prospect apart from the risk involved in the investment. The theory stated that value
of the firm is not dependent on the choice of capital structure or financing decision of the firm. If
a company has high growth prospect, its market value is higher and hence its stock priceswould
be high. If investors do not see attractive growth prospects in a firm, the market value of that firm
would not be that great.
Assumptions of Modigliani and Miller Approach

 There are no taxes.

 Transaction cost for buying and selling securities as well as bankruptcy cost is nil.
 There is a symmetry of information. This means that an investor will have access to same
information that a corporation would and investors would behave rationally.
 The cost of borrowing is the same for investors as well as companies.
 Debt financing does not affect companies EBIT.

Modigliani and Miller Approach indicates that value of a leveraged firm ( a firm which has a mix
of debt and equity) is the same as the value of an unleveraged firm ( a firm which is wholly financed
by equity) if the operating profits and future prospects are same. That is, if an investor purchases
shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1

With the above assumptions of “no taxes”, the capital structure does not influence the valuation of
a firm. In other words, leveraging the company does not increase the market value of the company.
It also suggests that debt holders in the company and equity shareholders have the same priority
i.e. earnings are split equally amongst them.

Proposition 2

It says that financial leverage is in direct proportion to the cost of equity. With an increase in debt
component, the equity shareholders perceive a higher risk to for the company. Hence, in return,
the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction
here is that proposition 2 assumes that debt-shareholders have upper-hand as far as the claim on
earnings is concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of
Leverage)

The Modigliani and Miller Approach assumes that there are no taxes. But in the real world, this is
far from the truth. Most countries, if not all, tax a company. This theory recognizes the tax benefits
accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the
same is not the case with dividends paid on equity. To put it in other words, the actual cost of debt
is less than the nominal cost of debt because of tax benefits. The trade-off theory advocates that a
company can capitalize its requirements with debts as long as the cost of distress
i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts, until a given
threshold value will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that a change in
debt-equity ratio has an effect on WACC (Weighted Average Cost of Capital). This means
higher the debt, lower is the WACC. This Modigliani and Miller approach is one of the modern
approaches of Capital Structure Theory.

Net Income Approach

Net Income Approach suggests that value of the firm can be increased by decreasing the overall
cost of capital (WACC) through higher debt proportion. There are various theories which
propagate the „ideal‟ capital mix / capital structure for a firm. Capital structure is the proportion
of debt and equity in which a corporate finances its business. The capital structure of a
company/firm plays a very important role in determining the value of a firm.

Net Income Approach was presented by Durand. The theory suggests increasing value of the firm
by decreasing the overall cost of capital which is measured in terms of Weighted Average Cost of
Capital. This can be done by having a higher proportion of debt, which is a cheaper source of
finance compared to equity finance.

Weighted Average Cost of Capital (WACC) is the weighted average costs of equity and debts
where the weights are the amount of capital raised from each source.

Required Rate of Return x Amount of Equity + Rate of Interest x Amount of Debt

WACC =
Total Amount of Capital (Debt + Equity)

According to Net Income Approach, change in the financial leverage of a firm will lead to a
corresponding change in the Weighted Average Cost of Capital (WACC) and also the value of the
company. The Net Income Approach suggests that with the increase in leverage (proportion of
debt), the WACC decreases and the value of firm increases. On the other hand, if there is a decrease
in the leverage, the WACC increases and thereby the value of the firm decreases.

For example, vis-à-vis equity-debt mix of 50:50, if the equity-debt mix changes to 20: 80, it would
have a positive impact on the value of the business and thereby increase the value per share.

Assumptions of Net Income Approach

Net Income Approach makes certain assumptions which are as follows.

 The increase in debt will not affect the confidence levels of the investors.
 The cost of debt is less than the cost of equity.
 There are no taxes levied.

Net Operating Income Approach

Net Operating Income Approach was also suggested by Durand. This approach is of the opposite
view of Net Income approach. This approach suggests that the capital structure decision of a firm
is irrelevant and that any change in the leverage or debt will not result in a change in the total
value of the firm as well as the market price of its shares. This approach also says that the overall
cost of capital is independent of the degree of leverage.

Features of NOI approach:

1. At all degrees of leverage (debt), the overall capitalization rate would remain constant. For
a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be
equal to EBIT/overall capitalization rate.
2. The value of equity of a firm can be determined by subtracting the value of debt from the
total value of the firm. This can be denoted as follows: Value
of Equity = Total value of the firm - Value of debt
3. Cost of equity increases with every increase in debt and the weighted average cost of capital
(WACC) remains constant. When the debt content in the capital structure increases, it
increases the risk of the firm as well as its shareholders. To compensate for the higher risk
involved in investing in highly levered company, equity holders naturally expect higher
returns which in turn increases the cost of equity capital.
 UNIT IV
INTRODUCTION

Once a company makes a profit, it must decide on what to do with those profits. They could
continue to retain the profits within the company, or they could pay out the profits to the owners
of the firm in the form of dividends. The dividend policy decision involves two questions: 1) What
fraction of earnings should be paid out, on average, over time? And, 2) What type of dividend
policy should the firm follow? I.e. issues such as whether it should maintain steady dividend policy
or a policy increasing dividend growth rate etc. On the other hand Management has to satisfy
various stakeholders from the profit. Out of the Stakeholders priority is to be given to equity share
- holders as they are being the highest risk.

DIVIDEND - DEFINED DEFINITION: DIVIDEND

According to the Institute of Chartered Accountants of India, dividend is "a distribution to

shareholders out of profits or reserves available for this purpose."7 "The term dividend refers to
that portion of profit (after tax) which is distributed among the owners / shareholders of the firm."

"Dividend may be defined as the return that a shareholder gets from the company, out of its profits,
on his shareholdings."

In other words, dividend is that part of the net earnings of a corporation that is distributed to its
stockholders. It is a payment made to the equity shareholders for their investment in the company.

As per the section 2(22) of the Income Tax Act, 1961, dividend defined as:-

"Any distribution of accumulated profits whether capitalized or not, if such distribution entails a
release of assets or part thereof".

Dividend is a reward to equity shareholders for their investment in the company. It is a basic right
of equity shareholders to get dividend from the earnings of a company. Their share should be
distributed among the members within the limit of an act and with rational behavior of directors.

The word dividend has not been defined in The Indian Companies Act, 1956. It may be described
as a periodical cannot be declared from capital gains under following conditions: i) Provision in
Articles of Association. ii) Capital gain must be realized. All assets & liabilities must be revalued
before distributing this capital gain.

DEFINITION: DIVIDEND POLICY

"Dividend policy determines the ultimate distribution of the firm's earnings between retention (that
is reinvestment) and cash dividend payments of shareholders."

"Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."

In other words, dividend policy is the firm's plan of action to be followed when dividend decisions
are made. It is the decision about how much of earnings to pay out as dividends versus retaining
and reinvesting earnings in the firm.

Dividend policy means policy or guideline followed by the management in declaring of dividend.
A dividend policy decides proportion of dividend and retains earnings. Retainedearnings are an
important source of internal finance for long term growth of the company while dividend reduces
the available cash funds of company.

"As long as the firm has investment project whose returns exceed its cost of capital, it will use
retained earnings to finance these projects".

There is a reciprocal relationship between retained earnings and dividend i.e. larger the retained
earnings, lesser the dividend and smaller the retained earnings, larger the dividend. James E.
Walter (1963) says "Choice of dividend policy almost effects the value of the enterprise”

The dividend policy of a company reflects how prudent its financial management is. The future
prospects, expansion, diversification mergers are effected by dividing policies and for a healthy
and buoyant capital market, both dividends and retained earnings are important factors. Most of
the company follows some kind of dividend policy. The usual policy of a company is to retain a
position of net earnings and distribute the remaining amount to the shareholders. Many factors
have to be evaluated before forming a long term dividend policy.

TYPES OF DIVIDENDS:

Classifications of dividends are based on the form in which they are paid. Following given below
are the different types of dividends:

1. Cash dividend
2. Bonus Shares
3. Property dividend interim dividend, annual dividend
4. Special- dividend, extra dividend etc.
5. Regular Cash dividend
6. Scrip dividend
7. Liquidating dividend
8. Property dividend
Cash dividend:

Companies mostly pay dividends in cash. A Company should have enough cash in its bank account
when cash dividends are declared. If it does not have enough bank balance, arrangement should be
made to borrow funds. When the Company follows a stable dividend policy, it should prepare a
cash budget for the coming period to indicate the necessary funds, which would be needed to meet
the regular dividend payments of the company. It is relatively difficult to make cash planning in
anticipation of dividend needs when an unstable policy is followed.

The cash account and the reserve account of a company will be reduced when the cash dividend is
paid. Thus, both the total assets and net worth of the company are reduced when the cash dividend
is distributed. The market price of the share drops in most cases by the amount of the cash dividend
distributed.

Bonus Shares:

An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In
India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend.
Hence, Companies in India may supplement cash dividend by bonus issues. Issuing bonus shares
increases the number of outstanding shares of the company. The bonus shares are distributed
proportionately to the existing shareholder. Hence there is no dilution of ownership.

The declaration of the bonus shares will increase the paid-up Share Capital and reduce the reserves
and surplus retained earnings) of the company. The total net-worth (paid up capital plus reserves
and surplus) is not affected by the bonus issue. Infect, a bonus issue represents a recapitalization
of reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid up
capital.

The following are advantages of the bonus shares to shareholders:

1) Tax benefit: One of the advantages to shareholders in the receipt of bonus shares is the
beneficial treatment of such dividends with regard to income taxes.

2) Indication of higher future profits: The issue of bonus shares is normally interpreted by
shareholders as an indication of higher profitability.

3) Future dividends may increase: if a Company has been following a policy of paying a fixed
amount of dividend per share and continues it after the declaration of the bonus issue, the total
cash dividend of the shareholders will increase in the future.

4) Psychological Value: The declaration of the bonus issue may have a favorable psychological
effect on shareholders. The receipt of bonus shares gives them a chance sell the shares to make
capital gains without impairing their principal investment. They also associate it with the
prosperity of the company.
Special dividend : In special circumstances Company declares Special dividends. Generally
company declares special dividend in case of abnormal profits.

Extra- dividend: An extra dividend is an additional non-recurring dividend paid over and above
the regular dividends by the company. Companies with fluctuating earnings payout additional
dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular
dividends.

Annual dividend: When annually company declares and pay dividend is defined as annual
dividend.

Interim dividend: During the year any time company declares a dividend, it is defined as Interim
dividend.

Regular cash dividends: Regular cash dividends are those the company exacts to maintain every
year. They may be paid quarterly, monthly, semiannually or annually.

Scrip dividends: These are promises to make the payment of dividend at a future date: Instead of
paying the dividend now, the firm elects to pay it at some later date. The „scrip‟ issued to
stockholders is merely a special form of promissory note or notes payable

Liquidating dividends: These dividends are those which reduce paid-in capital: It is a pro-rata
distribution of cash or property to stockholders as part of the dissolution of a business

Property dividends: These dividends are payable in assets of the corporation other than cash. For
example, a firm may distribute samples of its own product or shares in another company it owns
to its stockholders.

DIVIDENDS AND VALUE OF THE FIRM

The company's Board of Directors makes dividend decisions. They are faced with the decision to
pay out dividends or to reinvest the cash into new projects.

The tradeoff between paying dividends and retaining profits within the company The dividend
policy decision is a trade-off between retaining earnings v/s paying out cash dividends.

Dividend policies must always consider two basic objectives:

 Maximizing owners' wealth

 Providing sufficient financing

FACTORS DETERMINING DIVIDEND POLICY

While determining a firm's dividend policy, management must find a balance between current
income for stockholders (dividends) and future growth of the company (retained earnings).
In applying a rational framework for dividend policy, a firm must consider the following two
issues:

 How much cash is available for paying dividends to equity investors, after meeting all
needs-debt payments, capital expenditures and working capital (i.e. Free Cash Flow to
Equity - FCFE)
 To what extent are good projects available to the firm (i.e. Return on equity - ROE >
Required Return) The potential combinations of FCFE and Project Quality and the
generalizations of the dividend policy to be adapted in each situation are presentedbelow:

Dividend Decision Matrix

Factors FCFE> Dividends FCFE<Dividends

ROE> Cost of Equity Good Projects Good Projects
Cash flow surplus Decrease Dividends
No Change Invest in Projects
ROE< Cost of Equity Poor Projects Poor Projects
Cash flow surplus Cash flow Deficit
Increase Dividends Decrease Dividends
Reduce Investment Reduce Investment

DIVIDEND POLICY THEORIES

1. The Residual Theory of Dividend Policy

The residual theory of dividend policy holds that the firm will only pay dividend from residual
earnings, that is dividends should be paid only if funds remain after the optimum level of capital
expenditures is incurred i.e. all suitable investment opportunities have been financed.

With a residual dividend policy, the primary focus of the firm is on investments and hence
dividend policy is a passive decision variable. The value of a firm is a direct function of its
investment decisions thus making dividend policy irrelevant.

2. Dividend Irrelevancy Theory, (Miller & Modigliani, 1961)

The dividend irrelevancy theory asserts that dividend policy has no effect on either the price
of the firm or its cost of capital.

This theory argues that dividend policy does not affect share price because the value of the
firm is a function of its earning power and the risk of its assets. If dividends do affect value, it
is only due to:
  Information effect : The informational content of dividends relative to management's
earnings expectations
 Clientele effect: A clientele effect exists which allows firms to attract shareholders
whose dividend preferences match the firm's historical dividend payout patterns.
 Signaling effect: Rise in dividend payment is viewed as a positive signal whereas a
reduction in dividend payment is viewed as a negative signal about the future earnings
prospects of the company, thus leading to an increase or decreases in share prices of
the firm. Managers use dividends as signals to transmit information to the capital
market. Theoretical models by Bhattacharya (1979)19, Miller and Rock (1985)20 and
John and Williams (1985)21 and Williams (1988)22 tell us that dividend increases
convey good news and dividend decreases convey bad news.

However, this theory is based on the following assumptions:

 There is an existence of perfect capital markets i.e. No personal or corporate taxes

and no transaction costs.
 The firm's investment policy is independent of its dividend policy.
 Investors behave rationally and information is freely available to them
 Risk or uncertainty does not exist.

The above-mentioned assumptions exclude personal and corporate taxes as well as anylinkage
to capital investment policy as well as other factors that limit its application to real world
situations.

3. The Bird in the Hand Theory, (John Lintner 1962 and Myron Gordon, 1963)

The essence of this theory is not stockholders are risk averse and prefer current dividends due
to their lower level of risk as compared to future dividends. Dividend payments reduce investor
uncertainty and thereby increase stock value. This theory is based on the logic that ' what is
available at present is preferable to what may be available in the future'. Investors would prefer
to have a sure dividend now rather than a promised dividend in the future (even if the promised
dividend is larger). Hence dividend policy is relevant and does affect the share price of a firm.

A Summary View of Dividend Policy Theories

The dividend policy theories focus on the issue of the relevancy of dividend policy to the value
of a firm.

Dividend Irrelevance

Dividends do not make any difference (M & M theory)

If there are no taxes disadvantages associated with dividends.

Dividend Relevance

Dividends are relevant and have positive impact on firm value

If stockholders like dividends, or dividends operate as a signal of future prospects. (Lintner &
Gordon) Dividends help to resolve agency problem and thus enhancing shareholder value.
(Jenson) Dividends are not good (Graham and Dodd) If dividends have a tax disadvantage and
increasing dividends reduce value. There are therefore, conflicting viewpoints regarding the
impact of dividend decision on value of a firm.

DIVIDEND MODELS

The various models that support the above-mentioned theories of dividend relevance and
irrelevance are as follows:

Modigliani Miller approach (MM Hypothesis)

According to them the price of a share of a firm is determined by its earning potentiality and
investment policy and not by the pattern of income distribution. The model given by them is as
follows:

Po = D1 + P1/ (1/Ke)

Where, Po = Prevailing market price of a share

Ke = Cost of equity capital
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one

According to the MM hypothesis, market value of a share before dividend is declared is equal to
the present value of dividends paid plus the market value of the share after dividend is declared.

Walter's approach

According to Prof. James E. Walter, in the long run, share prices reflect the present value of future+
dividends. According to him investment policy and dividend policy are inter related and the choice
of a appropriate dividend policy affects the value of an enterprise. His formula for determination
of expected market price of a share is as follows:
P = D + r/k(E-D)
K

Where, P = Market price of equity share

D = Dividend per share
E = Earnings per share
(E-D) = Retained earnings per share
r = Internal rate of return on investment
 k = cost of capital

Gordon's approach: Dividend Yield Basis

The value of a share, like any other financial asset, is the present value of the future cash flows
associated with ownership. On this view, the value of the share is calculated as the present value
of an infinite stream of dividends.

Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of
establishing share value. Gordon's model uses the dividend capitalization approach for stock
valuation. The formula used is as follows: Po = E1 (1-b)
K-br

Where, Po = price per share at the end of year 0

E1 = earnings per share at the end of year 1
(1-b) = fraction of earnings the firm distributes by way of dividends
b = fraction of earnings the firm ploughs back
k = rate of return required by shareholders
r = rate of return earned on investments made by the firm
br = growth rate of dividend and earnings

The models, provided by Walter and Gordon lead to the following implications:

 If r > k Price per share increases as dividend payout ratio decreases

 If r = k Price per share remains unchanged with changes in dividend payout ratio
 If r < k Price per share increases as dividend payout ratio increases.

WORKING CAPITAL MANAGEMENT

Working Capital
The capital of a business which is used in its day-by-day trading operations, calculated as the
current assets minus the current liabilities. Working capital is also called operating assets or net
current assets.
WC= CA-CL
Working Capital Management
Working capital management refers to a company‟s managerial accounting strategy designed to
monitor and utilize the two components of working capital, current assets and current liabilities,
to ensure the most financially efficient operation of the company.

Need of Working Capital Management

1. Inventory management
2. Receivable management
3. Cash management

Factors affecting working capital management

 Nature of business
  Production policy
 Credit policy
 Inventory policy
 Abnormal factor
 Market conditions
 Conditions of supply
 Business cycle
 Taxation policy
 Dividend policy
 Operating efficiency
 Price level changes
 Depreciation policy
 Availability of raw material

Determining the Working Capital Needs

It depends on the following factors-
 Size of the firm
 Activities of the firm
 Availability of credits
 Attitudes towards profit
 Attitude toward risks
 Others
Importance of Adequate Working Capital
1. Smooth running of business
2. Profitability with manage risk
3. Growth and development possibility
4. Smooth payment
5. Increase in goodwill
6. Trade relationship better
7. Others

In managing WC two processes are there-

 Forecasting requirement of fund
 Arrangement of fund

The Operating Cycle Approach

The determination of WC helps in forecast, control& management of WC. The duration of WC

may vary depending upon the nature of business. The duration of operating cycle (WC cycle)
for the purpose of estimating WC is equal to the sum of duration of each of above events less the
credit period allowed by the supplier

For ex.- A co. holds raw material on an average for 60 days, it gets credit firm supplier for 15 days,
production process needs15 days, finished products are held 30 days & 30 days is the total WC
cycle. So, 60+15+30+30-15=120 days.

Various Components of Operating Cycle

A) Raw material shortage period = Average stock of raw material

Average cost of raw material consumed per day

B) WIP holding period = Average WIP inventory

Average cost of production per day

C) Finished goods storage period = Estimated production (in units) * direct lab permit
12 months / 360 days

OR

Average stock of finished goods

Average cost of goods sold per day

D) Debtors collection period = Average goods debtors

Average credit sale per day

E) Credit period available to suppliers = Average rate credit

Average credit purchase per day

Operating Cycle = R+W+F+D-C

Financing of Working Capital

Financing of working capital can be done in two ways:

A. Long term sources
B. Short term sources

A. Long term sources

1. Share capital
a. Equity share capital
b. Preference share capital
2. Debentures
a. Convertible debentures
b. Non-convertible debentures
c. Redeemable debentures
 d. Non-Redeemable debentures
3. Bonds
4. Loans from banks & financial institutions
5. Retained earnings
6. Venture capital fund for innovative projects

B. Short term sources

1. Bank credit
2. Transaction credit
3. Advances from customers
4. Bank advances
5. Loans
6. Overdraft
7. Bills purchase and discounted
8. Advance against documents of title of goods
9. Term loans by bank
10. Commercial paper
11. Bank deposits

Financing of Working Capital through Bank Finance and Trade Credit

Traditionally bank credit:
 Source of meeting of working capital needs of business firms.
 In other words, they have been extending credit to industry & trade on the basis of security.
 RBI has appointed various committees to ensure equitable distribution of bank resources to
various sectors of economy. The committees suggest ways & means to make the bank credit
& effective instrument of industrialization.

Recommendation of Daheja and Tondon Committee on Working Capital

1. DAHEJA COMMITTEE:

In September 1969, Daheja committee of RBI pointed out in his report that in the financing
practice of the banks. There was no relationship between the optimum requirement & bank loan.
The committee also pointed out that banks do not give proper attention to financing patterns. So
clients move towards double & multiple financing.
The Daheja committee suggested:
□ The heart hole which represents the minimum level of raw material, finished goods & stores
which any industrial concerned is required to hold for maintaining certain level of production.
□ The strictly short term components which should be the fluctuating path of the accounting,
the path should represents the short term inventory, taxes, dividend, bonus payments.
Conclusion of Daheja committee:
 Orientation towards project & need based lending.

2. TONDON COMMITTEE
 In July 1974, RBI constituted a study group under the chairpersonship of Mr. P.L Tondon. The
study group was asked to give its recommendations on the following matter:
□ What contsitutes the working capital requirement of industry and what is end use of credit?
□ How is the quantum of bank advanced to be decided?
□ Can norms be involved of current assets & for debt equity ratio to ensure minimum
dependents on bank finance?
□ Canthe current manner & stage of lending be imposed?
□ Can an adequate planning assessment & implementation system be involved to ensurea
discipline flow of credit to meet genuine production needs & its proper supervision?

The study group reviewed the system of working capital financing and identified its major
shortcoming as follows:

□ The cash credit system of lending wherein the borrower can draw freely within limits
sanctioned by the banker hinders sound credit planning on the part of the banker and induces
financial indiscipline in the borrower.
□ The securit-yoriented approach to lending favored borrowers with strong financial resources
and also led to diversion of funds, borrowed against the security of current assets, for financing
fixed assets.
Relativelyeasy access to working capital finance led to large inventory levels with industry.
□ Working capital finance provided by banks, theoretically supposed to be short term in nature,
tended to be, in practice, a long-term source of finance. For the regulating bank credit, the study
group made comprehensive recommendations which have been made by and large accepted by
the Reserve Bank of India.

The final recommendations for committee were:

A. Banks finance essentially for meeting working capital needs.
B. To fill up the working capital gap.
C. Norms: The borrowing requirement of industrial unit depends on the length of working capital
cycle.
D. Three different methods for calculating the borrowing limit to finance working capital
requirements are:
□ First step is to use required fund deposit your money in term deposit, never purchase
excessive inventory.
□ The borrower will have to provide a minimum 25% of total current assets fr o mhet
term fund.
□ To decide the limit as per current assets & current liabilities.

E. Style of credit
` F. Information system for banks
 UNIT 5
Introduction
Cash is one of the current assets of a business. It is needed at all times to keep
the business going. A business concern should always keep sufficient cash for meeting
its obligations. Any shortage of cash will hamper the operations of a concern and any
excess of it will be unproductive. Cash is the most unproductive of all the assets. While
fixed assets like machinery, plant, etc. and current assets such as inventory will help the
business in increasing its earning capacity, cash in hand will not add anything to the
concern. It is in this context that cash management has assumed much importance.
Nature of Cash
For some persons, cash means only money in the form of currency (cash in hand).
For other persons, cash means both cash in hand and cash at bank. Some even include
near cash assets in it. They take marketable securities too as part of cash. These are the
securities which can easily be converted into cash.
Cash itself does not produce good or services. It is used as a medium to acquire
other assets. It is the other assets which are used in manufacturing goods or providing
services. The idle cash can be deposited in bank to earn interest.
A business has to keep required cash for meeting various needs. The assets
acquired by cash again help the business in producing cash. The goods manufactured
of services produced are sold to acquire cash. A firm will have to maintain a critical
level of cash. If at a time it does not have sufficient cash with it, it will have to borrow
from the market for reaching the required level.
There remains a gap between cash inflows and cash outflows. Sometimes cash
receipts are more than the payments or it may be vice-versa at another time. A financial
manager tries to synchronize the cash inflow and cash outflows.
Motives for Holding Cash
The firm‟s needs for cash may be attributed to the following needs: Transactions
motive, Precautionary motive and Speculative motive. These motives are discussed as
follows:
1. Transaction Motive: A firm needs cash for making transacions in the day-to-
day operations. The cash is needed to make purchases, pay expenses, taxes, dividend,
etc. The cash needs arise due to the fact that there is no complete synchronization
between cash receipts and payments. Sometimes cash receipts exceed cash payments or
vice-versa. The transaction needs of cash can be anticipated because the expected
payments in near future can be estimated. The receipts in future may also be anticipated
but the things do not happen as desired. If more cash is needed forpayments than
receipts, it may be raised through bank overdraft. On the other hand if there are more
cash receipts than payments, it may be spent on marketable securities.
2. Precautionary Motive: A firm is required to keep cash for meeting various
contingencies. Though cash inflows and cash outflows are anticipated but there may be
variations in these estimates. For example a debtor who was to pay after 7 days may
inform of his inability to pay; on the other hand a supplier who used to give credit for
15 days may not have the stock to supply or he may not be in a position to give credit
at present. In these situations cash receipts will be less then expected and cash payments
will be more as purchases may have to be made for cash instead of credit. Such
contingencies often arise in a business. A firm should keep some cash for such
contingencies or it should be in a position to raise finances at a short period.
3. Speculative Motive: The speculative motive relates to holding of cash for
investing in profitable opportunities as and when they arise. Such opportunities do not
come in a regular manner. These opportunities cannot be scientifically predicted but
only conjectures can be made about their occurrence. The price of shares and securities
may be low at a time with an expectation that these will go up shortly. Such
opportunities can be availed of if a firm has cash balance with it.
Cash Management
Cash management has assumed importance because it is the most significant of
all the current assets. It is required to meet business obligations and it is unproductive
when not used.
Cash management deals with the following:
(i) Cash inflows and outflows
(ii) Cash flows within the firm
(iii) Cash balances held by the firm at a point of time.
Cash Management needs strategies to deal with various facets of cash. Following are
some of its facets.
(a) Cash Planning: Cash planning is a technique to plan and control the use of
cash. A projected cash flow statement may be prepared, based on the present business
operations and anticipated future activities. The cash inflows from various sources may
be anticipated and cash outflows will determine the possible uses of cash.
(b) Cash Forecasts and Budgeting: A cash budget is the most important device
for the control of receipts and payments of cash. A cash budget is an estimate of cash
receipts and disbursements during a future period of time. It is an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected
cash intake and outlay.
The short-term forecasts can be made with the help of cash flow projections. The
finance manager will make estimates of likely receipts in the near future and the
expected disbursements in that period. Though it is not possible to make exact forecasts
even then estimates of cash flow will enable the planners to make arrangement for cash
needs. A financial manager should keep in mind the sources from where he will meet
short-term needs. He should also plan for productive use of surplus cash for short
periods.
The long-term cash forecasts are also essential for proper cash planning. These
estimates may be for three, four, five or more years. Long-term forecasts indicate
company‟s future financial needs for working capital, capital projects, etc.
Both short term and long term cash forecasts may be made with help of following
methods.
(a) Receipts and Disbursements method
(b) Adjusted net income method
Receipts and Disbursements method
In this method the receipt and payment of cash are estimated. The cash receipts
may be from cash sales, collections from debtors, sale of fixed assets, receipts of
dividend or other income of all the items; it is difficult to forecast the sales. The sales
may be on cash as well as credit basis. Cash sales will bring receipts at the time of sales
while credit sale will bring cash later on. The collections from debtors will depend upon
the credit policy of the firm. Any fluctuation in sales will disturb the receipts of cash.
Payments may be made for cash purchases, to creditors for goods, purchase of fixed
assets etc.
The receipts and disbursements are to be equalled over a short as well as long
periods. Any shortfall in receipts will have to be met from banks or other sources.
Similarly, surplus cash may be invested in risk free marketable securities. It may be
easy to make estimates for payments but cash receipts may not be accurately made.
Adjusted Net Income Method
This method may also be known as sources and uses approach. It generally has
three sections: sources of cash, uses of cash and adjusted cash balance. The adjusted net
income method helps in projecting the company‟s need for cash at some future date and
to see whether the company will be able to generate sufficient cash. If not, then it will
have to decide about borrowing or issuing shares etc. in preparing its statement the items
like net income, depreciation, dividends, taxes etc. can easily be
Determined from company‟s annual operating budget. The estimation of working
capital movement becomes difficult because items like receivables and inventories are
influenced by factors such as fluctuations in raw material costs, changing demand for
company‟s products. This method helps in keeping control on working capital and
anticipating financial requirements.
Managing Cash Flows
After estimating the cash flows, efforts should be made to adhere to the estimates
or receipts and payments of cash. Cash management will be successful only if cash
collections are accelerated and cash disbursements, as far as possible, are delayed. The
following methods of cash management will help:
Methods of Accelerating Cash Inflows

1. Prompt Payment by Customers: In order to accelerate cash inflows, the collections

from customers should be prompt. This will be possible by prompt billing. The
customers should be promptly informed about the amount payable and the time by
which it should be paid. Another method for prompting customersto pay earlier is
to allow them cash discount.
2. Quick Conversion of Payment into Cash: Cash inflows can be accelerated by
improving the cash collecting process. Once the customer writes a cheque in favour
of the concern the collection can be quickened by its early collection. There is a
time gap between the cheque sent by the customer and the amount collected against
it. This is due to many factors, (i) mailing time, i.e. time taken by post office for
transferring cheque from customer to the firm, referred to as postal float; (ii) time
taken in processing the cheque within the organization and sending it to bank for
collection, it is called lethargy and (iii) collection time within the bank, i.e. time
taken by the bank in collecting the payment from the customer‟s bank, called bank
float. The postal float, lethargy and bank float are collectively referred to as deposit
float. The term deposit float refers to cheques written buy customers but the amount
not yet usable by the firm.
3. Decentralised Collections: A big firm operating over wide geographical area can
accelerate collections by using the system of decentralized collections. A number
of collecting centres are opened in different areas instead of collecting receipts at
one place. The idea of opening different collecting centres is to reduce the mailing
time for customer‟s dispatch of cheque and its receipt in the firm and thenreducing
the time in collecting these cheques.
4. Lock Box System: Lock box system is another technique of reducing mailing,
processing and collecting time. Under this system the firm selects some collecting
 centres at different places. The places are selected on the basis of number of
consumers and the remittances to be received from a particular place.
Methods of Slowing Cash Outflows
A company can keep cash by effectively controlling disbursements. The
objective of controlling cash outflows is slow down the payments as far as possible.
Following methods can be used to delay disbursements:
1. Paying on Last Date: The disbursements can be delayed on making payments
on the last due date only. It is credit is for 10 days then payment should be made on 10th
day only. It can help in using the money for short periods and the firm can make use of
cash discount also.
2. Payments through Drafts: A company can delay payments by issuing drafts
to the suppliers instead of giving cheques. When a cheque is issued then the company
will have to keep a balance in its account so that the cheque is paid whenever it comes.
On the other hand a draft is payable only on presentation to the issuer. The receiver will
give the draft to its bank for presenting it to the buyer‟s bank. It takes a number of days
before it is actually paid. The company can economies large resources by using this
method.
3. Adjusting Payroll Funds: Some economy can be exercised on payroll funds
also. It can be done by reducing the frequency of payments. If the payments are made
weekly then this period can be extended to a month. Secondly, finance manager can
plan the issuing of salary cheques and their disbursements. If the cheques are issued on
Saturday then only a few cheque may be presented for payment, even on Monday all
cheques may not be presented.
4. Centralisation of Payments: The payments should be centralized and
payments should be made through drafts or cheques. When cheques are issued from the
main office then it will take time for the cheques to be cleared through post. The benefit
of cheque collecting time is availed.
5. Inter-bank Transfer: An efficient use of cash is also possible by inter-bank
transfers. If the company has accounts with more than one bank then amounts can be
transferred to the bank where disbursements are to be made. It will help in avoiding
excess amount in one bank.
6. Making use of Float: Float is a difference between the balance shown in
company‟s cash book (Bank column) and balance in passbook of the bank. Whenever
a cheque is issued, the balance at bank in cashbook is reduced. The party to whom the
cheque is issued may not present it for payment immediately. If the party is at some
other station then cheque will come through post and it may take a number of days
before it is presented. Until the time; the cheques are not presented to bank for payment
there will be a balance in the bank. The company can make use of this floatif it is able
to estimate it correctly.
Determining Optimum Cash Balance
A firm has to maintain a minimum amount of cash for settling the dues in time.
The cash is needed to purchase raw materials, pay creditors, day-to-day expenses,
dividend etc.
An appropriate amount of cash balance to be maintained should be determined
on the basis of past experience and future expectations. If a firm maintains less cash
balance then its liquidity position will be weak. If higher cash balance is maintained
then an opportunity to earn is lost. Thus, a firm should maintain an optimum cash
balance, neither a small nor a large cash balance.
There are basically two approaches to determine an optimal cash balance,
namely, (i) Minimizing Cost Models and (ii) Preparing Cash Budget. Cash budget is
the most important tool in cash management.
Cash Budget
A cash budget is an estimate of cash receipts and disbursements of cash during a
future period of time. In the words of soloman Ezra, a cash budget is “an analysis of
flow of cash in a business over a future, short or long period of time. It is a forecast of
expected cash intake and outlay.” It is a device to plan and control the use of cash. Thus
a firm by preparing a cash budget can plan the use of excess cash and make
arrangements for the necessary cash as and when required.
The cash receipts from various sources are anticipated. The estimated cash
collections for sales, debts, bills receivable, interests, dividends and other incomes and
sale of investments and other assets will be taken into account. The amounts to be spent
on purchase of materials, payment to creditors and meeting various other revenue and
capital expenditure needs should be considered. Cash forecasts willinclude all possible
sources from which cash will be received and the channels in which payments are to be
made so that a consolidated cash position is determined.
Baumol’s Model
William J. Baumol has suggested a model for determining the optimum balance
of cash based upon carrying and transaction costs of cash. The carrying cost refers to
the cost of the holding cash i.e. interest; and transaction cost refers to the cost involved
in getting the marketable securities converted into cash, the algebraic representation of
the model is:
where, C = Optimum cash balance
A = Annual (or monthly) cash disbursements)
F = Fixed cost per transaction
O = Opportunity cost of cash
Limitations of Model:

1. The model assumes a constant rate of use of cash. This is hypothetical assumption.
Generally the cash outflows in any firm are not regular and hence thismodel may
not give correct results.
2. The transaction cost will also be difficult to be measured since these depend upon
the type of investment as well as the maturity period.
Miller-Orr Model
The Miller–Orr model argues that changes in cash balance over a given period are
random in size as well as in direction. The cash balance of a firm may fluctuate
irregularly over a period of time. The model assumes (i) out of the two assets i.e. cash
and marketable securities, the latter has a marginal yield, and (ii) transfer of cash to
marketable securities and vice versa is possible without any delay but of course of at
some cost.
The model has specified two control limits for cash balance. An upper limit, H,
beyond which cash balance need not be allowed to go and a lower limit, L, below which
the cash level is not allowed to reduce. The cash balance should be allowed to move
within these limits. If the cash level reaches the upper control limit, H, then at this point,
apart of the cash should be invested in marketable securities in such a way that the cash
balance comes down to a predetermined level called return level, R, Ifthe cash balance
reaches the lower level, L then sufficient marketable securities should be sold to realize
cash so that cash balance is restored to the return level, R. Notransaction between cash
and marketable securities is undertaken so long as the cash balance is between the two
limits of H and L.
The Miller–Orr model has superiority over the Baumol‟s model. The latter assumes
constant need and constant rate of use of funds, the Miller-Orr model, on the other hand
is more realistic and maintains that the actual cash balance may fluctuate between higher
and the lower limits. The model may be defined as:
Z = (3TV/4i)1/3
 Where, T = Transaction cost of conversion
V = Variance of daily cash flows
i = Daily % interest rate on investments.
Investment of Surplus Funds
There are, sometimes surplus funds with the companies which are required after
sometime. These funds can be employed in liquid and risk free securities to earn some
income. There are number of avenues where these funds can be invested. The selection
of securities or method of investment is very important. Some of these methods are
discussed herewith:
Treasury Bills : The treasury bills or T-Bills are the bills issued by the Reserve
Bank of India for different maturity periods. These bills are highly safe investment an
are easily marketable. These treasury bills usually have a vary low level of yield and
that too in the form of difference purchase price and selling price as there is no interest
payable on these bills.
Bank Deposits: All the commercial banks are offerings short term deposits
schemes at varying rate of interest depending upon the deposit period. A firm having
excess cash can make deposit for even short period of few days only. These deposits
provide full safety, facility of pre-mature retirement and a comfortable return.
Inter-Corporate Deposits: A firm having excess cash can make deposit with
other firms also. When company makes a deposits with another company, such deposit
is known as inter corporate deposits. These deposits are usually for a period ofthree
months to one year. Higher rate of interest is an important characteristic of these
deposits.
Bill Discounting: A firm having excess cash can also discount the bills of other
firms in the same way as the commercial banks do. On the bill maturity date, the firm
will get the money. However, the bill discounting as a marketable securities is subject
to 2 constraints (i) the safety of this investment depends upon the credit rating of the
acceptor of the bill, and (ii) usually the pre mature retirement of bills is not available.
 Illustration 1: From the following forecast of income and expenditure, prepare
cash budget for the months January to April, 1995.
Months Sales Purchases Wages Manufac- Adminis Selling
ring trative Expenses
1994 expenses expenses
Nov 30,000 15,000 3,000
Dec 35,000 20,000 3,200
1995
Jan 25,000 15,000 2,500 1,150 1,060 500
Feb 30,000 20,000 3,000
March 35,000 22,500 2,400 1,225 1,040 550
April 40,000 25,000 2,600

990 1,100 600

1,050 1,150 620

1,100 1,220 570

1,200 1,180 710

Additional information is as follows: -

1. The customers are allowed a credit period of 2 months.

2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on 15th January for Rs. 5,000; a
Building has been purchased on 1stMarch and the payments are to be made in
monthly installments of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on Ist January, 1995 is Rs. 15,000.
Solution:
Details January February March April
Receipts
Opening Balance of 15,000 18,985 28,795 30,975
cash
Cash realized from 30,000 35,000 25,000 30,000
debtors
Payments
Payments to 15,000 20,000 15,000 20,000
customers
Wages 3200 2500 3000 2400
Manufacturing 1225 990 1050 1100
expenses
Administrative
expenses 1040 1100 1150 1220
Selling expenses
Payment of dividend 560 600 620 570

Purchase of plant ------ ------ ------ 10,000

Instalment of building 5000 ----- ------ ------
plant ----- ---- 2,000 2,000
Total Payments
Closing Balance 26,015 25,190 22,820 37,290
18,985 28,795 30,975 23,685
Illustration 2: ABC Co. wishes to arrange overdraft facilities with its bankers during
the period April to June, 1995 when it will be manufacturing mostly for stock. Prepare
a cash budget for the above period from the following data, indicating the extent of the
bank facilities the company will require at the end of each month:
 1995 Sales Purchases Wages
Rs. Rs. Rs.
February 1,80,000 1,24,800 12,000
March 1,92,00 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
June 1,26,000 2,68,000 15,000
(c) 50 per cent of credit sales are realised in the month following the sales and
remaining 50 per cent in the second month following. Creditors are paid in the
month following the month of purchase.
(d) Cash at bank on 1.4.1995 (estimated) Rs.25000

Solution:
Receipts April May June
Opening Balance 25,000 53000 (-) 51000
Sales 90,000 96,000 54000
Amount received from 96,000 54,000 87000
sales
Total Receipts 2,11,000 2,03,000 90000
Payments
Purchase 1,44,000 2,43,000 246000
Wages 14,000 11,000 10000
Total Payments 1,58,000 2,54,000 256000
Closing Balance (a-b) 53,000 (-)51,000 (-)1,66,000

Lets Sum Up

 Cash Management refers to management of ash and bank balance or in a broader

sense it is the management of cash inflows and outflows.
 Every firm must have minimum cash. There may be different motives for holding
cash. These may be Transactionary motive, Precautionary motive or Speculative
motive for holding cash.
 The objectives of cash management may be defined as meeting the cash outflows
and minimizing the cost of cash balance.
 Cash budget is the most important technique for planning the cash movement. It is
a summary of cash inflows and outflows during particular period. In cash budget
all expected receipts and payments are noted to find out the cash shortage or surplus
during that period.
 Optimum level of cash balance is the balance which firm should have in order to
minimize the cost of maintaining cash. Baumol‟s model gives optimum cash
balance which aims at minimizing the total cost of maintaining cash. The Miller –
Orr model says that a firm should maintain its cash balance within a range of lower
and higher limit.