DEPARTMENT OF MANAGEMENT STUDIES

I YEAR / II SEMESTER

BA4202
Financial Management

STUDY MATERIAL – NOTES

Anna University Chennai

Regulation 2021
 SYLLABUS

UNIT – I FOUNDATIONS OF FINANCE

Financial management – An overview- Time value of money- Introduction to the concept of risk
and return of a single asset and of a portfolio- Valuation of bonds and shares-Option valuation.

UNIT – II INVESTMENT DECISIONS

Capital Budgeting: Principles and techniques - Nature of capital budgeting- Identifying relevant
cash flows - Evaluation Techniques: Payback, Accounting rate of return, Net Present Value,
Internal Rate of Return, Profitability Index - Comparison of DCF techniques - Project selection
under capital rationing - Inflation and capital budgeting - Concept and measurement of cost of
capital - Specific cost and overall cost of capital

UNIT – III FINANCING AND DIVIDEND DECISION

Financial and operating leverage - capital structure - Cost of capital and valuation - designing
capital structure. Dividend policy - Aspects of dividend policy - practical consideration - forms
of dividend policy - forms of dividends - share splits.

UNIT – IV WORKING CAPITAL MANAGEMENT

Principles of working capital: Concepts, Needs, Determinants, issues and estimation of working
capital - Accounts Receivables Management and factoring - Inventory management - Cash
management - Working capital finance: Trade credit, Bank finance and Commercial paper.

UNIT – V LONG TERM SOURCES OF FINANCE

Indian capital and stock market, New issues market Long term finance: Shares, debentures and
term loans, lease, hire purchase, venture capital financing, Private Equity. Total No Period:45

Text Books:

1. M.Y. Khan and P.K.Jain Financial management, Text, Problems and cases Tata McGraw Hill,
6 th edition, 2011.

2. M. Pandey Financial Management, Vikas Publishing House Pvt. Ltd., 10th edition, 2012.

Reference books:

1. Prasanna Chandra, Financial Management, 9th edition, Tata McGraw Hill, 2012.

2. Srivatsava, Mishra, Financial Management, Oxford University Press, 2011

 FINANCIAL MANAGEMENT
UNIT I

Foundation of Finance

INTRODUCTION

Financial Management is concerned with planning, directing, monitoring, organizing and

controlling monetary resources of an organization. Financial Management simply deals
with management of money matters. Management of funds is a critical aspect of financial
management. The process of financial management takes place: at the individual as well as
organization levels. Our area of dealing is from the view- point of organization. 'Financial
Management' is a combination of two words. 'Finance' and 'Management'. Finance is the
lifeblood of any business enterprise. No business activity can be imagined, without
finance. It has been rightly said that business needs money to make more money. However,
money begets money, when it is properly managed. Efficient management of business is
closely linked with efficient management of its finances. Financial Management is that
specialized function of general management, which is related to the procurement of finance
and its effective utilization for the achievement of common goal of the organization.

FOUNDATIONS OF FINANCE

Business concern needs finance to meet their requirements in the economic world.
Any kind of business activity depends on the finance. Hence, it is called as lifeblood of
business organization. Whether the business concerns are big or small, they need finance to
fulfill their business activities. In the modern world, all the activities are concerned with
the economic activities and very particular to earning profit through any venture or
activities. The entire business activities are directly related with making profit. According
to the economics concept of factors of production, rent given to landlord, wage given to
labour, interest given to capital and profit given to shareholders or proprietors, a business
concern needs finance to meet all the requirements. Hence finance may be called as capital,
investment, fund etc., but each term is having different meanings and unique characters.
Increasing the profit is the main aim of any kind of economic activity.

Meaning of Finance

Finance is defined as the provision of money at the time, it is required. Finance is the art
and science of managing money. There is no human being, without blood. Similarly, there
is no organization that does not require finance, irrespective of the activity, it is engaged in.

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The way blood is needed for a person to live, so is the requirement of finance to any firm
for its survival and growth. Without adequate finance, no organization can possibly
achieve its objectives.
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. The concept of finance includes capital,
funds, money, and amount. But each word is having unique meaning. Studying and
understanding the concept of finance become an important part of the business concern.

Definition of Finance

● According to Khan and Jain, ―Finance is the art and science of managing money‖.
● Webster’s Ninth New Collegiate Dictionary defines finance as ―the Science on study
of the management of funds‘ and the management of fund as the system that includes the
circulation of money, the granting of credit, the making of investments, and the provision
of banking facilities.

MEANING AND DEFINITION OF FINANCIAL MANAGEMENT

The general meaning of finance refers to the provision of funds, as and when needed.
However, as management function, the term 'Financial Management' has a distinct
meaning. Financial management deals with the study of procuring funds and its effective
and judicious utilization, in terms of the overall objectives of the firm, and expectations of
the providers of funds.

The term financial management has been defined differently by various authors. Some of
the authoritative definitions are given below:

"Financial Management is concerned with the efficient use of an important Economic

resource, namely. Capital Funds." - Solomon

"Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short-term and long-term credits for the firm."
- Phillioppatus

"Financial Management is concerned with the acquisition on. SaFinancing and

Management of assets with some overall goal in mind."- James C. Van Home

"Financial Management deals with procurement of funds and their effective utilization in
the business." - S.C. Kuchhal

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 Finance Manager's Role
● Raising of Funds
● Allocation of Funds
● Profit Planning
● Understanding Capital Markets Financial Goals
● Profit maximization (profit after tax)
● Maximizing Earnings per Share
● Shareholder's Wealth Maximization
● Profit maximization
● Maximizing the Rupee Income of Firm
● Resources are efficiently utilized
● Appropriate measure of firm performance
● Serves interest of society also Objections to Profit Maximization
● It is Vague
● It Ignores the Timing of Returns
● It Ignores Risk
● Assumes Perfect Competition
● In new business environment profit maximization is regarded as
● Unrealistic
● Difficult
● Inappropriate
● Immoral.
● Maximizing EPS
● Ignores timing and risk of the expected benefit
● Market value is not a function of EPS. Hence maximizing EPS will not result in highest
price for company's shares
● Maximizing EPS implies that the firm should make no dividend payment so long as funds
can be invested internally at any positive rate of return—such a policy may not always be
to the shareholders' advantage.
● Shareholders' Wealth Maximization (SWM)
● Maximizes the net present value of a course of action to shareholders.
● Net Present Value (NPV) or wealth of a course of action is the difference between the
present value of its benefits and present value of its cost.
● Accounts for the timing and risk of the expected benefits.
● Benefits are measured in terms of cash flows.
● Fundamental objective—maximize the market value of the firm's shares.
● Risk-return Trade-off
● Risk and expected return move in tandem: the greater the risk, the greater the expected
return.
● Financial decisions of the firm are guided by the risk-return trade-off.
● The return and risk relationship: Return = Risk- free rate + Risk premium
● Risk-free rate is a compensation for time and risk premium for risk.

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 SCOPE OF FINANCIAL MANAGEMENT

1. Estimating Financial Requirements

Financial Manager is to estimate short term and long term funds requirements
of his business. For that, he will prepare a financial plan for present as well as
for future. The amount required for purchasing fixed assets as well as needs
for working capital will have to be ascertained.

2. Decisiding Capital Structure

Different kinds of 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 of funds should be linked to the cost of
raising funds.

3. Selecting a Sources of Finance

Sources of finance are selected after preparing a capital structure which
included share capital, debentures, financial institutions, Public Deposits.

4. Selecting a Patten of Investment

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

Proper cash management is an important task of financial managers, 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
payment to creditors meet wages bill and meet day to day expenses.

6. Implementation of Financial Controls

The use of various financial control devices. They are Return on Investment,
Break Even Analysis, Cost control, ratio analysis and internal audit. Return
on investment is the best control device in order to evaluate the performance
of various financial policies.

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 OBJECTIVES OF FINANCIAL MANAGEMENT

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.

Profit Maximization
Is the basic objectives of a business enterprises. Investor purchase the share of a company
with the hope of getting maximum profit from the company as dividend. It is possible only,
when company to earn maximum profits out of its available resources. They must get the
maximum return for their contribution. This possible only when the company earns higher
profit or sufficient profit to discharge its obligations to them.

● It consider all the possible way to increase the profitability of the concern.
● Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
● Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.
● Profit is the parameter of measuring the efficiency of the business concern. So it shows
the entire position of the business concern.
● Profit maximization objectives help to reduce the risk of the business.

Favorable Arguments for Profit Maximization

 Main aim is earning profit.

 Profit is the parameter of the business operation.
 Profit reduces risk of the business concern.
 Profit is the main source of finance.
 Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

 Profit maximization leads to exploiting workers and consumers.

 Profit maximization creates

 practices such as corrupt practice, unfair trade practice, etc.

 Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.
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 Drawbacks of Profit Maximization

(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, which involves latest

innovations and improvements in the field of the business concern. 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 a universally accepted concept in the field of business.

Favorable Arguments for Wealth Maximization

● 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.
● 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.
● Wealth maximization considers both time and risk of the business concern.
● Wealth maximization provides efficient allocation of resources.
● It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

● Wealth maximization leads to prescriptive idea of the business concern but it may not
be suitable to present day business activities.
● Wealth maximization is nothing, it is also profit maximization, it is the indirect name of
the profit maximization.
● Wealth maximization creates ownership- management controversy.

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 ● Management alone enjoys certain benefits.
● The ultimate aim of the wealth maximization objectives is to maximize the profit.
● Wealth maximization can be activated only with the help of the profitable position of
the business concern.

APPROACHES TO FINANCIAL MANAGEMENT

Theoretical points of view, financial management approach may be broadly divided

into two major parts.
⮚ Traditional Approach
⮚ Modern Approach

Traditional Approach
Traditional approach is the initial stage of financial management, which was
followed, in the early part of during the year 1920 to 1950. This approach is based on the
past experience and the traditionally accepted methods. Main part of the traditional
approach is rising of funds for the business concern. Traditional approach consists of the
following important area.

● Arrangement of funds from lending body.

● Arrangement of funds through various financial instruments.
● Finding out the various sources of funds.

Functions of Finance Manager

1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the
financial requirement of the business concern. He should estimate, how much finances
required to acquire fixed assets and forecast the amount needed to meet the working capital
requirements in future.

2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate
how the finance is mobilized and where it will be available. It is also highly critical in
nature.

3. Investment Decision
The finance manager must carefully select best investment alternatives and
consider the reasonable and stable return from the investment. He must be well versed in
the field of capital budgeting techniques to determine the effective utilization of
investment. The finance manager must concentrate to principles of safety, liquidity and
profitability while investing capital.

4. Financing Decision

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 Total funds required by the firm will be made available through the issue of different
types of securities. A company nonot depend upon only one source of capital. Hence before
using any particular source of capital have to be carefully examined by the financial manager.

5.Dividend Decision
Dividend decision helps the management in the declaration and payment of dividend to the
shareholders. It decides how much of the earning should be distributed among the
shareholders and how much should be retained in the business for future expansion
6. Cash Management
Present day‘s cash management plays a major role in the area of finance because
proper cash management is not only essential for effective utilization of cash but it also
helps to meet the short-term liquidity position of the concern.

7. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing,
production, personnel, system, research, development, etc. Finance manager should have
sound knowledge not only in finance related area but also well versed in other areas. He
must maintain a good relationship with all the functional departments of the business
organization.

IMPORTANCE OF FINANCIAL MANAGEMENT

Financial Planning
Financial management helps to determine the financial requirement of the business
concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise.

Acquisition of Funds
Financial management involves the acquisition of required finance to the business
concern. Acquiring needed funds play a major part of the financial management, which
involve possible source of finance at minimum cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of
the business concern. When the finance manager uses the funds properly, they can reduce
the cost of capital and increase the value of the firm.

Financial Decision
Financial management helps to take sound financial decision in the business
concern. Financial decision will affect the entire business operation of the concern.
Because there is a direct relationship with various department functions such as marketing,
production personnel, etc.

Improve Profitability

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 Profitability of the concern purely depends on the effectiveness and proper
utilization of funds by the business concern. Financial management helps to improve the
profitability position of the concern with the help of strong financial control devices such
as budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the
investors and the business concern. Ultimate aim of any business concern will achieve the
maximum profit and higher profitability leads to maximize the wealth of the investors as
well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings.
Nowadays financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance
of the financial management.

Financial Decision
1. Investment Decisions
It is concerned with effective utilization of funds in one activity. This decision relating to
investment in both capital and current assets. The finance manager has to evaluating
different capital investment proposals and select the best keeping in view the overall
objectives of the enterprises.

2. Financing Decision
Total funds required by the firm will be made available through the issue of different types
of securities. A company canot depend upon only one source of capital. Hence before
using any particular source of capital have to be carefully examined by the financial
manager.

3. Dividend Decision
Helps the management in the declaration and payment of dividend to the shareholders. It decides
how much of the earning should be distributed among the shareholders and how much should be
retained in the business for future expansion.

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Organization of the Finance

From the above that board of directors is the supreme body under whose supervision and
control Managing director, PD,PD,FD,PD,MD and MD prefer their respective duties and
functions, two more officers namely Treaurer and Controller may be appointed under the
direct supervision of CFO to assist him/her. The terms controller and treasurer are in fact
used in USA. This pattern is not popular in Indian Corporate sectors. Practically the
controller/Financial Controller to carryout the functions of chief accountant or Finance
officer of an organization. Financial controller who has been a person of executive rank
does not control the fiancé. But monitors whether funds are properly utilized . the
controller of functions include costing policies, preparation of financial report, internal
audit, budgetary, inventory and payment of taxes. The function of the treasurer of an

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organization is to raise funds and manage funds. The treasurer functions include
forecasting the financial requirements, managing credit, protecting funds and securities.

Explain the Relationship between Financial Management and other areas

of management

1. Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro environmental
factors are closely associated with the functions of financial manager. Financial
management also uses the economic equations like money value discount factor, economic
order quantity etc. Financial economics is one of the emerging area, which provides
immense opportunities to finance, and economical areas.

2. Financial Management and Accounting

Accounting records includes the financial information of the business concern.
Hence, we can easily understand the relationship between the financial management and
accounting. In the olden periods, both financial management and accounting are treated as
a same discipline and then it has been merged as Management Accounting because this
part is very much helpful to finance manager to take decisions. But nowadays financial
management and accounting discipline are separate and interrelated.

3. Financial Management or Mathematics

Modern approaches of the financial management applied large number of

mathematical and statistical tools and techniques. They are also called as econometrics.
Economic order quantity, discount factor, time value of money, present value of money,
cost of capital, capital structure theories, dividend theories, ratio analysis and working
capital analysis are used as mathematical and statistical tools and techniques in the field of
financial management.

4. Financial Management and Production Management

Production management is the operational part of the business concern, which
helps to multiple the money into profit. Profit of the concern depends upon the production
performance. Production performance needs finance, because production department
requires raw material, machinery, wages, operating expenses etc. These expenditures are
decided and estimated by the financial department and the finance manager allocates the

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appropriate finance to production department. The financial manager must be aware of the
operational process and finance required for each process of production activities.

5. Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For
this, the marketing department needs finance to meet their requirements. The financial
manager or finance department is responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial management are interrelated and
depends on each other.

6. Financial Management and Human Resource

Financial management is also related with human resource department, which
provides manpower to all the functional areas of the management. Financial manager
should carefully evaluate the requirement of manpower to each department and allocate the
finance to the human resource department as wages, salary, remuneration, commission,
bonus, pension and other monetary benefits to the human resource department. Hence,
financial management is directly related with human resource management.

FUNCTIONS FINANCIAL MANAGEMENT

Determining the Sources of Funds: The financial manager has to choose the various
sources of funds. He may issue different types of securities. He may borrow from a number
of financial institutions and the public. When a firm is new and small and little known in
financial circles, the financial manager faces a great challenge in raising funds. Even when
he has a choice in selecting sources of funds, he should exercise it with great care and
caution. A firm is committed to the lenders of finance and has to meet various terms and
conditions on which they offer credit.
To be precise, the financial manager must definitely know what he is doing.

Financial Analysis: It is the evaluation and interpretation of a firm's financial position and
operations, and involves the comparison and interpretation of accounting data. The
financial manager has to interpret different statements. He has to use a large number of
ratios to analyse the financial status and activities of his firm. He is required to measure its
liquidity, determine its profitability and assets and overall performance in financial terms.
This is often a challenging task, because he must understand the importance of each one of
these aspects to the firm and he should be crystal clear in his mind about the purposes for
which liquidity, profitability and performance are to be measured.

Capital Structure: The financial manager has to establish an optimum capital structure
and ensure the maximum rate of return on investment. The ratio between equity and other
liabilities earning fixed charges has to be defined. In the process, he has to consider the
operating and financial leverages of his firm. The operating leverage exists because of
operating expenses, while financial leverage exists because of the amount of debt involved
in a firm's capital structure. The financial manager should have adequate knowledge of
different empirical studies on the optimum capital structure and find out whether, and to
what extent, he can apply their findings to the advantage of the firm.

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Cost-Volume-Profit Analysis: This is popularly known as the "CYP relationship'. For this
purpose, fixed costs, variable costs and semi-variable costs have to be analysed. Fixed
costs are more or less constant for varying sales volumes. Variable costs vary according to
sales volume. Semi-variable costs are either fixed or variable in the short run. The finance
manager has to ensure that the income for the firm will cover its variable costs, for there is
no point in being in business, if this is not accomplished. Moreover, a firm will have to
generate an adequate income to cover its fixed costs as well. The finance manager has to
find out the break- even-point (i.e). The point at which total costs are matched by total
sales or total revenue. He has to try to shift the activity of the firm as far as possible from
the break-ever point to ensure company's survival against seasonal fluctuations.

Profit Planning and Control: Profit planning and control have assumed great importance
in the financial activities of modem business. Economists have long before considered the
importance of profit maximization in influencing business decisions. Profit planning
ensures attainment of stability and growth. In view of the fact that earnings are the most
important measure of corporate performance, the profit test is constantly used to gauge
success of a firm's activities.

Profit planning is an important responsibility of the finance manager.

Fixed Assets Management: A firm's fixed assets include tangibles such as land, building,
machinery and equipment, furniture and also intangibles such as patents, copyrights,
goodwill, and so on. The acquisition of fixed assets involves capital expenditure decisions
and long-term commitments of funds. These fixed assets are justified to the extent of their
utility and or their productive capacity. Because of this long-term commitment of funds,
decisions governing their purchase, replacement, etc.

Capital Budgeting: Capital budgeting decisions are most crucial: for they have long-term
implications. They relate to judicious allocation of capital. Current funds have to be
invested in long-term activities in anticipation of an expected flow of future benefits spread
over a long period of time. Capital budgeting forecasts returns on proposed long-term
investments and compares profitability of different investments and their cost of capital. It
results in capital expenditure investments. The various proposal assets ranked on the basis
of such criteria as urgency, liquidity, profitability and risk sensitivity. The financial
analyzer should be thoroughly familiar with such financial techniques as pay back, internal
rate of return, discounted cash flow and net present value among others because risk
increases when investment is stretched over a long period of time.

Dividend Policies: Dividend policies constitute a crucial area of financial management.

While owners are interested in getting the highest dividend from a corporation, the board
of directors may be interested in maintaining its financial health by retaining the surplus to
be used when contingencies arise. A firm may try to improve its internal financing so that
it may avail itself of benefits of future expansion. However, the interests of a firm and its
stockholders are complementary, f or the financial management is interested in maximizing

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the value of the firm, and the real interest of stockholders always lies in the maximization
of this value of the firm: and this is the ultimate goal of financial management.

Corporate Taxation: Corporate taxation is an important function of the financial

management, for the former has a serious impact on the financial planning of a firm. Since
the corporation is a separate legal entity, it is subject to an income- tax structure which is
distinct from that which is applied to personal income.

Time value of money

Time value of money shows the relation of value of money with time. Time value of
money is also value of interest which we have earned for giving money to other for
specific period. Value of Rs. 1 which you have today is more valuable than what Rs. 1 you
will receive after one year because you can invest today receive Rs. 1 in any scheme and
you can earn minimum interest on it. It means today received money is important than
tomorrow receivable money. Interest rate is the cost of borrowing money as a yearly
percentage. For investors, interest rate is the rate earned on an investment as a yearly
percentage.

Time value of money results from the concept of interest. So it now time to discuss
Interest.

Simple Interest

It may be defined as Interest that is calculated as a simple percentage of the original

principal amount.The formula for calculating simple interest is
SI = P0 (i)(n)
Future value of an account at the end of n period

Compound Interest

If interest is calculated on original principal amount it is simple interest. When

interest is calculated on total of previously earned interest and the original principal it
compound interest. Naturally, the amount calculated on the basis of compound interest rate
is higher than when calculated with the simple rate.

FV n = Po (1+ i) n

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 Effective Rate of Interest

It is the actual equivalent annual rate of interest at which an investment grows in

value when interest is credited more often than once a year. If interest is paid m times in a
year it can be found by calculating:
Ei = (1+ i/m) m -1

Present Value

―Present Value‖ is the current value of a ―Future Amount‖. It can also be defined as the
amount to be invested today (Present Value) at a given rate over specified period to equal
the ―Future Amount‖.

The present value of a sum of money to be received at a future date is determined

by discounting the future value at the interest rate that the money could earn over the
period. This process is known as Discounting. The present value interest factor declines as
the interest rate rises and as the length of time increases.

Po = FVn /(1+ i) n
Po = FVn (1+ i) -n
Where,

FVn = Future value n years hence

I = Rate of interest per annum

n= Number of years for which discounting is done.

Discount (or) present value technique: -

Present value Vo = Future value (Vn) x DFin

INTRODUCTION TO THE CONCEPT OF RETURN OF AN

INVESTMENT

Introduction
Risk and Return of the investments are interrelated covenants in the selection any
investments, which should be studied through the meaning and definition of risk and return
and their classification of themselves in the first part of this chapter and the relationship in
between them is illustrated in the second half of the chapter.

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 Meaning Of Return & Rate of Return

Return is the combination of both the regular income and capital appreciation of the
investments. The regular income is nothing but dividend/interest income of the
investments. The capital appreciations of the investments are nothing but the capital gains
of the investments i.e. the difference in between the closing and opening price of the
investments.
Return symbolized as follows
D1 + Pt – Pt – 1 / Pt – 1
These two categories, Earnings yield and Capital gains yield *Earnings Yield = Earnings

per share / Market price per share***

Concept and Types of Risk

⮚ The variability of the actual return from the expected return which is associated with the
investment/asset known as risk of the investment. Variability of return means that the
Deviation in between actual return and expected return which is in other words as variance
i.e., the measure of statistics.
⮚ Greater the variability means that Riskier the security/ investment. Lesser the variability
means that More certain the returns, nothing but Least risky

Interest Rate Risk

It is risk – variability in a security's return resulting from the changes in the level of
interest rates.

Market Risk
It refers to variability of returns due to fluctuations in the securities market which is
more particularly to equities market due to the effect from the wars, depressions etc.

Business Risk
. Business risk is nothing but Operational risk which arises only due to the
presence of the fixed cost of operations.

Financial Risk
Connected with the raising of fixed charge of funds viz Debt finance & Preference
share capital. More the application of fixed charge of financial will lead to Greater the
financial Risk which is nothing but the Trading on Equity.

Liquidity Risk

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 Liquidity risk reflects only due to the quality of benefits with reference to certainty
of return to receive after some period which is normally revealed in terms of quality of
benefits.

Measurement of Risk

Standard Deviation:

⮚ Greater the standard deviation - Greater the risk

⮚ Does not consider the variability of return to the expected value
⮚ This may be misleading - if they differ in the size of expected values

Coefficient of variation = S.D/ Mean

Risk and Return of the Portfolio

⮚ Portfolio is the Combination of two or more assets or investments.

⮚ Portfolio Expected Return is the weighted average of the expected returns of the securities
or assets in the portfolio. Weights are the Proportion of total funds in each
⮚ Security which form the portfolio Wj Kj.
⮚ Wj = funds proportion invested in the security.
⮚ Kj = expected return for security J.
⮚ Benefits of portfolio holdings are bearing certain benefits to single assets.
⮚ Including the various types of industry securities - Diversification of assets.
⮚ It is not the simple weighted average of individual security.
⮚ Risk is studied through the correlation/co-variance of the constituting assets of the
portfolio. The Correlation among the securities should be relatively considered to
maximize the return at the given level of risk or to minimize the risk.
⮚ Correlation of the expected returns of the constituent securities in the portfolio.
⮚ It is a Statistical expression which reveals the securities earning pattern in the portfolio
as together.

Diversification of the Risk of Portfolio

 Diversification of the portfolio can be done through the selection of the securities which
have negative correlation among them which formed the portfolio. The return of the
risky and riskless assets is only having the possibilities to bring down the risk of the
portfolio.
 The risk of the portfolio cannot be simply reduced by way adopting the principle of
correlation of returns among the securities in the portfolio. To reduce the risk of the
portfolio, the classification of the risk has to be studied, which are as follows:
 The risk can be further classified into two categories viz Systematic and Unsystematic
risk of the securities

17
 Systematic Risk: Which only requires the investors to expect additional return/
compensation to bear the
 Unsystematic Risk: The investors are not given any such additional compensation to
bear unlike the earlier. The relationship could be obviously understood through the
study of Capital
● Asset Pricing Model (CAPM).
● Developed by William F. Sharpe
● Explains the relationship in between the risk and expected / required return
● Behaviour of the security prices
● Extends the mechanism to assess the dominance of a security on the total risk and return
● Highlights the importance of bearing risk through some premium
● No transaction costs - No intermediation cost during the transaction
● No single investor is to influence the market Risk and Return
● Highest return for given level of risk or Lowest risk for a give n level of return
● Risk - Expected value, standard deviation

Valuation of Bonds and Shares

Valuation of Bonds

A bond or a debenture is a long-term debt instrument or security. It is issued by

business enterprises or government agencies to raise long-term capital. A bond usually
carries a fixed rate of interest. It is called as coupon payment and the interest rate is called
as the coupon rate. The coupon payment can be either annually or semi-annually.

.
Where:
Interest 1 to n = Interests in periods 1 to n.
Unless otherwise mentioned, the maturity value of the bond is the face value.
When the required rate of return is equal to the coupon rate, the bond value equals
the par value.
When the required rate of return is more than the coupon rate, the bond value
would be less than its par value. The bond in this case would sell at a discount.
When the required rate of return is less than the coupon rate, the bond value would
be more than its par value. The bond in this case would sell at a premium.

Bond valuation is generally called debt valuation because the features that distinguish
bonds from other debts are primarily non financial in nature. Since bonds have promised
payment steam. They are less risky as compared to the shares.
Bonds with Maturity Period
When the bonds have a definite maturity period, its valuation is determined by considering
the annual interest payments plus its maturity value.

18
 Bonds in Perpetuity
Perpetuity bonds are the bonds which never mature of have infinitive maturity period.
Value of such bonds is simply the discounted value of infinite streams of interest flows.

VALUATION OF SHARES

Factors Which Influence the Value of Shares

The factors which influence the value of shares can be broadly classified into two
groups- internal and external factors. They are stated below-

(i) Internal factors

● Earning capacity of assets

● Return on investments
● Profit after tax
● Profit available to equity shareholders
● Earnings per share
● Dividend per share or Rate of dividend.

(ii)External Factors

● General economic condition of the country.

● Political and social environment.
● International economic scenario.
● International political environment.

METHODS OF VALUATION OF SHARES

The methods of valuation depend on the purpose for which valuation is required.
Generally, there are three methods of valuation of shares:

1. Net Assets Method of Valuation of Shares

Under this method, the net value of assets of the company is divided by the number
of shares to arrive at the value of each share. For the determination of net value of assets, it
is necessary to estimate the worth of the assets and liabilities. The goodwill as well as non-
trading assets should also be included in total assets.
Value per Share= (Net Assets-Preference Share Capital)/Number of Equity Shares

2. Yield or Market Value Method of Valuation of Shares

The expected rate of return in investment is denoted by yield. The term "rate of
return" refers to the return which a shareholder earns on his investment. Further it can be
classified as

19
 (a) Rate of earning and
Rate of dividend. In other words, yield may be earning yield and dividend yield.

a. Earning Yield
Value per Share = (Expected rate of earning/Normal rate of return) X Paid up value of
equity share
Expected rate of earning = (Profit after tax/paid up value of equity share) X 100

b. Dividend Yield
Expected rate of dividend = (profit available for dividend/paid up equity share capital) X
100 Value per share = (Expected rate of dividend/normal rate of return) X 100

3. Earning Capacity Method of Valuation of Shares

Under this method, the value per share is calculated on the basis of disposable
profit of the company. The disposable profit is found out by deducting reserves and taxes
from net profit.

Value per share = Capitalized Value/Number of Shares

UNIT 2

INVESTMENT DECISION

CAPITAL BUDGETING

It is the process of making investment decision in capital expenditures. Capital

expenditure defined as an expenditure the benefits of which are expected to be received
more than one year. It is incurred in one point of time and the benefits are received in
different point of time in future.

● Cost of acquisition of permanent asset as land and building, plant and machinery, goodwill
● Cost of addition, expansion and improvement or alteration in fixed assets
● Cost of replacement of permanent assets
● Research and development project cost etc.

20
 Why the capital budgeting is considered as most important decision over
the others?

● The capital budgeting is the decision of long term investments, which mainly focuses the
acquisition or improvement on fixed assets.
● The capital budgeting decision is a decision of capital expenditure or long term investment
or long term commitment of funds on the fixed assets.

Principles

⮚ Decisions are based on cash flow not accounting income

⮚ The capital budgeting decisions are based on the cash flow forecasts instead of relying on
the accounting income. These are the incremental cash flows that is additional cash flows
that will occur if the project undertaken compare to if the project is not undertaken Timing
of cash flows
⮚ To estimate the timing of cash flows as accurately as possible.it is used the concept of time
value of money, the time at which the cash flows occur significantly impacts at the present
value of the project.
⮚ Financing cost should be ignored
⮚ Cash flow should be considered
⮚ Opportunity cost are also considered

NEED AND IMPORTANCE/NATURE

Large investment
⮚ Involve large investment of funds
⮚ Fund available is limited and the demand for funds exceeds the existing resources
⮚ Important for firm to plan and control capital expenditure

Long term commitment of funds

⮚ Involves not only large amount of fund but also long term on permanent basis.
⮚ It increases financial risk involved in investment decision.
⮚ Greater the risk greater the need for planning capital expenditure.

Irreversible Nature

⮚ Capital expenditure decision are irreversible

⮚ Once decision for acquiring permanent asset is taken, it become very difficult to dispose of
these assets without heavy losses.

Long-term effect on profitability

⮚ Capital expenditure decision are long-term and have effect on profitability of a concern
⮚ Not only present earning but also the future growth and profitability of the firm depends on
investment decision taken today
⮚ Capital budgeting is needed to avoid over investment or under investment in fixed assets.

Difficulties of investment decision

21
⮚ Long term investment decision are difficult to take because (i) decision extends to a series
of year beyond the current accounting period
⮚ (ii) uncertainties of future
⮚ (iii) higher degree of risk

National importance

⮚ Investment decision taken by individual concern is of national importance because it

determines employment, economic activities and economic growth.

Steps Involved in Capital Budgeting Process

1. Identification of Investment Proposals

The proposal may originate from the top management. The department head analysis the
various proposals in the corporate strategies and submit the suitable proposal to the capital
expenditure planning committee with the process of long term investment decisions.

2. Screening the Proposals

The expenditure planning committee screens the various proposals in accordance with the
corporate strategies.

3.Evaluation of Various Proposals

Evaluating the profitability of various proposals on the basis of future cash flows.

1. Fixing Priorities
After rejecting the unprofitable proposals, it is very essential to rank the various profitable
proposals to establish priorities for selection.

4.Final Approval

Projects finally recommended by the committee are sent to the top management along with
the detailed report, both of the capital expenditure and of sources of funds to meet them.

5.Implementing Proposals
When the proposals are finally selected funds are allocated for them.

EVALUATION OF INVESTMENT PROPOSALS

Traditional methods or Non-Discounted method

8.2.1Net Present Value method

8.2.2 Internal Rate of Return method

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 8.2.3 Rate of return method or accounting method

Time-adjusted method or discounted methods

● Net Present Value method

● Internal Rate of Return method

● (iii)Profitability Index method

Pay-back period method

This method represent the period in which total investment in permanent asset pays
back itself. It measure the period of time for the original cost of a project to be recovered
from the additional earning of a project itself.

Investment are ranked according to the length of the payback period, investment
with shorter payback period is preferred.

How the payback period is calculated?

The payback period is ascertained in the following manner

● Calculate annual net earnings(profit) before depreciation and after taxes, these are called
annual cash inflow
● Divide the initial outlay(cost) of the project by the annual cash inflow, where the project
generates constant annual cash inflow
● Payback period = cash outlay of the project or original cost of the asset
Annual cash inflows
● Where the annual cash inflows (profit before depreciation and after taxes) are unequal the
payback period is found by adding up the cash inflows until the total is equal to the initial
cash outlay of the project.

Selection criterion

Discounted payback period : - (time value of money in consider)

Merits
● It is a simple method to calculate and understand
● It is a method in terms of years for easier appraisal

23
 Demerits
● It is a method rigid
● It has completely discarded the principle of time value of money
● It has not given any due weight age to cash inflows after the payback period
● It has sidelined the profitability of the project.

Average Rate of Return method (ARR)

This method takes in to account the earnings expected from the investment over
their whole life. It is known as accounting rate of return.

The project which gives the higher rate of return is selected when compared to one
with lower rate of return.

Selection criterion of the projects:

Merits

● It is simple method to compute the rate of return

● Average return is calculated from the total earnings of the enterprise throughout the life of
the firm
● The entire rate of return is being computed on the basis of the available accounting data
Demerits
● Under this method, the rate of return is calculated on the basis of profits extracted from the
books but not on the basis of cash inflows

24
 ● The time value of money is not considered
● It does not consider the life period of the project
● The accounting profits are different from one concept to another which leads to greater
confusion in determining the accounting rate of return of the projects

Net present value method (NPV)

It is a modern method of evaluating investment proposals. It takes into

consideration time value of money and calculates the return on investment by introducing
the factor of time element.

● First determine the rate of interest that should be selected as the minimum required rate of
return
● Compute the present value of total investment outlay
● Compute the present value of total cash inflows
● Calculate Net Present Value by subtracting the present value of cash inflow by present
value of cash outflow.
● NPV = is positive or zero the project is accepted
● NPV= is negative then reject the proposal
● In order for ranking the project the first preference is given to project having maximum
positive net present value
NPV= Present value of cash inflow – present value of cash outflow/Initial investment

Selection criterion of Net present value method

Internal Rate of Return Method (IRR)

Under the internal rate of return method, the cash flows of a project are discounted
at a suitable rate by hit and trial method, which equates the net present value so calculated
to the amount of investment.

● Determine the future net cash flows during the entire economic life of the project. The cash
inflows are estimated for future profits before depreciation but after taxes
● Determine the rate of discount at which the value of cash inflow is equal to the present
value of cash outflows
● Accept the proposal if the internal rate of return is higher than or equal to the cost of
capital or cut off rate.
● In case of alternative proposals select the proposal with the highest rate of return.

25
 Profitability index method or Benefit cost Ratio (P.I)

It is also called Benefit cost ratio is the relationship between present value of cash
inflow and present value of cash outflow

PI (Gross) = present value of cash inflows

Present value of cash outflows/ Initial Investment

PI (net) = NPV (Net Present Value)

Initial investment

The proposal is accepted if the profitability index is more than one and is rejected the
profitability index is less than one.

The various projects are ranked; the project with higher profitability index is ranked higher
than other.

CONCEPT AND MEASUREMENT OF 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 the firm. The capital
used may be debt, preference shares, retained earnings and equity shares.

● The decision to invest in particular project depends on cost of capital or cut off rate of the
firm,.
● To achieve the objective of wealth maximization, a firm must earn a rate of return more
than its cost of capital.
● Higher the risk involved in the firm, higher is the cost of capital.

Components of Cost of Capital

1.Return at Zero Risk Level

Expected rate of return when a project involves no risk.

2.Premium for business risk

Variability in Operating Profit due to change in sales

3.Premium for Financial Risk

Risk on account of higher debt content in capital structure

26
FACTORS AFFECTING THE COST OF CAPITAL OF A FIRM
1) Risk Free Interest Rate:
The risk free interest rate, If, is the interest rate on the risk free and default- free
securities. Theoretically speaking, the risk free interest rate depends upon the supply and
demand consideration in financial market for long term funds. The market sources of
demand and supply determines the If, which is consisting of two components:

o Real interest Rate:

The real interest rate is the interest rate payable to the lender for supplying the
funds or in other words, for surrendering the funds for a particular period.

o Purchasing power risk premium:

Investors, in general, like to maintain their purchasing power and therefore, like
to be compensated for the loss in purchasing power over the period of lending or
supply of funds. So, over and above the real interest rate, the purchasing power
risk premium is added to find out the risk free interest rate. Higher the expected
rate of inflation, greater would be the purchasing power risk premium and
consequently higher would be the risk free interest rate.

2) Business Risk:
Another factor affecting the cost of capital is the risk associated with the firm‘s promise to
pay interest and dividends to its investors. The business risk is related to the response of
the firm‘s Earnings Before Interest and Taxes, EBIT, to change in sales revenue.
Every project has its effect on the business risk of the firm. If a firm accepts a proposal
which is more risky than average present risk, the investors will probably raise the cost of
funds so as to be compensated for the increased risk. This premium is added for the
business risk compensation is also known as Business Risk Premium.

3) Financial Risk:
The financial risk is a type of risk which can affect the cost of capital of the firm.
The particular composition and mixing of different sources of finance, known as the
financial plan or the capital structure, can affect the return available to the investors. The
financial risk is affected by the capital structure or the financial plan of the firm. Higher the
proportion of fixed cost securities in the overall capital structure, greater would be the
financial risk.

4) Other Consideration:

The investors may also like to add a premium with reference to other factors. One
such factor may be the liquidity or marketability of the investment. Higher the liquidity
available with an investment, lower would be the premium demanded by the investor. If
the investment is not easily marketable, then the investors may add a premium for this also
and consequently demand a higher rate of return.

27
 Computation of Cost of Capital

● Computation of cost of specific source of finance

● Computation of cost of weighted average cost of capital

2.7.2 Computation of specific source of finance

(i) Cost of debt

It is the rate of interest payable on debt.

Debenture before tax

● Issued at par
● Issued at premium or discount

Debenture after tax

(ii)Cost of redeemable debt

The debt is to be redeemed after a certain period during the life time of the firm. Such
debt issued is known as redeemable debt.

● Before tax cost of redeemable debt

● After tax cost of redeemable debt

(iii) Cost of preference capital

A fixed rate of dividend is payable on preference shares. Dividend is payable at the
discretion of the board of directors and there is no legal binding to pay dividend. In case
dividend are not paid, it will affect the fund raising capacity of the firm. Hence dividends
are paid regularly except when there is no profit

● Issued at par
● Issued at premium or discount

Cost of redeemable preference shares

Redeemable preference shares are issued which can be redeemed or cancelled on
maturity date.

(iv) Cost of equity share capital

The cost of equity is the maximum rate of return that the company must earn on equity
financed position of its investments in order to leave or unchanged the market price of its
stock. It may or may not be paid. Shareholders invest money in equity shares on the
expectation of getting dividend and the company must earn this minimum rate so that the
market price of the shares remains unchanged.

(a) Dividend yield method or dividend / price ratio method

(b) Dividend yield plus growth in dividend method

28
(c) Earnings yield method

(v) Cost of retained earnings

The retained earnings do not involve any cost because a firm is not required to pay
dividend on retained earnings. But shareholder expects return on retained earnings.

Computation of Cost of Capital

Computation of cost of capital consists of two important parts:

1. Measurement of specific costs
2. Measurement of overall cost of capital

Measurement of Cost of Capital

It refers to the cost of each specific sources of finance like:

• Cost of equity
• Cost of debt
• Cost of preference share
• Cost of retained earnings
• Realized yield approach.

Importance of Cost of Capital

1.Capital Budgeting Decision
Cost of capital is used to select an investment proposal, out of various proposals pending before
the management. According to discounted cashflow methods of capital budgeting, if the present
value of expected return from investment is greater than or equal to the cost of investment. The
project may be accepted otherwise the project may be rejected. Hence the concept of cost of
capital is very useful in capital budgeting decision.
2. Designing the capital structure
Management has to keep in mind the objectives of maximizing the value of the firm and
minimizing the cost of capital.
3. Decision about the method of financing
Financial executives must analyze the rate of interest on loans and normal dividend rates in the
market from time to time, and then he may have a better choice of the source of finance which
bears the minimum cost of capital, whenever the company requires additional finance.
4. Evaluation of Performance of Top Management
Cost of capital can be used to evaluate the financial performance of top management. The
actual profitability of the project is compared with the projected overall cost of capital and the
actual cost of capital funds raised to finance the project.

29
 UNIT 3

FINANCING AND DIVIDEND DECISION

LEVERAGES

Leverage refers to the firm‘s ability to use fixed cost asset or funds to
increase the return to its owners i.e, Equity shareholders.

The employment of an asset or sources of funds for which the firm has
to pay a fixed cost or fixed return. The fixed cost is also called as fixed
operating cost and the fixed return is called financial cost remains constant
irrespective of the change in volume of output of sales

Higher the degree of leverage, higher is the risk as well as return to the owner.

1. Financial leverage or Trading on equity

2. Operating leverage

3. Combined leverage or composite leverage

Financial leverage

Leverage activities with financing activities is called financial leverage.

Financial leverage represents the relationship between the company‘s
earnings before interest and taxes (EBIT) or operating profit and the earning
available to equity shareholders.

Financial leverage is defined as ―the ability of a firm to use fixed

financial charges to magnify the effects of changes in EBIT on the earnings
per share.
Financial leverage may be favorable or unfavorable depends upon
the use of fixed.
Unfavourable financial leverage occurs when the company does not earn
as much as the funds cost. Hence, it is also called as negative financial
leverage.

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in
taxable profit as a result of percentage change in earnings before interest and
tax (EBIT). This can be calculated by the following formula
 Percentage change in taxable profit

Percentage change in earnings before interest and tax (EBIT).

Alternative Definition of Financial Leverage

According to Gitmar, ―financial leverage is the ability of a firm to use fixed financial
Changes to magnify the effects of change in EBIT and EPS‖.

FL= Financial Leverage

EBIT = Earnings before Interest and Tax
EPS = Earnings Per share.

Uses of Financial Leverage

● Financial leverage helps to examine the relationship between EBIT and

EPS.
● Financial leverage measures the percentage of change in taxable income to
the percentage change in EBIT.
● Financial leverage locates the correct profitable financial decision
regarding capital structure of the company.
● Financial leverage is one of the important devices which is used to measure
the fixed cost proportion with the total capital of the company.
● If the firm acquires fixed cost funds at a higher cost, then the earnings from
those assets, the earning per share and return on equity capital will
decrease.
● The impact of financial leverage can be understood with the help of the
following exercise.
Composite leverage

Combination of operating &financial leverage is called composite leverage

DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating Leverage:
 Operating leverage is associated with investment activities of the company.
 Operating leverage consists of fixedoperating expenses of the company.
 It represents the ability to use fixedoperating cost.
  A percentage change in the profits resulting from a percentage change in the sales is called as
degree of operating leverage.
 Trading on equity is not possible while the company is operating leverage.
 Operating leverage depends upon fixed cost and variable cost.
 Tax rate and interest rate will not affect the operating leverage.

Financial Leverage

 Financial leverage is associated withfinancing activities of the company.

 Financial leverage consists of operating profit of the company.
 It represents the relationship between EBIT and EPS.
 A percentage change in taxable profit is the result of percentage change inEBIT
 Trading on equity is possible only whenthe Company uses financial leverage

 Financial leverage will change due to taxrate and interest rate.

 CAPITAL STRUCTURE

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

Optimum Capital Structure

Optimum capital structure is the capital structure at which the weighted

average cost of capital is minimum and thereby the value of the firm is
maximum.
Optimum capital structure may be defined as the capital structure or
combination of debt and equity that leads to the maximum value of the firm.

Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.

2. Minimize the overall cost of capital.

Forms of Capital Structure

Capital structure pattern varies from company to company and the availability
of finance. Normally the following forms of capital structure are popular in
practice.
● Equity shares only.
● Equity and preference shares only.
● Equity and Debentures only.
● Equity shares, preference shares and debentures.

Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a
firm. Normally long- term finance such as equity and debt consist of fixed
cost while mobilization. When the cost of capital increases, value of the firm
will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
COST OF CAPITAL AND VALUATION

o Every rupee invested in a firm has a cost

o It is the minimum return expected by the suppliers.
o Debt is the cheaper source of finance due to

(i) Fixed rate of interest on debt

(ii) Legal obligation to pay interest
(iii) Repayment of loan
(iv) Priority at the time of winding up of the company

o Equity shares , not legal obligation to pay dividend and shareholders

undertake more risk, investment is repaid at the time of winding up
after paying to others
o Preference capital is also cheaper, less risk involved, fixed rate of
dividend payable and priority given at the time of winding up of the
company

Cash flow ability to service debt

● Firm generating larger and stable cash inflow use more debt in capital
structure
● Debt implies burden of fixed charge due to the fixed payment of interest
and principal
● Whenever firm wants to raise additional funds ,it should estimate, project
future cash inflow to cover the fixed charges

Nature and size of firm

● All public utility has different capital structure as compared to

manufacturing concern
● Public utility employ more debt because of stable and regularity of
earnings
● Concern cannot provide stable earnings will depend on equity shares
● Small companies depend on owned capital it is very difficult to raise long
term loans

Control

● Whenever additional funds are required by firm the management should

raise without any loss of control over the firm
● If firm issue equity shares then the control of existing shareholder is diluted
● So it might be raised by debt or preference capital
● Preference share and debt do not have voting right.
Flexibility

● Capital structure should be flexible

● It should be capable of being adjusted according to the needs of the
changing condition
● It should be possible to raise additional funds with mush risk and delay.
● Redeemable preference shares and convertible debenture is preferred for
flexibility

Requirement of investors

● Requirement is the another factor that influence the capital structure of the
firm
● It is necessary to meet requirement of institutional as well as investor when
debt financing is used.
● Investors 3 kinds
● Bold investor- takes all type of risk; prefer capital gains and control – so
equity capital
● is preferred
● Over-cautious – prefer safety of investment and stability in returns – so
debenture is
● preferred
● Less cautious - prefer stability in return – so preference share capital is
used.

Capital market condition

● Capital market conditions do not remain same forever.

● Sometime depression or may be boom in the market
● Share market depressed, then company should not issue equity capital as
investor prefer safety
● Boom period, firm must issue equity shares.

Asset structure

● The liquidity and composition of assets should kept in mind while selecting
capital structure.
● Fixed asset contribute the major portion of the company then company
should raise long-term debt.

Purpose of financing
● Funds are required for productive purpose – debt financing is suitable
because the company can pay interest out of profit generated.
● Funds are needed for unproductive or general development – company
prefer equity capital

Period of finance

● The period is an important factor to be kept in mind while selecting

appropriate capital mix
● Finance required for limited period (7 years) – debenture should be
preferred
● Redeemable preference shares is also used for limited period
● Funds needed for permanent basis equity share capital is more appropriate.

DESIGNING CAPITAL STRUCTURE

Capital structure is the major part of the firm‘s financial decision which
affects the value of the firm and it leads to change EBIT and market value of
the shares. There is a relationship among the capital structure, cost of capital
and value of the firm. The aim of effective capital structure is to maximize the
value of the firm and to reduce the cost of capital.

● There are only two sources of funds used by a firm; debt and shares.
● The firm pays 100% of its earning as dividend.
● The total assets are given and do not change.
● The total finance remains constant.
● The operating profits (EBIT) are not expected to grow.
● The business risk remains constant.
● The firm has a perpetual life.
● The investors behave rationally.

Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach,
the capital structure decision is relevant to the valuation of the firm. In other
words, a change in the capital structure leads to a corresponding change in the
overall cost of capital as well as the total value of the firm.
According to this approach, use more debt finance to reduce the overall cost
of capital and increase the value of firm.
Net income approach is based on the following three important assumptions:
● There are no corporate taxes.
● The cost debt is less than the cost of equity.
● The use of debt does not change the risk perception of the investor.

Where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:
S =NI/ Ke whe re
NI = Earnings available to equity shareholder Ke = Cost of equity/equity
capitalization rate

According to this approach, the change in capital structure will not lead to
any change in the total value of the firm and market price of shares as well as
the overall cost of capital.

NI approach is based on the following important assumptions;

● The overall cost of capital remains constant;
● There are no corporate taxes;
● The market capitalizes the value of the firm as a whole;

The value of the firm under Net Income Approach

Overall cost of capital (Ko) = EBIT/V

EBIT - Earnings before Interest and Taxes

V- Value of the firm

Value of the Firm (V) =S+B

S- Market Value of Equity
B- Market Value of Debt

Market Value of Equity can be ascertained in the following manner

 S=NI/Ke

NI – Earning available for equity shareholders

Ke- Equity capitalization rate

Net Operating Income Approach

According to this approach, the market value of the firm is not at all affected
by the capital structure changes. The overall cost of capital remains constant
irrespective of the method of financing. Thus, there is nothing as an optimum
capital structure and every capital structure is the optimum capital structure.

This approach is based upon the following assumptions:

 The market capitalizes the value of the firm as a whole.
 The business risk remains constant at every level of debt equity mix.
 There are no corporate taxes

Value of the firm under Net Operating Income Approach

V= EBIT/Ko

V- Value of the firm

Ko- Overall cost of capital
EBIT – Earnings before interest and taxes

The Value of the equity can be determined by the following equations

S=V-B

Equity capitalization rate (Ke)=EBIT – I/V-B

V- Value of firm
B-Value of Debt
Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm
does not affect the market value of a firm in a perfect capital market. In other
words MM approach maintains that the average cost of capital does not
change with change in the debt weighted equity mix or capital structures of
the firm.
Modigliani and Miller approach is based on the following important
assumptions:

● There is a perfect capital market.

● There are no retained earnings.
● There are no corporate taxes.
● The investors act rationally.
● The dividend payout ratio is 100%.
● The business consists of the same level of business risk.

According to MM Approach : the value of a firm unlevered can be

calculated as

Vu=(1-t)EBT /Ke

EBT- Earnings before tax

T-Tax rate
Ke- Capitalization rate

The value of levered firm can be calculated as

VL = Vu +Bt

VL – Value of the levered firm

Vu- Value of the unlevered firm
B- Amount of debt
T-Tax rate
Determinant of Capital Structure of the Company

1.Nature of Business
Nature of business is an important factor which affect the capital structure of
the company. Business enterprises which have stability in their earnings to
raise funds through debentures or preference shares.

2. Size of the Company

Small size find it difficult to obtain long term debt. Hence, such companies
have to considerably upon the owner funds for financing.
Large companies are generally considered to be less risky by the investors.
Therefore , they can issue different types of securities and collect their funds
from different sources.

3. Regularity of Income
If a company expect regular income in future, debenture and bond may be
issued. Preference shares may be issued if a company does not expect regular
income.

4. Purpose of Financing
The purpose of financing also affect the capital structure of the company. If
funds are needed for productive purposes or purchase of machinery. On the
other hand if the funds are required for Non productive purpose.

5. Requirements of Investors
Collect funds from different types of investors, the companies to issue
different types of securities. Some investor preference security of investment
and stability of income, while others prefer higher income and capital
appreciation.

6. Legal Requirements
Every company has to follow the law of the country regarding the issue of
different types of securities.

7. Government Policy
Government policy is also an important factor in planning the company
capital structure. A change in the lending policy of financial institution may
need a complete change in the financial pattern. Besides this, the monetary
and fiscal policies of the government also affect the capital structure decision.
8. Conditions of capital market

Conditions of capital market has an important bearing on the capital structure

of the company because investor is very often influenced by the general mood
or sentiment of the capital market.

Dividend and Dividend Policy

The term dividend refers to that part of profits of a company which is

distributed by the company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. The
investors are interested in earning maximum return to maximize their wealth.

A firm needs funds to meet its long-term growth. If a company pays

most of the profit as dividend, then for business requirement or further
expansion then it will have to depend on outsiders for funds. Such as issue of
debt or new shares.

Dividend is fixed annual percentage of paid up capital as incase of

preference shares or equity shares. Dividend is proposed by board of directors
and approved by the shareholders in the annual general meeting.

Firms decision to pay dividend in equitable proportion of dividend and

retained earnings.

Types of Dividend
1.Cash dividend

Shareholders are paid dividend in cash. The company must have sufficient
cash balance in its bank account , otherwise it would have to arrange funds for
the payment of dividend.
There are two types of cash dividend.
1. Regular dividend
Paid annually proposed by the board of directors approved by the shareholder
in general meeting. It is also known as regular dividend. Because it is usually
paid after the finalization of account. It is generally paid in cash as a
percentage of paid dup capital, say 10 % or 15 % of the capital.
 2. Interim Dividend

Directors may decide to pay dividend at any time between the two annual general
meeting before finalization of accounts. It is generally declared and paid when
company has earned heavy profit.
2. Stock Dividend
Companies not having good cash position, generally pay dividend in the form of
shares by capitalizing the profit of current year and of past year. Such shares are
issued instead of paying dividend in cash.

3. Scrip Dividend

Cash position of company is temporarily weak. So shareholders are issued shares

if other companies held by the company as investment. Such payment of dividend
is called scrip’s dividend.
4. Bond dividend
Dividends are paid in the form of bond for long period bearing interest at fixed
rate. The effect of such dividend is the same as that of paying dividend in scrip’s.
5. Property Dividend

Dividend is paid in the form of asset instead of payment of dividend in cash.

Distribution of dividend is made whenever the asset is no longer required in the
business . Such investment or stock of finished goods.

Determinants of Dividend Policy (or) Factors

1. Stability of Earnings
Is one of the important factors influencing the dividend policy? If earning is
relatively stable. A firm is in a better position to predict what its future earnings
will be and such companies are more likely to pay out a higher percentage of its
earnings in dividends than a concern.
2.Financing Policy of the Company
Dividend policy may be affected and influenced by financing policy of the
company. If the company decides to meet its expenses from its earnings, then it
will have to pay less dividend to shareholders. On the other hand, if the company
feels that outside borrowing is cheaper than internal financing. Then it may
decide to pay higher rate of dividend to shareholders.
3.Liquidity of the firm
Payment of dividend means a cash outflows and hence, the greater the cash
position and liquidity of the firm is determined by the firms investment and
financing decisions. While the investment decisions the rate of asset expansion
and the firms needs for funds.
4.Dividend policy of Competitive concerns

Dividend policy of the other competitive concern in the market are paying higher
rate of dividend than this concern. The shareholders may prefer to invest their
money in those concerns rather than in this concern. Every company will have to
decide the dividend policy by keeping in view the dividend policy of other
competitive concern in the market.
5.Past Dividend Rate

The dividend rate may be decided on the basis of dividend declare in the previous
years. Generally the directors will have to keep in mind the rate of dividend
declared in the past.

6.Debt Obligations

A firm which has incurred heavy in debtness, is not in a position to pay higher
dividend to shareholders.

7.Ability to borrow

Every company requires finance both for expansion programmes as well as

meeting unanticipated expenses. Hence the company have to borrow from the
market. Lager firm have better access to the capital market than new and small
firms and hence, they can pay higher rate of dividend. The new companies
generally find it difficult to borrow from the market.

8.Growth need of the company

If the company has expansion programmes, it would need more money for growth
and development. When money for expansion is not needed then it is easy for the
company to declare high rate of dividend.

9.Legal Requirements

While declaring dividend , the board of directors will have to considered the legal
restriction. The Indian company act 1956 prescribed certain guidelines in respect
of declaration and payment of dividends and they are to be strictly observed by
the company for declaring dividends.

ASPECTS OF DIVIDEND POLICY

Relevance of Dividend
According to this concept, dividend policy is considered to affect the value of
the firm. Dividend relevance implies that shareholders prefer current dividend
and there is no direct relationship between dividend policy and value of the
firm. Relevance of dividend concept is supported by two eminent persons like
Walter and Gordon.

Walter’s Model

Walter model support the theory that dividend, are relevant. The choice of
dividend policies always affects the value of enterprises because dividend
policy maximizes the wealth of shareholders.

According to the Walter‘s model, the relationship between the return on a

firms investment (r) or and its cost of capital (k).

If the return on investment exceeds the cost of capital (r>k) and if the firm
has adequate profitable investment opportunities, then the firm should retain
the entire earnings within the firm. Such firm may be called growth firm. The
optimum dividend payout ratio for this type is zero percentage.

If a firm does not have profitable investment opportunities and if the cost
of capital exceeds the expected return on the firms investments (r<k) then the
firm should distribute the entire earnings as dividends. Such firm may be
called weak firms. The optimum dividend payout ratio is 100 percentages.

If the firms r=k then they are called normal firms. It is a matter of
indifference whether earnings are retained or distributed the market price of
shares will remain constant at all dividend payout ratio ranging between 0
parentages and 100 percentages.

Assumptions:

● The firm has 100 recent payout.

● The firm has constant EPS and dividend.
● The firm has a very long life.
● Walter has evolved a mathematical formula for determining the value of
market share.
Gordon’s Model

Gordon‘s model consists of the following important criticisms:

Gorden’s model is based on relevance of dividend concept according to it

dividends are relevant and dividend policy affects the value of the firm. His
basic valuation model is based on the following assumptions.

Assumptions
 The firm is an all equity firm.
 No external financing is used and investment progammes are financed
exclusively by retained earnings.
 The firm has perpetual life and its stream of earnings are perpetual.
 The corporate tax does not exist.

Modigliani Millers Approach

The dividend policy has no effect on the market price of the shares and the
value of the firm is determined by the earning capacity of the firm or its
investment policy. As observed by them, under conditions of perfect capital
markets, rational investors, absence of tax discrimination between dividend
income and capital appreciation, given the firms investment policy its
dividend policy may have no influence on the market price of the shares.

Assumptions
1. Capital Markets are perfect
2.All investors are rational
3.There are no transaction costs
4.there are no flotation costs.
Information is available to all free of cost.
No investor is larger enough to influence the market price of securities.
FORMS OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and
profitable position. On the basis of the dividend declaration by the firm, the
dividend policy may be classified under the following types:
● Regular dividend
● Stable dividend policy
● Irregular dividend policy
● No dividend policy.

Regular Dividend Policy

Dividend payable at the usual rate is called as regular dividend policy. This
type of policy is suitable to the small investors, retired persons and others.

Stable Dividend Policy

Stable dividend policy means payment of certain minimum amount of
dividend regularly. This dividend policy consists of the following three
important forms:
● Constant dividend per share
● Constant payout ratio
● Stable rupee dividend plus extra dividend.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful
business operation, they may follow irregular dividend policy. It is one of the
temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.

No Dividend Policy
Sometimes the company may follow no dividend policy because of its
unfavorable
working capital position of the a mount required for future growth of the
concerns.
SHARE SPLIT

Definition
A corporate action in which a company's existing shares are divided
into multiple shares. Although the number of shares outstanding increases by
a specific multiple, the total dollar value of the shares remains the same
compared to pre-split amounts, because no real value has been added as a
result of the split.

Share split

Share split is the process of splitting shares with high face value into shares of
a lower face value.

● Alteration of shares
● Increase the number of outstanding shares
● Approval from board of directors

Reasons of share splits

● The price of their stock exceeds the amount smaller investors would be
willing to pay. it is aimed at making the stock more affordable and liquid
from retail investors point of view
● There are more buyers and sellers of shares trading Rs 100 than say Rs 400
as retail shareholders may find low price stocks to be better bargains.
 Legal, Procedural and Tax Aspects of Dividend Policy

1. Legal Aspects
The amount of dividend that can be legally distributed by company law.
 The important provisions of company law
 Companies can pay only cash dividend
 Dividend can be paid only out of the profits earned during the financial
year.

2. Procedural Aspects

1. Board Resolution
The dividend decision is the taken by the board of directors. Hence the board
of directors should in a formal meeting resolve to pay the dividend.

2. Shareholders Approval
The resolution of the board of directors to pay the dividend has to be
approved by the shareholders in the annual general meeting.

3. Record date
The dividend is payable to shareholders whose name appear in the register of
members as on the record date.

4. Dividend Payment
Once a dividend declaration has been made, dividend warrant must be posted
within 42 days, within a period of 7 days after the expiry of 42 days, unpaid
dividends must be transferred to a special account opened with a scheduled
bank.

3.Tax Aspects
A domestic company which declare pay dividend is liable to, in addition to
income tax in respect of total income, a 10 % dividend tax on distributed
profit under section 115 of the Income Tax Act.
 Unit – III IMPORTANT QUESTIONS

(2 Marks)
12. Define leverage?
13. Define Operating leverage?
14. Define financial leverage?
15. Define combined leverage?
16. What is Capital structure?
17. What is optimum Capital structure?
18. What are the forms of capital structure?
19. List out theories of capital structure.
20. What is dividend policy?
21. List out the determinants of dividend policy.
22. 11.What are the types of dividend policy?
23. What is stable dividend policy?
24. What is stock dividend?
25. What do you mean by bonus shares?

(16 Marks)

1. What is Capital Structure? Explain the factors determining the capitalStructure?

2. What is dividend policy? Explain the types of dividend policy itsadvantages and
limitations?
3. Explain its types of leverage.
4. Explain the factors determining the dividend policy?
5. List out the different forms of dividends?
6. Discuss various theories of dividend?
7. Explain various theories of capital structure?
8. Distinguish between Operating leverage and financial leverage?
 UNIT 4

WORKING CAPITAL MANAGEMENT

Working Capital

Funds required for the purchase of raw material, payment of wages and other
day to day expenses are known as working capital. Working capital
management is related with managing current asset and current liabilities and
inter relationship. It is an integral part of corporate management. The main
objectives of working capital management is profitability and liquidity.
Profitability offers satisfactory return on investment.
Liquidity ensures satisfactory financial obligations.
Concept of working capital
1.Gross Working capital
Amount of funds invested in the total current assets such as marketable
securities, inventories and bills receivable. Current asset are those assets
which are normally converted into cash within one year.
2.Net Working Capital
Difference between current asset and current liabilities. Current liabilities are
those claims of outsiders, which are expected to mature for payment within
one year and include creditors, bills payable, bank overdraft and outstanding
expenses.
There are two types

1. Positive working capital: when current asset exceed the current

liabilities

2. Negative working capital: when current liabilities exceed the current

assets.
Types of Working Capital
1.Permanent Working capital
Minimum amount of investment in all current assets required at all time to
carryout minimum level of business activity. This capital is permanently
blocked in current assets. The working capital remain permanent in current
asset and should be financed out of long term funds. The amount of various
from year to year depending upon the growth of company.
 There are two types

1. Regular working capital

Minimum amount of working capital required to ensure circulation of current

asset from cash in to inventories from inventories into receivables and from
receivable to cash.
2. Reserve Working capital

Is the excess amount over the requirement for regular working capital. Such
as strikes, rise in prices.
2.Temporaory Working capital
Additional working capital required for a short period. It is needed to meet the
seasonal demand at different times during a year. It is temporarily, hence it
should be financed out of short term funds.
There are two types
1. Seasonal working capital: working capital required to meet seasonal needs.
2. Special working capital: required to meet special purpose such as
lunching new product and research.

Operating Cycles
Cash – Inventory – Receivables
Operating cycle consist of three stages.
 Cash get converted into inventory. This is included purchase of raw
materials, conversion of raw material into work in progress, finished goods
finally the transfer of goods to stock at the end of Manufacturing Process.

 Inventory is converted into receivables as credit sales are made to

customer.

 When receivables are collected from debtors.

Working Capital Policy

The various working capital policies are

Liquidity policies

Under this policy, finance manager will increase the amount of liquidity for
reducing the risk of business. If business has high volume of cash and bank balance, then
business can easily pay his dues at maturity. But finance manager should not forget that the
excess cash will not produce and earning and return on investment will decrease. So
liquidity policy should be optimized.

Profitability policy

Under this policy, finance manager will keep low amount of cash in business and
try to invest maximum amount of cash and bank balance. It will sure that profit of business
will increase due to increasing of investment in proper way but risk of business will also
increase because liquidity of business will decrease and it can create bankruptcy position
of business. So, profitability policy should make after seeing liquidity policy and after this
both policies will helpful for proper management of working capital.

Matching or hedging approach/policy

This approach or policy is a moderate policy that matches assets and liabilities to
maturities. Basically, a firm uses long term sources to finance fixed assets and permanent
current assets and short term financing to finance temporary current assets

Example
A fixed asset/equipment which is expected to provide cash flow for 8 years should
be financed by say 8 years long-term debts .Assuming a firm needs to have additional
inventories for 2 months, it will then sought short term 2 months bank credit to match it.

Conservative approach/policy

● Conservative because the firm prefers to have more cash on hands

● Fixed and part of current assets are financed by long-term or permanent funds
● As permanent or long-term sources are more expensive, this leads to ―lower risk lower
return‖
● Having excess cash at off-peak period hence the need to invest the idle or excess cash to
earn returns.

Aggressive approach/policy

The firm wants to take high risk where short term funds are used to a very high degree to
finance current and even fixed assets.
Determinants of Working Capital Requirement
1. Nature of Business

● Working capital requirement depends upon the nature of its business

● Public utility undertaking like electricity, water supply and railways need very limited
working capital because they offer cash sales only supply services not products.
● Trading and financial firm require less investment in fixed asset but invest large amount
in current asset like inventories, receivables and cash.
● Manufacturing undertaking require working capital along with fixed investment

2. Size of Business / Scale of Operation

● Working capital requirement of a concern influenced by size of its business which is

measured in term s of scale of operation
● Size of business unit large- require more working capital
● Size of business unit small – require less working capital

3. Production Policy
● Production is based on seasonal variation.
● Requirement of working capital depends on production policy.
● Production is seasonal less working capital
● Production is carried out throughout the year the working capital requirement is more

4. Manufacturing Process / Length of Production cycle

● Longer the process or period of manufacture, larger the amount of working capital is
required
● Short the length of production cycle, smaller the amount of working capital requirement

5. Seasonal Variation

● For certain industries raw material is not available throughout the year.
● They have to buy raw material in bulk during the season and process them during the
entire year
● A huge amount is blocked in the form of inventories during such season which give rise
to more working capital requirement.
● During busy season a firm requires larger working capital than in the slack season.

6. Working capital cycle

● In manufacturing concern, the working capital cycle starts with the purchase of raw
material and ends with the realization of cash from the sale of finished products.

7. Business Cycle

● It refers to alternate expansion and contraction in general business activity.

● Boom period when business is prosperous – larger amount of working capital due to
increase in sales
● Depression – sales decline, difficulties are faced in collection from debtors and firms
may have larger amount of working capital requirement.
 8. Earning capacity of the Firm

● Some firms have more earning capacity than others due to quality of their products,
monopoly condition etc.
● Such firms with high earning capacity may generate cash profit from operation and to
contribute to their working capital.
● Dividend policy influences the requirement of working capital.

9. Credit policies
A company which allows credit to its customer will need higher amount of working capital.
Company enjoying credit facilities from its supplier will need less amount of working capital.

10. Changes in Technologies

After the requirements of working capital, the firm adopt labour intensive process, it require
more working capital, if it go for automation it improve the raw material processing. The
reducing wastages and make fast production hence the requirement of working capital is less.

Estimation of Working Capital Requirement

● Components such as cash, marketable securities, receivables and inventory

● Working capital management requires much of the financial managers time.
● It has greater significance for all firms but it is very critical for small firms
● The need for working capital is directly related to the firm’s growth.

Internal sources
● Retained Earnings
● Reserve and Surplus
● Depreciation Funds etc.
● External sources Public
● Deposits
● Loans from Banks and Financial Institutions
● Advances and Credit

WORKING CAPITAL FINANCE

Cash Credit – Under this facility, the bank specifies a predetermined limit and the
borrower is allowed to withdraw funds from the bank up to that sanctioned credit limit
against a bond or other security. However, the borrower cannot borrow the entire
sanctioned credit in lump sum; he can draw it periodically to the extent of his
requirements. Similarly, repayment can be made whenever desired during the period.
There is no commitment charge involved and interest is payable on the amount actually
utilized by the borrower and not on the sanctioned limit.

Overdraft – Under this arrangement, the borrower is allowed to withdraw funds in excess
of the actual credit balance in his current account up to a certain specified limit during a
stipulated period against a security. Within the stipulated limits any number of withdrawals
is permitted by the bank. Overdraft facility is generally available against the securities of
life insurance policies, fixed deposits receipts, Government securities, shares and
debentures, etc. of the corporate sector. Interest is charged on the amount actually
withdrawn by the borrower, subject to some minimum (commitment) charges.

Loans – Under this system, the total amount of borrowing is credited to the current
account of the borrower or released to him in cash. The borrower has to pay interest on the
total amount of loan, irrespective of how much he draws. Loans are payable either on
demand or in periodical instalments. They can also be renewed from time to time. As a
form of financing, loans imply a financial discipline on the part of the borrowers.

Bills Financing – This facility enables a borrower to obtain credit from a bank against its
bills. The bank purchases or discounts the bills of exchange and promissory notes of the
borrower and credits the amount in his account after deducting discount. Under this
facility, the amount provided is covered by cash credit and overdraft limit. Before
purchasing or discounting the bills, the bank satisfies itself about the creditworthiness of
the drawer and genuineness of the bill.

Letter of Credit – While the other forms of credit are direct forms of financing in which
the banks provide funds as well as bears the risk, letter of credit is an indirect form of
working capital financing in which banks assumes only the risk and the supplier himself
provide the funds.

Trade Credit
Trade credit is a form of short term financing common to almost all businesses. In
fact, it is the largest source of short term funds for business firms collectively. In an
advanced economy, most buyers are not required to pay for goods upon delivery but are
allowed a short deferment period before payment is due. During this period, the seller of
the goods extends credit to the buyer. Because suppliers generally are more liberal in the
extension of credit than are financial institutions, small companies in particular rely on
trade credit.

COD and CBD No, Extension of Credit: COD terms mean cash on delivery of the goods.
The only risk the seller undertakes in this type of arrangement is that the buyer may refuse
the shipment. Under such circumstances, the seller will be stuck with the shipping costs.
Occasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. Under
either COD or CBD terms, the seller does not extend credit. CBD terms must be
distinguished from progress payments, which are very common in certain industries. With
progress payments, the buyer pays the manufacturer at various stages of production prior
to actual delivery of the finished product. Because large sums of money are tied up in work
in progress, aircraft manufacturers request progress payments from airlines in advance of
the actual delivery of aircraft.

Net Period No Cash Discount: When credit is extended, the seller specifies the period of
time allowed for payment. The terms "net 30" indicate that the invoice or bill must be paid
within 30 days. If the seller bills on a monthly basis, it might require such terms as "net/15
EOM," which means that all goods shipped before the end of the month must be paid for
by the fifteenth of the following month.
Net Period with Cash Discount In addition to extending credit, the seller may offer a cash
discount if the bill is paid during the early part of the net period. The terms "2/10, net 30"
indicate that the seller offers a 2 percent discount if the bill is paid within 10 days;
otherwise, the buyer must pay the full amount within 30 days. Usually, a cash discount is
offered as an incentive to the buyer to pay early.

Bank Finance
Banks generally do not provide working capital finance without adequate security.
The nature and extent of security offered play an important role in influencing the decision
of the bank to advance working capital finance. The bank provides credit on the basis of
following modes of security:

Commercial Paper
Commercial paper is a fairly new instrument which was originated in US. It helps
private companies with good credit rating to raise money directly from the market and
investors. They raise money by issuing commercial papers in tight money market
conditions through sources other than banks. CP is a fairly popular instrument and exists in
most of the developed economies. Large corporate and private companies find CPs
cheaper, simpler and more flexible due to their better credit rating.

Main Characteristics of Commercial Paper are

● Commercial paper is a short term debt instrument (money market instrument) issued by
both financial and non-financial companies.
● These debt instruments are unsecured in nature, that is, they do not require any change
to be created on the company‘s assets.
● If the company fails to pay back the investors the amount of commercial papers after
their maturity, the investors cannot sell a particular asset and recover their dues.
● Commercial papers are discount instruments, which mean they are issued at discount
and redeemed at face value.
● IT can have different maturity periods but it varies within 1 year. In India, the mature
period varies between 90 days to 365 days.
● In India, RBI regulates the commercial paper instruments. Companies have to adhere to
the norms set by the RBI in order to raise money using commercial papers.
 RECEIVABLES MANAGEMENT

Concept of Receivables Management

The receivables are normally arising out of the credit sales of the firm.

What is meant by the accounts receivable?

It is an asset owed to the firm by the buyer out of the credit sales with the terms and
conditions of repayment on an agreed time period.

Meaning of the receivables management

The receivables out of the credit sales crunch the availability of the resources to
meet the day today requirements. The acute competition requires the firm to sustain among
the other competitors through more volume of credit sales and in the intention of retaining
the existing customers. This requires the firm to sell more through credit sales only in
order to encourage the buyers to grab the opportunities unlike the other competitors they
offer in the market.

Objectives of Accounts Receivables

● Achieving the growth in the volume of sales

● Increasing the volume of profits
● Meeting the acute competition

Cost of Maintaining the Accounts Receivables

Capital cost
Due to insufficient amount of working capital with reference to more volume of credit
sales which drastically affects the existence of the working capital of the firm. The firm
may be required to borrow which may lead to pay certain amount of interest on the
borrowings. The interest which is paid by the firm due to the borrowings in order to meet
the shortage of working capital is known as capital cost of receivables.

Administrative cost
Cost of maintaining the receivables.
Collection cost
Whatever the cost incurred for the collection of the receivables are known as collection
cost.

Defaulting cost
This may arise due to defaulters and the cost is in other words as cost of bad debts and so
on.
 Factors Affecting the Accounts Receivables

i) Level of sales
The volume of sales is the best indicator of accounts receivables. It differs from one firm
to another.

ii) Credit policies

The credit policies are another major force of determinant in deciding the size of the
accounts receivable. There are two types of credit policies viz lenient and stringent credit
policies.

Lenient credit policy

Enhances the volume of the accounts receivable due to liberal terms of the trade which
normally encourage the buyers to buy more and more.

Stringent credit policy

It curtails the motive buying the goods on credit due stiff terms of the trade put forth by
the supplier unlike the earlier.

iii) Terms of trade

The terms of the trade are normally bifurcated into two categories viz credit period and
cash discount

Credit period
Higher the credit period will lead to more volume of receivables, on the other side that will
lead to greater volume of debts from the side of buyers.

Cash discount
If the discount on sales is more, that will enhance the volume of sales on the other hand
that will affect the income of the enterprise.
 INVENTORIES

Inventories can be classified into five major categories.

Raw Material
● It is basic and important part of inventories. These are goods which have not yet been
committed to production in a manufacturing business concern. Work in Progress
● These include those materials which have been committed to production process but
have not yet been completed.

Consumables
● These are the materials which are needed to smooth running of the
● Manufacturing process.

Finished Goods
● These are the final output of the production process of the business
● concern. It is ready for consumers.

Spares
● It is also a part of inventories, which includes small spares and parts.

Objectives of Inventory Management

The major objectives of the inventory management are as follows:
● To efficient and smooth production process.
● To maintain optimum inventory to maximize the profitability.
● To meet the seasonal demand of the products.
● To avoid price increase in future.
● To ensure the level and site of inventories required.
● To plan when to purchase and where to purchase
● To avoid both over stock and under stock of inventory.

Techniques of Inventory Management

Inventory management consists of effective control and administration of inventories.

Inventory control refers to a system which ensures supply of required quantity and quality
of inventories at the required time and at the same time prevent unnecessary investment in
inventories. It needs the following important techniques.
Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is
the level when the business concern makes fresh order at this level.
Re-order level= maximum consumption × maximum Re-order period.

Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain.
If the quantity exceeds maximum level limit then it will be overstocking. Maximum level =
Re-order level + Re-order quantity
– (Minimum consumption × Minimum delivery period)

Danger Level
It is the level below the minimum level. It leads to stoppage of the production process.

Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with
suppliers. The time taken in processing the order and then executing it is known as lead
time.

ABC ANALYSIS

ABC analysis is the technique of selective control over inventory. It is based on the
assumption that a firm does not exercise the same degree of control on all items of
inventory. It should keep greater control over the costly items than on the cheaper items.
Hence the inventories are divided into three categories.

Category A

The cost of these materials is high in value. Whereas the number of items is less.
Therefore, maximum attention should be paid to this category because it will increase the
cost of production.

Category B

The cost and the number of items of these materials are less. Therefore normal control
procedures may be followed.

Category C

The cost of these materials is very low whereas the number of items is high. Hence, it
needs simple and economic control procedures.
 Cash Management

Cash include coin, currency notes, cheques, bank draft and demand deposits
held by the firm.

Motive for Holding Cash

1. Transaction Motive
A firm has to involve in so many transactions in the course of the business.
These transactions may be either cash or credit transactions. If it is a cash
transaction, the firm needs cash to meet it out. For eg. Cash payment have to
be made for purchases, wages, operating expenses, interest, taxes and
dividend. At the same time, the firm may receive cash from sales and return
on investments, generally the inflow and out flow of cash do not coincide.
Therefore, it is the duty of the finance manager to plan for holding sufficient
cash to meet out the expenditure for the smooth conduct of the business.

2. Precautionary Motive
Precautionary motive refers to maintaining adequate cash to meet out the
unexpected cash needs at short notice. For eg. Strikes, dely in collection,
increase in cost of raw materials and the like are unexpected cash needs. To
meet such existence, cash balances are usually held in the form of marketable
securities so that they earn a return.

3. Speculative Motive
When the price of the raw material in the market is lower, naturally, the firm
may purchase in bulk and keep the same as stock. At the same time, when
price is higher, firm may delay the purchase of raw material expecting a
decline in the price. Hence to make a bulk purchase under such circumstances
the firm needs cash and holds for this purpose also. This is known as cash held
for speculative motive

4. Compensating Motive

It is the normal responsibility of the firm to maintain a minimum balance of

cash in the bank. This balance cant be utilized by the firm. It is used by the
bank to earn return. Since the bank renders services like collection of
cheques, arrangement of loan and overdraft, the firm is expected to hold a
 minimum balance of cash as a compensation for these services.

Objectives of cash management

Meeting the cash requirement

Meeting of cash requirements on time which normally involves in the

maintenance of the goodwill of the firm. The firm should keep the adequate
cash balances to meet the requirement which are greater in importance.

Minimizing the funds locked up in the cash balances

The funds locked up in the form of cash resources should be more, but it
should only to the tune of the requirement.

Basic Problems of Cash Management

Controlling level of cash

(a) Preparing the cash budget: Through the preparation of the budget, the cash
requirement could be identified which would normally facilitate the firm to
trim off the excessive cash in holding.
(b) Providing room for unpredictable discrepancies: The separate amount
should be maintained for the purpose to meet out the discrepancies which are
not easily foreseen.
Controlling of inflows of cash

(a) Concentration banking

The amount of collection from the local branches are normally deposited in a
particular account of the firm, as soon as the deposit has reached the certain
limit , the amount in the respective branch account will be transferred to the
account at where the firm maintains in the head office. This process of
transfer is normally taking place only through telegraphic transfer during the
early days but on now a day the anywhere banking is facilitated to transfer the
amount of deposit instantaneously.
Controlling of cash outflows
(a) Centralizing of disbursing the payments
The centralizing the process of payment may facilitate the enterprise to take
advantage of time in settling the payments i.e., reduces the need of immediate
cash requirements.
(b) Stretching payment schedule
 It is another methodology to avail the maximum possible credit period to
postpone the payment by making use of the cash resources most effectively.

Investing the excessive cash surplus

(a) Determine the need of the surplus cash

Identify the excessive cash resources which are kept simply idle more than
the requirement.

(b) Determination of the various avenues of investment

After identifying the various investment opportunities , the excessive cash
resources should be invested to earn appropriate rate of return during the
slack season at when the firm does not require greater volume of working
capital and vice versa.

Model of cash management

1. Baumol model

The basic objective of the Baumol model is to determine the minimum cost
amount of cash conversion and the lost opportunity cost.
It is a model that provides for cost efficient transactional balances and
assumes that the demand for cash can be predicated with certainty and
determines the optimal conversion size.

2. Orgler’s model
Orgler model provides for integration of cash management with production
and Other aspects of the business concern. Multiple linear programming
is used to determine the optimal cash management. Orgler‘s model is
formulated, based on the set of objectives of the firm and specifying the
set of constrains of the firm.
 Unit – IV IMPORTANT QUESTIONS

(2 Marks)

1. What is working capital management?

2.List out the concept of workingcapital

3. Mention the kinds of working capital

4. What are the different types of working capital policies?

5. Write any two factors determining working capital requirement?

6. Explain Gross Working capital concept?

7. Explain Net Working Capital Concept? 8.Write a note on inventory

management
9.Write about receivables management

10.What are the components of working

capital?

11.What is permanent or core working capital?

12.What is temporary working capital?
13. What is operating cycle?
14. What do you mean by management of inventory/stock?

15.What is cash management?

16.What is trade credit?

(16 Marks)
1. What are the important concepts of working capital?
2. Describe the essentials of working capital in manufacturing concern?
3. What are the factors which influence the amount of working capital
 requirements?
4. Describe the structure of working capital?
5. explain about inventory management
6. Discuss about cash management
7. Enumerate the concept of receivable management

8 Define factoring. State the mechanism involved in a factoring financial

service. 9.Explain Commercial Paper &bank finance
 UNIT 5

Venture Capital

Venture capital is understood in many ways. In a narrow sense, it refer to

investment in new and untried enterprises that are lacking a stable record of
growth. In border sense, venture capital refers to the commitment of capital as
shareholding for the formulation and setting up of small firms specializing in new
ideas or new technologies.

Meaning of Venture Capital

Venture capital is long term risk capital to finance high technology projects which
involve risk but at the same time has strong potential for growth. Venture
capitalists pool their resources including managerial abilities to assist new
entrepreneurs in the early years of the project. Once the project reaches the stage of
profitability, they sell their equity holdings at high premium.

Definitions

A venture capital company is defined as a financing institution which join an

entrepreneur as a co promoter in a project and shares the risks and rewards of the
enterprises.

Features

 Venture capital is usually in the form of an equity participation. It may also

take the form of convertible debt or long term loan.

 Investment is made only in high risk but high growth potential projects.

 Venture capital is available only for commercialization of new ideas or new

technologies and not for enterprises which are engaged in trading, broking,
financial services, agency, research and development.
  There is a continuous involvement in business after making an investment
by the investor.
 Investment is usually made in small and medium scale enterprises.

Scope of Venture capital

Venture capital may take various forms at different stages of the project. There are
four successive stages of development of project. Development of project idea,
implementation of the idea, commercial production and marketing and finally large
scale investment to exploit the economics of scale and achieve stability.

1.Development of an Idea – seed Finance

In the initial stage venture capitalist provide seed capital for translating an idea into
business proposition. At this stage investigation is made in-depth which normally
takes a year or more.

2.Implementation Stage – start up finance

When the firm is set up to manufacture a product or provide a service, start up

finance is provided by the venture capitalists. The first and second stage capital is
used for full scale manufacturing and further business growth.

3.Fledging Stage – additional finance

In the third stage, the firm has made some headway and entered the stage of
manufacturing a product but faces teething problems. It may not be able to
generate adequate funds and so additional round of financing is provided to
develop the marketing infrastructure.

4.Establishment stage – Establishment finance

At this stage the firm is established in the market and expected to expand at a
rapid place. It need further financing for expansion and diversification so that it
can reap economics of scale and attain stability. At the end of the establishment
stage, the firm is listed on the stock exchange and at this point the venture
capitalist disinvests their shareholdings through available exist routes.
Importance of venture capital

1. Advantages to investing public

 The investing public will be able to reduce risk significantly against
unscrupulous management. If the public invest in venture fund who in turn
will invest in equity of new business. With their expertise in the field and
continuous involvement in the business they would be able to stop
malpractices by management.

 Investor has no means to vouch for the reasonableness of the claims made by
the promoters about profitability of the business. The venture funds
equipped with necessary skills will be able to analyze the prospects of the
business.

 The investors do not have any means to ensure that the affairs of the
business are conducted prudently. the venture fund having representatives on
the board of directors of the company would overcome it.

2. Advantages to promoters
 The entrepreneur for the success of public issue is required to convince tens
of underwriters, brokers and thousands of investors but to obtain venture
capital assistance; he will be required to sell his idea to justify the officials
of the venture fund.

 Public issue of equity fund has to be preceded by a lot of efforts. Necessary

statutory sanctions, underwriting and brokers arrangement. Publicity of issue
etc.
 The entrepreneurs find it very difficult to make underwriting arrangement, as
nobody would take risk with them. All these arrangements require a great
deal of effort.

3. General
 A developed venture capital institutional set up reduces the time lag between
a technological innovation and its commercial exploitation.
  It helps in developing new processes / products in conducive atmosphere,
free from the dead weight of corporate bureaucracy, which helps in
exploiting full potential.

 A venture capital firm serves as an intermediary between investors looking

for high returns for their money and entrepreneurs in search of needed
capital for their start ups.

Method of Venture financing

Venture capital available in three forms in India.
1.Equity
2.Conditional Loan
3.Income Note

1.Equity: all venture capital finance in India provide equity but generally their
contribution does not exceed 49 percentage of the total equity capital. Venture
capital finances but equity shares of an enterprises with an intention to ultimately
sell off to make capital gain.

2.Conditional loan
A conditional loan is repayable in the form of royalty after the project generates
sales. No interest is paid on such loans. Venture capital finance charge royalty
ranging between 2 and 15 percent.

3.Income Note
An income note combines the features of both conventional loan and conditional
loan. The entrepreneur has to pay both interest and royalty on sales.

At present several venture capital firms are incorporated in India and they
promoted either by all India financial institutions like IDBI,ICICI,IFCI, State level
financial institution, public sector banks or promoted by foreign bank.

IDBI Venture capital fund

The initial impetus was given by IDBI technology division when venture capital
fund was set up in 1986 for encouraging commercial application of indigenously
developed technology and adopting imported technology.

Salient features
 1. Financial assistance under the scheme is available to projects whose
requirements range between Rs.5 lakhs and 2.5 crores. The promoters stake
should be at least 10 percent for the ventures below Rs.50 lakhs and 15
percent for those above Rs.50 lakhs.
2. Assistance was extended in the form of unsecured loan involving minimum
legal formalities. Interest at a concessional rate of 9 percent is charged
during technology development and trial run production and 17 percent once
the product is introduced in the market.

2.Technology Development and Information Company of India Limited

(TDICI -1988)

 The venture capital fund was jointly created by industrial credit and
Investment Corporation of India and unit trust of India to finance projects of
professional technologies in the small and medium size industries who take
initiatives in designing and developing indigenous crores was subscribed
equally by ICICI and UTI under the new venture capital unit scheme I of
UTI.

 The TDICI second venture fund of Rs.100 crores has been contributed by
UTI,ICICI, other financial institutions, banks, corporate sector etc. by 31,
March 1993. TDICI had provided a cumulative financial assistance of Rs.
79.29 crore. The scheme II in a variety of industries such as computers,
electronics, bio technology, medical, non conventional energy etc. many of
these projects are set up by first generation entrepreneurs.

3.Gujarath Venture Finance Ltd

 The Gujarath industrial investment corporation promoted Gujarat venture
finance ltd. The first state level venture finance company to begin venture
finance activities since 1990. It provides financial support to the ventures
whose requirements range between 25 lakhs and 2 crore. GUFL provides
finance through equity participation and quasi equity instruments. The firm
engaged in bio technology, surgical instruments, conversion of energy and
food processing industries are covered by GUFL.

4.Canara Bank
 Canara bank has set up a venture capital fund called canbank venture capital
fund worth Rs.10 crore. It has sanctioned Rs.10 crores to 33 projects as on
March 1992 in diverse fields like chemicals, machines, food stuffs etc.
5.Credit Capital venture fund limited
 The first private sector venture capital fund called credit capital venture fund
ltd. was set up by credit Capital Corporation limited in April 1989 with an
authorized capital of Rs.10 lakhs. It provides entrepreneurs who have ideas
and ability, but no finance, with equity capital for new Greenfield projects. It
main thrust area would be export oriented industries and technology orated
projects.

LEASE FINANCING

Lease financing is one of the popular and common methods of assets based
finance, which is the alternative to the loan finance. Lease is a contract. A
contract under which one party, the leaser (owner) of an asset agrees to grant
the use of that asset to another leaser, in exchange for periodic rental
payments.
Lease is contractual agreement between the owner of the assets and user of
the assets for a specific period by a periodical rent.
Definition
Lease may be defined as a contractual arrangement in which a party owning
an asset provides the asset for use to another, the right to use the assets to the
user over a certain period of time, for consideration in form of periodic
payment, with or without a further payment.

Elements of Leasing
● Parties: These are essentially two parties to a contract of lease financing,
namely the owner and user of the assets.
● Leaser: Leaser is the owner of the assets that are being leased. Leasers
may be individual partnership, joint stock companies, corporation or
financial institutions.
● Lease: Lease is the receiver of the service of the assets under a lease
contract. Lease assets may be firms or companies
● Lease broker: Lease broker is an agent in between the leaser (owner) and
lessee. He acts as an intermediary in arranging the lease deals. Merchant
 banking divisions of foreign banks, subsidiaries Indian banking and private
foreign banks are acting as lease brokers.
● Lease assets: The lease assets may be plant, machinery, equipment’s,
land, automobile, factory, building etc.

Steps involved in Leasing Transaction

 The lessee has to decide the asset required and select the supplier, he has to
decide about the design specifications, the price, warranties, terms of
delivery, servicing etc.

 The lessee, then enters into a lease agreement with the lessor, the lease
agreement contains the terms and conditions of the lease such as

 (a). the basic lease period during which the lease is irrecoverable.

 (a). the timing and amount of periodical rental payments during the lease
period.

 Details of any option to renew the lease or to purchase the asset at the end
of the period.

 Details regarding payment of cost of maintenance and repairs, taxes,

insurance and other expenses.
Types of lease

1. Operating lease
 Operating lease is also called as service lease. Operating lease is one of
the short-term and cancelable leases. It means a lease for a time shorter
than the economic life of the assets, generally the payments over the
term of the lease are less than the leaser‘s initial cost of the leased
asset. For example: Hiring a car for a particular travel. It includes all
expenses such as driver salary, maintenance, fuels, repairs etc. this
means that the lease is for a limited period, may be a month, six
months, a year of few years. The lease is terminable by giving
stipulated notice as per the agreement. Normally, the lease rentals will
be higher as compared to other leases on account of short period of
primary lease.
  When the lease belongs to the owner of the assets and users of the
assets with direct relationship it is called as direct lease. Direct lease
may be Dipartite lease (two parties in the lease) or tripartite lease.
(Three parties in the lease)

 The operating lease is suitable for computers, copy machines and other
office equipments, vehicles, material handling equipments etc.

2. Financial Lease
 A financial lease is also known as capital lease, long term lease, net
lease and close ended lease. In a financial lease, the lessee selects the
equipments, settles the price and terms of sale and arranges with a
leasing company to buy it. He enters into a irrevocable and non
cancellable contractual agreement with the leasing company. The lessee
uses the equipment exclusively, maintains it, insures and avails of the
after sales service and warranty backing it. He also bears the risk of
obsolescence as it stands committed to pay the rentals for the entire
lease period.

 The financial lease could also be with purchase option. Where at the
end of the predetermined period. The lessee has the option to buy the
equipment at a predetermined value or at a nominal value or at fair
market price. The financial lease may also contain a non cancellable
clause which means that the lessor transfer the title to the lessee at the
end of the lease period. Financial lease is very popular in India as in
other countries like USA,UK and Japan. On an all India basis, at
present, approximately a lease worth Rs.75 to Rs.100 crores is
transacted as a tax planning device. The high cost equipments such as
office equipment, diesel generators, machine tools, textile machinery,
containers, are leased under financial lease.

3.Single investor lease

 When the lease belongs to only two parties namely leaser and it is
called as single investor lease. It consists of only one investor (owner).
Normally all types of leasing such as operating, financially, sale and
lease back and direct lease are coming under these categories.
4. Leverage lease
This type of lease is used to acquire the high level capital cost of assets and
equipment’s. Under this lease, there are three parties involved; the leaser, the
lender and the lessee. Under the leverage lease, the leaser acts as equity
participant supplying a fraction of the total cost of the assets while the lender
supplies the major part.

4.Domestic lease
In the lease transaction, if both the parties belong to the domicile of the same
country it is called as domestic leasing.

5.International lease
If the lease transaction and the leasing parties belong to the domicile of
different Countries, it is called as international leasing.

Advantages of Leasing

Leasing finance is one of the modern sources of finance, which plays a major
role in the part of the asset based financing of the company. It has the
following important advantages.

1. Financing of fixed asset

Lease finance helps to mobilize finance for large investment in land and
building, Plant and machinery and other fixed equipment’s, which are used in
the business concern.
Lease rent is fixed by the lease agreement and it is based on the assets which
are used by the business concern. Lease rent may be less when compared to
the rate of interest payable to the fixed interest leasing finance like debt or
loan finance.
 2. Simplicity
Lease formalities and arrangement of lease finance facilities are very simple
and easy. If the leaser agrees to use the assets or fixed equipment by the
lessee, the leasing arrangement is mostly finished.

3. Transaction cost
When the company mobilizes finance through debt or equity, they have to pay
some amount as transaction cost. But in case of leasing finance, transaction
cost or floating cost is very less when compared to other sources of finance.

Leasing by Specialized Institutions

Specialized financial institutions also provide lease finance to the industrial

concern.
Some of the lease finance providing institutions are as follows:
• Life Insurance Corporation of India (LIC)
• General Insurance Corporation of India (GIC)
• Unit Trust of India (UTI)
• Housing Development Finance Corporation of India (HDFC)
Private Sector Leasing Company

Private sector leasing companies also provide financial assistance to the

industrial concerns.
The following are the example of the private sector leasing companies in
India:
o Express Leasing Limited
o 20th Century Leasing Corporation Ltd.
o First Leasing Company of India
o Mazda Leasing Limited
o Grover Leasing Limited
 Private Sector Financial Company
Private sector financial companies also involve in the field of leasing finance.
The following are the example of the private sector finance companies:
• Cholamandal Investment and Finance Company Ltd.
• Dcl Finance Limited
• Sundaram Finance Limited
• Anagram Finance Limited
• Nagarjuna Finance Limited.

HIRE PURCHASE

Introduction
Hire purchase is a mode of financing the price of the goods to be sold on a
future date. In a hire purchase transaction, the goods are let on hire, the
purchase price is to be paid in installments and hirer is allowed an option to
purchase the goods by paying all the installments. Hire purchase is a method
of selling goods. In a hire purchase transaction the goods are let out on hire by
a finance company (creditor) to the hire purchase customer (hirer). The buyer
is required to pay an agreed amount in periodical installments during a given
period. The ownership of the property remains with creditor and passes on to
hirer on the payment of the last installment.

A hire purchase agreement is defined in the Hire Purchase Act,

1972 as peculiar kind of transaction in which the goods are let on hire with an
option to the hirer to purchase them, with the following stipulations:

a. Payments to be made in installments over a specified period.

b. The possession is delivered to the hirer at the time of entering into
the contract.
c. The property in goods passes to the hirer on payment of the last
installment.
 d. Each installment is treated as hire charges so that if default is made
in payment of any installment, the seller becomes entitled to take
away the goods, and
e. The hirer/ purchase is free to return the goods without being required
to pay any further installments falling due after the return.
Features
▪ Under hire purchase system, the buyer takes possession of
goods immediately and agrees to pay the total hire purchase
price in installments.
▪ Each installment is treated as hire charges.
▪ The ownership of the goods passes from the seller to the buyer
on the payment of the last installment.
▪ In case the buyer makes any default in the payment of any
installment the seller has right to repossess the goods from the
buyer and forfeit the amount already received treating it as
hire charges.
▪ The hirer has the right to terminate the agreement any time
before the property passes. That is, he has the option to return
the goods in which case he need not pay installments falling
due thereafter. However, he cannot recover the sums already
paid as such sums legally represent hire charges on the goods
in question.

H ire Purchase Agreement

● Nature of Agreement: Stating the nature, term and commencement of the

agreement.
● Delivery of Equipment: The place and time of delivery and the hirer‘s
liability to bear delivery charges.
● Location: The place where the equipment shall be kept during the period
of hire.
● Inspection: That the hirer has examined the equipment and is satisfied
with it.
● Repairs: The hirer to obtain at his cost, insurance on the equipment and to
hand over the insurance policies to the owner.
● Alteration: The hire not to make any alterations, additions and so on to
the equipment, without prior consent of the owner.
● Termination: The events or acts of hirer that would constitute a default
eligible to terminate the agreement.
● Risk: of loss and damages to be borne by the hirer.
● Registration and fees: The hirer to comply with the relevant laws, obtain
registration and bear all requisite fees.
● Indemnity clause: The clause as per Contract Act, to indemnify the lender.
● Stamp duty: Clause specifying the stamp duty liability to be borne by the
hirer.
● Schedule: of equipment forming subject matter of agreement.
● Schedule of hire charges: The agreement is usually accompanied by a
promissory note signed by the hirer for the full amount payable under the
agreement including the interest and finance charges.
DIFFERENCE BETWEEN LEASING AND HIRE-PURCHASE
INDIAN CAPITAL MARKET

Capital market is the market for long term funds. It refers to all the facilities
and the institutional arrangements for borrowings and lending term funds. It
does not deal in capital goods but is concerned with the raising of money
capital. The demand for long term money capital comes predominantly from
private sector manufacturing industries and from the government, largely for
the purpose of economic development and to very small extent from
agriculture. As the central and state governments are investing not only on
economic overheads as transport irrigation and power development but also
on basic industries and sometimes even consumer goods industries, they
require substantial sums from the capital market.

Capital Market in India

Government Securities Market

This is also known as the Gilt-edged market. This refers to the market for
government and semi- government securities backed by the Reserve Bank of
India (RBI).

Industrial Securities Market

This is a market for industrial securities i.e. market for shares and debentures
of the existing and new corporate firms. Buying and selling of such
instruments take place in this market. This market is further classified into
two types such as the New Issues Market (Primary) and the Old (Existing)
Issues Market (secondary). In primary market fresh capital is raised by
companies by issuing new shares, bonds, units of mutual funds and
debentures. However in the secondary market already existing i.e old shares
and debentures are traded. This trading takes place through the registered
stock exchanges. In India we have three prominent stock exchanges. They are
the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE) and
over the Counter Exchange of India (OTCEI).

Development Financial Institutions (DFIs) : This is yet another important

segment of Indian capital market. This comprises various financial
institutions. These can be special purpose institutions like IFCI, ICICI, SFCs,
IDBI, IIBI, UTI, etc. These financial institutions provide long term finance
for those purposes for which they are set up.

Features of the Indian Capital Market

1.Greater reliance on debt instruments as against equity and in particular,
borrowing from financial institutions.

2.Issue of debentures, particularly convertible debentures with automatic or

compulsory conversion into equity without the normal option given investors.

3.Avoidance of underwriting by some companies to reduce the costs and

avoid scrutiny by the FIs.

4.Fast growth of mutual funds and subsidiaries of banks for financial service
leading to larger mobilization of savings from the capital market.

Functions of Capital Market

1.Mobilize Savings
The capital market in India mobilizes savings of the members of public and
industrial concern. Such savings are then utilized for the economic
development of the country.

2.Leanding funds

The capital market facilities to lend fund to various industrial concerns. The
industrial concern can borrow long term funds from various financial
institutions.

3.Direct collection of funds

The primary market makes it possible to collect funds from the market.
Interested individuals or corporate bodies subscribe for the issue of shares and
debentures.

4.Acts as a link
The capital market acts as a link between those who save and who are
interested in investing these savings.
5.Profitable use of funds

Capital market makes it possible to make productive and profitable use of

funds. This is because the funds, which are lying idle with the owners, are
utilized by industrial enterprises in a profitable manner, thus bringing rewards
to the investors, user and the society.

Role of capital market in india’s Industrial Growth

1.Mobilisation of savings and acceleration of capital formation

In developing countries like India plagued by paucity of resources and

increasing demand for investments by industrial organizations and
governments, the importance of the capital market is self evident. In this
market, various type of securities help mobilize savings from various section
of the population.

2.Promotion of industrial growth

The stock exchange is a central market through which resources are

transferred to the industrial sector of the economy. The existence of such an
institution encourages people to invest in productive channel rather than in the
unproductive sector like real estate etc.

3.Raising the long term capital

The existence of a stock exchange enables companies to raise permanent

capital. The investor cannot commit their funds for a permanent period but
companies require funds permanently.

4.Ready to Continues market

The stock exchange provides a central convenient place where buyers and
sellers can easily purchase and sell securities. The element of easy
marketability makes investment in securities more liquid as compared to other
assets.
 5.Provision of a variety of services

 The financial institutions functioning in the capital market provide a

variety of services, the more important ones being the following

 Grant a long term and medium term loans to entrepreneurs to enable

them to establish, expand or modernize business units.

 Provision of underwriting facilities.

 Assistance in the promotion of companies.

 Participation in equity capital

 Expert advice on management of investment in industrial securities.

New Issue Market

New issue market is for sale of new securities. It made in appeal to investors to
purchase and supply capital. There are two parties in the new issue market.
Firstly, companies issuing new securities and secondly individuals and
institutional investors interested in purchasing securities. There are several
intermediary agencies such as promoters, underwriters, and brokers etc. who
bring the companies and investors closer to interaction. The demand for the
securities of a company comes from large number of investors like businessmen,
potential customer of the company, its employees, intuitional investors and
present holders of equity shares of the company.

Secondary Market

This is also known as stock market. In this market buying and selling of second
hand are transacted
Financial Intermediaries
The fourth important segment of the Indian capital market is the financial
intermediaries. This comprises various merchant banking institutions, mutual
funds, leasing finance companies, venture capital companies and other
financial institutions.

LONG TERM FINANCE

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

❖ Long-term sources of finance.

❖ It is also called as corporate securities.
❖ Security finance includes both shares and debentures.
❖ It plays a major role in deciding the capital structure of the company.
❖ Repayment of finance is very limited.
❖ It is a major part of the company‘s total capitalization.
SHARES
Equity Shares also known as ordinary shares, which means, other than
preference shares. Equity shareholders are the real owners of the company.
They have a control over the management of the company. Equity
shareholders are eligible to get dividend if the company earns profit.

Equity share capital cannot be redeemed during the lifetime of the

company. The liability of the equity shareholders is the value of unpaid
value of shares.

Features of Equity Shares

1. Maturity of the shares: Equity shares have permanent nature of capital,

which has no maturity period. It cannot be redeemed during the lifetime of
the company.
 2. Residual claim on income: Equity shareholders have the right to get
income left after paying fixed rate of dividend to preference shareholder.
The earnings or the income available to the shareholders is equal to the
profit after tax minus preference dividend.

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

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

4. Right to control
Equity shareholders are the real owner of the company. Hence, they have
power to control the management of the company and they have power to
take any decision regarding the business operations
5. Voting rights
Equity shareholder only has voting right in the company meeting

Preference Shares

The part of corporate securities are called as preference shares, which have
preferential right to get dividend and get take the initial investment at the time of
winding up of the company. Preference shareholders are eligible to get fixed rate
of dividend and they do not have voting rights.

Cumulative preference Shares

Cumulative preference shares have right to claim dividend for those year which
have no profit. If the company is unable to earn profit in any one or more years.
Cumulative preference shares are unable to get any dividend but they have right
to get comparative dividend for the previous years if the company earned profit.

Non Commutative Preference Shares

They are eligible to get only dividend , if the company earns profit during the
years otherwise they cannot claim any dividend.
Redeemable preference shares:

When, the preference shares have a fixed maturity period it becomes redeemable
preference shares. It can be redeemable during the lifetime of the company. The
Company Act has provided certain restrictions on the provided certain restrictions
on the return of the redeemable..
Irredeemable Preference Shares: Irredeemable preference shares can be
redeemed only when the company goes for liquidator. There is no fixed maturity
period for such kind of preference shares.

Participating Preference Shares: Participating preference shareholders have

right to participate extra profits after distributing the equity shareholders.

Non-Participating Preference Shares: Non-participating preference

shareholders are not having any right to participate extra profits after distributing
to the equity shareholders. Fixed rate of dividend is payable to the type of
shareholders.

Convertible Preference Shares: Convertible preference shareholders have right

to convert their holding into equity shares after a specific period. The articles of
association must authorize the right of conversion.

Non-convertible Preference Shares: There shares, cannot be converted into

equity shares from preference shares.

Features of Preference Shares: The following are the important features of the
preference shares:

● Maturity period: Normally preference shares have no fixed maturity

Period except in the case of redeemable preference shares. Preference
shares can be redeemable only at the time of the company
liquidation.

● Residual claims on income: Preferential shareholders have a residual

claim on income
Fixed rate of dividend is payable to the preference shareholders.
 ● Residual claims on assets: The first preference is given to the
preference shareholders at the time of liquidation. If any extra Assets
are available that should be distributed to equity shareholder.
● Control of Management: Preference shareholder does not have any
voting rights. Hence, they cannot have control over the management of
the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

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

shares.

● Cumulative dividends: Preference shares have another advantage which is

called cumulative dividends. If the company does not earn any Profit in any
previous years, it can be cumulative with future period dividend.

● Redemption: Preference Shares can be redeemable after a specific period

except in the case of irredeemable preference shares. There is a fixed
maturity period for repayment of the initial investment.
● Participation: Participative preference shareholders can participate in the

● No voting right: Generally preference shareholders do not have any

voting rights. Hence they cannot have the control over the management of
the company.

● Fixed dividend only: Preference shares can get only fixed rate of
dividend. They may not enjoy more profits of the company.

● Permanent burden: Cumulative preference shares become a permanent

Burden so far as the payment of dividend is concerned. Because the
company must pay the dividend for the unprofitable periods also.
● Taxation: In the taxation point of view, preference shares dividend is not
a deductible expense while calculating tax. But, interest is a deductible
expense. Hence, it has disadvantage on the tax deduction point of view.
 DEFERRED SHARES
Deferred shares also called as founder shares because these shares were
normally issued to founders. The shareholders have a preferential right to get
dividend before the preference shares and equity shares. According to
Companies Act 1956 no public limited company or which is a subsidiary of a
public company can issue deferred shares. These shares were issued to the
founder at small denomination to control over the management by the virtue
of their voting rights.

Debenture
Creditor ship Securities also known as debt finance which means the finance
is mobilized from the creditors. Debenture and Bonds are the two major parts
of the Creditor ship Securities.

A Debenture is a document issued by the company. It is a certificate issued by

the company under its seal acknowledging a debt.
According to the Companies Act 1956,―debenture includes debenture
stock,
Bonds and any other securities of a company whether constituting a charge of
the assets of the company or not.

Types of Debentures
Debentures may be divided into the following major types:

1. Unsecured debentures: Unsecured debentures are not given any security on

assets of the company. It is also called simple or naked debentures. This type
of debentures are treaded as unsecured creditors at the time of winding up of
the company.

3. Redeemable debentures: These debentures are to be redeemed on the

debentures
6. Other types: Debentures can also be classified into the following types.
Some of the common types of the debentures are as follows:
▪ Collateral Debenture
▪ Guaranteed Debenture
▪ First Debenture
 ▪ Zero Coupon Bond
▪ Zero Interest Bond/Debenture

Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period.
Normally, debentures consist of 10–20 years maturity period and are
repayable with the principle investment at the end of the maturity period
preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on
Assets of the company over equity and preference shareholders. The
Debenture holders may have either specific change on the Assets or floating
change of the assets of the company. Specific change of
Debenture holders are treated as secured creditors and floating change of
Debenture holders are treated as unsecured creditors.
 UNIT 3

FINANCING AND DIVIDEND DECISION

LEVERAGES

Leverage refers to the firm‘s ability to use fixed cost asset or funds to
increase the return to its owners i.e, Equity shareholders.

The employment of an asset or sources of funds for which the firm has
to pay a fixed cost or fixed return. The fixed cost is also called as fixed
operating cost and the fixed return is called financial cost remains constant
irrespective of the change in volume of output of sales

Higher the degree of leverage, higher is the risk as well as return to the owner.

1. Financial leverage or Trading on equity

2. Operating leverage

3. Combined leverage or composite leverage

Financial leverage

Leverage activities with financing activities is called financial leverage.

Financial leverage represents the relationship between the company‘s
earnings before interest and taxes (EBIT) or operating profit and the earning
available to equity shareholders.

Financial leverage is defined as ―the ability of a firm to use fixed

financial charges to magnify the effects of changes in EBIT on the earnings
per share.
Financial leverage may be favorable or unfavorable depends upon
the use of fixed.
Unfavourable financial leverage occurs when the company does not earn
as much as the funds cost. Hence, it is also called as negative financial
leverage.

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in
taxable profit as a result of percentage change in earnings before interest and
tax (EBIT). This can be calculated by the following formula
 Percentage change in taxable profit

Percentage change in earnings before interest and tax (EBIT).

Alternative Definition of Financial Leverage

According to Gitmar, ―financial leverage is the ability of a firm to use fixed financial
Changes to magnify the effects of change in EBIT and EPS‖.

FL= Financial Leverage

EBIT = Earnings before Interest and Tax
EPS = Earnings Per share.

Uses of Financial Leverage

● Financial leverage helps to examine the relationship between EBIT and

EPS.
● Financial leverage measures the percentage of change in taxable income to
the percentage change in EBIT.
● Financial leverage locates the correct profitable financial decision
regarding capital structure of the company.
● Financial leverage is one of the important devices which is used to measure
the fixed cost proportion with the total capital of the company.
● If the firm acquires fixed cost funds at a higher cost, then the earnings from
those assets, the earning per share and return on equity capital will
decrease.
● The impact of financial leverage can be understood with the help of the
following exercise.
Composite leverage

Combination of operating &financial leverage is called composite leverage

DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating Leverage:
 Operating leverage is associated with investment activities of the company.
 Operating leverage consists of fixedoperating expenses of the company.
 It represents the ability to use fixedoperating cost.
  A percentage change in the profits resulting from a percentage change in the sales is called as
degree of operating leverage.
 Trading on equity is not possible while the company is operating leverage.
 Operating leverage depends upon fixed cost and variable cost.
 Tax rate and interest rate will not affect the operating leverage.

Financial Leverage

 Financial leverage is associated withfinancing activities of the company.

 Financial leverage consists of operating profit of the company.
 It represents the relationship between EBIT and EPS.
 A percentage change in taxable profit is the result of percentage change inEBIT
 Trading on equity is possible only whenthe Company uses financial leverage

 Financial leverage will change due to taxrate and interest rate.

 CAPITAL STRUCTURE

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

Optimum Capital Structure

Optimum capital structure is the capital structure at which the weighted

average cost of capital is minimum and thereby the value of the firm is
maximum.
Optimum capital structure may be defined as the capital structure or
combination of debt and equity that leads to the maximum value of the firm.

Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:

1. Maximize the value of the firm.

2. Minimize the overall cost of capital.

Forms of Capital Structure

Capital structure pattern varies from company to company and the availability
of finance. Normally the following forms of capital structure are popular in
practice.
● Equity shares only.
● Equity and preference shares only.
● Equity and Debentures only.
● Equity shares, preference shares and debentures.

Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a
firm. Normally long- term finance such as equity and debt consist of fixed
cost while mobilization. When the cost of capital increases, value of the firm
will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
COST OF CAPITAL AND VALUATION

o Every rupee invested in a firm has a cost

o It is the minimum return expected by the suppliers.
o Debt is the cheaper source of finance due to

(i) Fixed rate of interest on debt

(ii) Legal obligation to pay interest
(iii) Repayment of loan
(iv) Priority at the time of winding up of the company

o Equity shares , not legal obligation to pay dividend and shareholders

undertake more risk, investment is repaid at the time of winding up
after paying to others
o Preference capital is also cheaper, less risk involved, fixed rate of
dividend payable and priority given at the time of winding up of the
company

Cash flow ability to service debt

● Firm generating larger and stable cash inflow use more debt in capital
structure
● Debt implies burden of fixed charge due to the fixed payment of interest
and principal
● Whenever firm wants to raise additional funds ,it should estimate, project
future cash inflow to cover the fixed charges

Nature and size of firm

● All public utility has different capital structure as compared to

manufacturing concern
● Public utility employ more debt because of stable and regularity of
earnings
● Concern cannot provide stable earnings will depend on equity shares
● Small companies depend on owned capital it is very difficult to raise long
term loans

Control

● Whenever additional funds are required by firm the management should

raise without any loss of control over the firm
● If firm issue equity shares then the control of existing shareholder is diluted
● So it might be raised by debt or preference capital
● Preference share and debt do not have voting right.
Flexibility

● Capital structure should be flexible

● It should be capable of being adjusted according to the needs of the
changing condition
● It should be possible to raise additional funds with mush risk and delay.
● Redeemable preference shares and convertible debenture is preferred for
flexibility

Requirement of investors

● Requirement is the another factor that influence the capital structure of the
firm
● It is necessary to meet requirement of institutional as well as investor when
debt financing is used.
● Investors 3 kinds
● Bold investor- takes all type of risk; prefer capital gains and control – so
equity capital
● is preferred
● Over-cautious – prefer safety of investment and stability in returns – so
debenture is
● preferred
● Less cautious - prefer stability in return – so preference share capital is
used.

Capital market condition

● Capital market conditions do not remain same forever.

● Sometime depression or may be boom in the market
● Share market depressed, then company should not issue equity capital as
investor prefer safety
● Boom period, firm must issue equity shares.

Asset structure

● The liquidity and composition of assets should kept in mind while selecting
capital structure.
● Fixed asset contribute the major portion of the company then company
should raise long-term debt.

Purpose of financing
● Funds are required for productive purpose – debt financing is suitable
because the company can pay interest out of profit generated.
● Funds are needed for unproductive or general development – company
prefer equity capital

Period of finance

● The period is an important factor to be kept in mind while selecting

appropriate capital mix
● Finance required for limited period (7 years) – debenture should be
preferred
● Redeemable preference shares is also used for limited period
● Funds needed for permanent basis equity share capital is more appropriate.

DESIGNING CAPITAL STRUCTURE

Capital structure is the major part of the firm‘s financial decision which
affects the value of the firm and it leads to change EBIT and market value of
the shares. There is a relationship among the capital structure, cost of capital
and value of the firm. The aim of effective capital structure is to maximize the
value of the firm and to reduce the cost of capital.

● There are only two sources of funds used by a firm; debt and shares.
● The firm pays 100% of its earning as dividend.
● The total assets are given and do not change.
● The total finance remains constant.
● The operating profits (EBIT) are not expected to grow.
● The business risk remains constant.
● The firm has a perpetual life.
● The investors behave rationally.

Net Income (NI) Approach

Net income approach suggested by the Durand. According to this approach,
the capital structure decision is relevant to the valuation of the firm. In other
words, a change in the capital structure leads to a corresponding change in the
overall cost of capital as well as the total value of the firm.
According to this approach, use more debt finance to reduce the overall cost
of capital and increase the value of firm.
Net income approach is based on the following three important assumptions:
● There are no corporate taxes.
● The cost debt is less than the cost of equity.
● The use of debt does not change the risk perception of the investor.

Where
V = S+B
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of the equity can be ascertained by the following formula:
S =NI/ Ke whe re
NI = Earnings available to equity shareholder Ke = Cost of equity/equity
capitalization rate

According to this approach, the change in capital structure will not lead to
any change in the total value of the firm and market price of shares as well as
the overall cost of capital.

NI approach is based on the following important assumptions;

● The overall cost of capital remains constant;
● There are no corporate taxes;
● The market capitalizes the value of the firm as a whole;

The value of the firm under Net Income Approach

Overall cost of capital (Ko) = EBIT/V

EBIT - Earnings before Interest and Taxes

V- Value of the firm

Value of the Firm (V) =S+B

S- Market Value of Equity
B- Market Value of Debt

Market Value of Equity can be ascertained in the following manner

 S=NI/Ke

NI – Earning available for equity shareholders

Ke- Equity capitalization rate

Net Operating Income Approach

According to this approach, the market value of the firm is not at all affected
by the capital structure changes. The overall cost of capital remains constant
irrespective of the method of financing. Thus, there is nothing as an optimum
capital structure and every capital structure is the optimum capital structure.

This approach is based upon the following assumptions:

 The market capitalizes the value of the firm as a whole.
 The business risk remains constant at every level of debt equity mix.
 There are no corporate taxes

Value of the firm under Net Operating Income Approach

V= EBIT/Ko

V- Value of the firm

Ko- Overall cost of capital
EBIT – Earnings before interest and taxes

The Value of the equity can be determined by the following equations

S=V-B

Equity capitalization rate (Ke)=EBIT – I/V-B

V- Value of firm
B-Value of Debt
Modigliani and Miller Approach

Modigliani and Miller approach states that the financing decision of a firm
does not affect the market value of a firm in a perfect capital market. In other
words MM approach maintains that the average cost of capital does not
change with change in the debt weighted equity mix or capital structures of
the firm.
Modigliani and Miller approach is based on the following important
assumptions:

● There is a perfect capital market.

● There are no retained earnings.
● There are no corporate taxes.
● The investors act rationally.
● The dividend payout ratio is 100%.
● The business consists of the same level of business risk.

According to MM Approach : the value of a firm unlevered can be

calculated as

Vu=(1-t)EBT /Ke

EBT- Earnings before tax

T-Tax rate
Ke- Capitalization rate

The value of levered firm can be calculated as

VL = Vu +Bt

VL – Value of the levered firm

Vu- Value of the unlevered firm
B- Amount of debt
T-Tax rate
Determinant of Capital Structure of the Company

1.Nature of Business
Nature of business is an important factor which affect the capital structure of
the company. Business enterprises which have stability in their earnings to
raise funds through debentures or preference shares.

2. Size of the Company

Small size find it difficult to obtain long term debt. Hence, such companies
have to considerably upon the owner funds for financing.
Large companies are generally considered to be less risky by the investors.
Therefore , they can issue different types of securities and collect their funds
from different sources.

3. Regularity of Income
If a company expect regular income in future, debenture and bond may be
issued. Preference shares may be issued if a company does not expect regular
income.

4. Purpose of Financing
The purpose of financing also affect the capital structure of the company. If
funds are needed for productive purposes or purchase of machinery. On the
other hand if the funds are required for Non productive purpose.

5. Requirements of Investors
Collect funds from different types of investors, the companies to issue
different types of securities. Some investor preference security of investment
and stability of income, while others prefer higher income and capital
appreciation.

6. Legal Requirements
Every company has to follow the law of the country regarding the issue of
different types of securities.

7. Government Policy
Government policy is also an important factor in planning the company
capital structure. A change in the lending policy of financial institution may
need a complete change in the financial pattern. Besides this, the monetary
and fiscal policies of the government also affect the capital structure decision.
8. Conditions of capital market

Conditions of capital market has an important bearing on the capital structure

of the company because investor is very often influenced by the general mood
or sentiment of the capital market.

Dividend and Dividend Policy

The term dividend refers to that part of profits of a company which is

distributed by the company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. The
investors are interested in earning maximum return to maximize their wealth.

A firm needs funds to meet its long-term growth. If a company pays

most of the profit as dividend, then for business requirement or further
expansion then it will have to depend on outsiders for funds. Such as issue of
debt or new shares.

Dividend is fixed annual percentage of paid up capital as incase of

preference shares or equity shares. Dividend is proposed by board of directors
and approved by the shareholders in the annual general meeting.

Firms decision to pay dividend in equitable proportion of dividend and

retained earnings.

Types of Dividend
1.Cash dividend

Shareholders are paid dividend in cash. The company must have sufficient
cash balance in its bank account , otherwise it would have to arrange funds for
the payment of dividend.
There are two types of cash dividend.
1. Regular dividend
Paid annually proposed by the board of directors approved by the shareholder
in general meeting. It is also known as regular dividend. Because it is usually
paid after the finalization of account. It is generally paid in cash as a
percentage of paid dup capital, say 10 % or 15 % of the capital.
 2. Interim Dividend

Directors may decide to pay dividend at any time between the two annual general
meeting before finalization of accounts. It is generally declared and paid when
company has earned heavy profit.
2. Stock Dividend
Companies not having good cash position, generally pay dividend in the form of
shares by capitalizing the profit of current year and of past year. Such shares are
issued instead of paying dividend in cash.

3. Scrip Dividend

Cash position of company is temporarily weak. So shareholders are issued shares

if other companies held by the company as investment. Such payment of dividend
is called scrip’s dividend.
4. Bond dividend
Dividends are paid in the form of bond for long period bearing interest at fixed
rate. The effect of such dividend is the same as that of paying dividend in scrip’s.
5. Property Dividend

Dividend is paid in the form of asset instead of payment of dividend in cash.

Distribution of dividend is made whenever the asset is no longer required in the
business . Such investment or stock of finished goods.

Determinants of Dividend Policy (or) Factors

1. Stability of Earnings
Is one of the important factors influencing the dividend policy? If earning is
relatively stable. A firm is in a better position to predict what its future earnings
will be and such companies are more likely to pay out a higher percentage of its
earnings in dividends than a concern.
2.Financing Policy of the Company
Dividend policy may be affected and influenced by financing policy of the
company. If the company decides to meet its expenses from its earnings, then it
will have to pay less dividend to shareholders. On the other hand, if the company
feels that outside borrowing is cheaper than internal financing. Then it may
decide to pay higher rate of dividend to shareholders.
3.Liquidity of the firm
Payment of dividend means a cash outflows and hence, the greater the cash
position and liquidity of the firm is determined by the firms investment and
financing decisions. While the investment decisions the rate of asset expansion
and the firms needs for funds.
4.Dividend policy of Competitive concerns

Dividend policy of the other competitive concern in the market are paying higher
rate of dividend than this concern. The shareholders may prefer to invest their
money in those concerns rather than in this concern. Every company will have to
decide the dividend policy by keeping in view the dividend policy of other
competitive concern in the market.
5.Past Dividend Rate

The dividend rate may be decided on the basis of dividend declare in the previous
years. Generally the directors will have to keep in mind the rate of dividend
declared in the past.

6.Debt Obligations

A firm which has incurred heavy in debtness, is not in a position to pay higher
dividend to shareholders.

7.Ability to borrow

Every company requires finance both for expansion programmes as well as

meeting unanticipated expenses. Hence the company have to borrow from the
market. Lager firm have better access to the capital market than new and small
firms and hence, they can pay higher rate of dividend. The new companies
generally find it difficult to borrow from the market.

8.Growth need of the company

If the company has expansion programmes, it would need more money for growth
and development. When money for expansion is not needed then it is easy for the
company to declare high rate of dividend.

9.Legal Requirements

While declaring dividend , the board of directors will have to considered the legal
restriction. The Indian company act 1956 prescribed certain guidelines in respect
of declaration and payment of dividends and they are to be strictly observed by
the company for declaring dividends.

ASPECTS OF DIVIDEND POLICY

Relevance of Dividend
According to this concept, dividend policy is considered to affect the value of
the firm. Dividend relevance implies that shareholders prefer current dividend
and there is no direct relationship between dividend policy and value of the
firm. Relevance of dividend concept is supported by two eminent persons like
Walter and Gordon.

Walter’s Model

Walter model support the theory that dividend, are relevant. The choice of
dividend policies always affects the value of enterprises because dividend
policy maximizes the wealth of shareholders.

According to the Walter‘s model, the relationship between the return on a

firms investment (r) or and its cost of capital (k).

If the return on investment exceeds the cost of capital (r>k) and if the firm
has adequate profitable investment opportunities, then the firm should retain
the entire earnings within the firm. Such firm may be called growth firm. The
optimum dividend payout ratio for this type is zero percentage.

If a firm does not have profitable investment opportunities and if the cost
of capital exceeds the expected return on the firms investments (r<k) then the
firm should distribute the entire earnings as dividends. Such firm may be
called weak firms. The optimum dividend payout ratio is 100 percentages.

If the firms r=k then they are called normal firms. It is a matter of
indifference whether earnings are retained or distributed the market price of
shares will remain constant at all dividend payout ratio ranging between 0
parentages and 100 percentages.

Assumptions:

● The firm has 100 recent payout.

● The firm has constant EPS and dividend.
● The firm has a very long life.
● Walter has evolved a mathematical formula for determining the value of
market share.
Gordon’s Model

Gordon‘s model consists of the following important criticisms:

Gorden’s model is based on relevance of dividend concept according to it

dividends are relevant and dividend policy affects the value of the firm. His
basic valuation model is based on the following assumptions.

Assumptions
 The firm is an all equity firm.
 No external financing is used and investment progammes are financed
exclusively by retained earnings.
 The firm has perpetual life and its stream of earnings are perpetual.
 The corporate tax does not exist.

Modigliani Millers Approach

The dividend policy has no effect on the market price of the shares and the
value of the firm is determined by the earning capacity of the firm or its
investment policy. As observed by them, under conditions of perfect capital
markets, rational investors, absence of tax discrimination between dividend
income and capital appreciation, given the firms investment policy its
dividend policy may have no influence on the market price of the shares.

Assumptions
1. Capital Markets are perfect
2.All investors are rational
3.There are no transaction costs
4.there are no flotation costs.
Information is available to all free of cost.
No investor is larger enough to influence the market price of securities.
FORMS OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and
profitable position. On the basis of the dividend declaration by the firm, the
dividend policy may be classified under the following types:
● Regular dividend
● Stable dividend policy
● Irregular dividend policy
● No dividend policy.

Regular Dividend Policy

Dividend payable at the usual rate is called as regular dividend policy. This
type of policy is suitable to the small investors, retired persons and others.

Stable Dividend Policy

Stable dividend policy means payment of certain minimum amount of
dividend regularly. This dividend policy consists of the following three
important forms:
● Constant dividend per share
● Constant payout ratio
● Stable rupee dividend plus extra dividend.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful
business operation, they may follow irregular dividend policy. It is one of the
temporary arrangements to meet the financial problems. These types are
having adequate profit. For others no dividend is distributed.

No Dividend Policy
Sometimes the company may follow no dividend policy because of its
unfavorable
working capital position of the a mount required for future growth of the
concerns.
SHARE SPLIT

Definition
A corporate action in which a company's existing shares are divided
into multiple shares. Although the number of shares outstanding increases by
a specific multiple, the total dollar value of the shares remains the same
compared to pre-split amounts, because no real value has been added as a
result of the split.

Share split

Share split is the process of splitting shares with high face value into shares of
a lower face value.

● Alteration of shares
● Increase the number of outstanding shares
● Approval from board of directors

Reasons of share splits

● The price of their stock exceeds the amount smaller investors would be
willing to pay. it is aimed at making the stock more affordable and liquid
from retail investors point of view
● There are more buyers and sellers of shares trading Rs 100 than say Rs 400
as retail shareholders may find low price stocks to be better bargains.
 Legal, Procedural and Tax Aspects of Dividend Policy

1. Legal Aspects
The amount of dividend that can be legally distributed by company law.
 The important provisions of company law
 Companies can pay only cash dividend
 Dividend can be paid only out of the profits earned during the financial
year.

2. Procedural Aspects

1. Board Resolution
The dividend decision is the taken by the board of directors. Hence the board
of directors should in a formal meeting resolve to pay the dividend.

2. Shareholders Approval
The resolution of the board of directors to pay the dividend has to be
approved by the shareholders in the annual general meeting.

3. Record date
The dividend is payable to shareholders whose name appear in the register of
members as on the record date.

4. Dividend Payment
Once a dividend declaration has been made, dividend warrant must be posted
within 42 days, within a period of 7 days after the expiry of 42 days, unpaid
dividends must be transferred to a special account opened with a scheduled
bank.

3.Tax Aspects
A domestic company which declare pay dividend is liable to, in addition to
income tax in respect of total income, a 10 % dividend tax on distributed
profit under section 115 of the Income Tax Act.
 Unit – III IMPORTANT QUESTIONS

(2 Marks)
12. Define leverage?
13. Define Operating leverage?
14. Define financial leverage?
15. Define combined leverage?
16. What is Capital structure?
17. What is optimum Capital structure?
18. What are the forms of capital structure?
19. List out theories of capital structure.
20. What is dividend policy?
21. List out the determinants of dividend policy.
22. 11.What are the types of dividend policy?
23. What is stable dividend policy?
24. What is stock dividend?
25. What do you mean by bonus shares?

(16 Marks)

1. What is Capital Structure? Explain the factors determining the capitalStructure?

2. What is dividend policy? Explain the types of dividend policy itsadvantages and
limitations?
3. Explain its types of leverage.
4. Explain the factors determining the dividend policy?
5. List out the different forms of dividends?
6. Discuss various theories of dividend?
7. Explain various theories of capital structure?
8. Distinguish between Operating leverage and financial leverage?
 UNIT 4

WORKING CAPITAL MANAGEMENT

Working Capital

Funds required for the purchase of raw material, payment of wages and other
day to day expenses are known as working capital. Working capital
management is related with managing current asset and current liabilities and
inter relationship. It is an integral part of corporate management. The main
objectives of working capital management is profitability and liquidity.
Profitability offers satisfactory return on investment.
Liquidity ensures satisfactory financial obligations.
Concept of working capital
1.Gross Working capital
Amount of funds invested in the total current assets such as marketable
securities, inventories and bills receivable. Current asset are those assets
which are normally converted into cash within one year.
2.Net Working Capital
Difference between current asset and current liabilities. Current liabilities are
those claims of outsiders, which are expected to mature for payment within
one year and include creditors, bills payable, bank overdraft and outstanding
expenses.
There are two types

1. Positive working capital: when current asset exceed the current

liabilities

2. Negative working capital: when current liabilities exceed the current

assets.
Types of Working Capital
1.Permanent Working capital
Minimum amount of investment in all current assets required at all time to
carryout minimum level of business activity. This capital is permanently
blocked in current assets. The working capital remain permanent in current
asset and should be financed out of long term funds. The amount of various
from year to year depending upon the growth of company.
 There are two types

1. Regular working capital

Minimum amount of working capital required to ensure circulation of current

asset from cash in to inventories from inventories into receivables and from
receivable to cash.
2. Reserve Working capital

Is the excess amount over the requirement for regular working capital. Such
as strikes, rise in prices.
2.Temporaory Working capital
Additional working capital required for a short period. It is needed to meet the
seasonal demand at different times during a year. It is temporarily, hence it
should be financed out of short term funds.
There are two types
1. Seasonal working capital: working capital required to meet seasonal needs.
2. Special working capital: required to meet special purpose such as
lunching new product and research.

Operating Cycles
Cash – Inventory – Receivables
Operating cycle consist of three stages.
 Cash get converted into inventory. This is included purchase of raw
materials, conversion of raw material into work in progress, finished goods
finally the transfer of goods to stock at the end of Manufacturing Process.

 Inventory is converted into receivables as credit sales are made to

customer.

 When receivables are collected from debtors.

Working Capital Policy

The various working capital policies are

Liquidity policies

Under this policy, finance manager will increase the amount of liquidity for
reducing the risk of business. If business has high volume of cash and bank balance, then
business can easily pay his dues at maturity. But finance manager should not forget that the
excess cash will not produce and earning and return on investment will decrease. So
liquidity policy should be optimized.

Profitability policy

Under this policy, finance manager will keep low amount of cash in business and
try to invest maximum amount of cash and bank balance. It will sure that profit of business
will increase due to increasing of investment in proper way but risk of business will also
increase because liquidity of business will decrease and it can create bankruptcy position
of business. So, profitability policy should make after seeing liquidity policy and after this
both policies will helpful for proper management of working capital.

Matching or hedging approach/policy

This approach or policy is a moderate policy that matches assets and liabilities to
maturities. Basically, a firm uses long term sources to finance fixed assets and permanent
current assets and short term financing to finance temporary current assets

Example
A fixed asset/equipment which is expected to provide cash flow for 8 years should
be financed by say 8 years long-term debts .Assuming a firm needs to have additional
inventories for 2 months, it will then sought short term 2 months bank credit to match it.

Conservative approach/policy

● Conservative because the firm prefers to have more cash on hands

● Fixed and part of current assets are financed by long-term or permanent funds
● As permanent or long-term sources are more expensive, this leads to ―lower risk lower
return‖
● Having excess cash at off-peak period hence the need to invest the idle or excess cash to
earn returns.

Aggressive approach/policy

The firm wants to take high risk where short term funds are used to a very high degree to
finance current and even fixed assets.
Determinants of Working Capital Requirement
1. Nature of Business

● Working capital requirement depends upon the nature of its business

● Public utility undertaking like electricity, water supply and railways need very limited
working capital because they offer cash sales only supply services not products.
● Trading and financial firm require less investment in fixed asset but invest large amount
in current asset like inventories, receivables and cash.
● Manufacturing undertaking require working capital along with fixed investment

2. Size of Business / Scale of Operation

● Working capital requirement of a concern influenced by size of its business which is

measured in term s of scale of operation
● Size of business unit large- require more working capital
● Size of business unit small – require less working capital

3. Production Policy
● Production is based on seasonal variation.
● Requirement of working capital depends on production policy.
● Production is seasonal less working capital
● Production is carried out throughout the year the working capital requirement is more

4. Manufacturing Process / Length of Production cycle

● Longer the process or period of manufacture, larger the amount of working capital is
required
● Short the length of production cycle, smaller the amount of working capital requirement

5. Seasonal Variation

● For certain industries raw material is not available throughout the year.
● They have to buy raw material in bulk during the season and process them during the
entire year
● A huge amount is blocked in the form of inventories during such season which give rise
to more working capital requirement.
● During busy season a firm requires larger working capital than in the slack season.

6. Working capital cycle

● In manufacturing concern, the working capital cycle starts with the purchase of raw
material and ends with the realization of cash from the sale of finished products.

7. Business Cycle

● It refers to alternate expansion and contraction in general business activity.

● Boom period when business is prosperous – larger amount of working capital due to
increase in sales
● Depression – sales decline, difficulties are faced in collection from debtors and firms
may have larger amount of working capital requirement.
 8. Earning capacity of the Firm

● Some firms have more earning capacity than others due to quality of their products,
monopoly condition etc.
● Such firms with high earning capacity may generate cash profit from operation and to
contribute to their working capital.
● Dividend policy influences the requirement of working capital.

9. Credit policies
A company which allows credit to its customer will need higher amount of working capital.
Company enjoying credit facilities from its supplier will need less amount of working capital.

10. Changes in Technologies

After the requirements of working capital, the firm adopt labour intensive process, it require
more working capital, if it go for automation it improve the raw material processing. The
reducing wastages and make fast production hence the requirement of working capital is less.

Estimation of Working Capital Requirement

● Components such as cash, marketable securities, receivables and inventory

● Working capital management requires much of the financial managers time.
● It has greater significance for all firms but it is very critical for small firms
● The need for working capital is directly related to the firm’s growth.

Internal sources
● Retained Earnings
● Reserve and Surplus
● Depreciation Funds etc.
● External sources Public
● Deposits
● Loans from Banks and Financial Institutions
● Advances and Credit

WORKING CAPITAL FINANCE

Cash Credit – Under this facility, the bank specifies a predetermined limit and the
borrower is allowed to withdraw funds from the bank up to that sanctioned credit limit
against a bond or other security. However, the borrower cannot borrow the entire
sanctioned credit in lump sum; he can draw it periodically to the extent of his
requirements. Similarly, repayment can be made whenever desired during the period.
There is no commitment charge involved and interest is payable on the amount actually
utilized by the borrower and not on the sanctioned limit.

Overdraft – Under this arrangement, the borrower is allowed to withdraw funds in excess
of the actual credit balance in his current account up to a certain specified limit during a
stipulated period against a security. Within the stipulated limits any number of withdrawals
is permitted by the bank. Overdraft facility is generally available against the securities of
life insurance policies, fixed deposits receipts, Government securities, shares and
debentures, etc. of the corporate sector. Interest is charged on the amount actually
withdrawn by the borrower, subject to some minimum (commitment) charges.

Loans – Under this system, the total amount of borrowing is credited to the current
account of the borrower or released to him in cash. The borrower has to pay interest on the
total amount of loan, irrespective of how much he draws. Loans are payable either on
demand or in periodical instalments. They can also be renewed from time to time. As a
form of financing, loans imply a financial discipline on the part of the borrowers.

Bills Financing – This facility enables a borrower to obtain credit from a bank against its
bills. The bank purchases or discounts the bills of exchange and promissory notes of the
borrower and credits the amount in his account after deducting discount. Under this
facility, the amount provided is covered by cash credit and overdraft limit. Before
purchasing or discounting the bills, the bank satisfies itself about the creditworthiness of
the drawer and genuineness of the bill.

Letter of Credit – While the other forms of credit are direct forms of financing in which
the banks provide funds as well as bears the risk, letter of credit is an indirect form of
working capital financing in which banks assumes only the risk and the supplier himself
provide the funds.

Trade Credit
Trade credit is a form of short term financing common to almost all businesses. In
fact, it is the largest source of short term funds for business firms collectively. In an
advanced economy, most buyers are not required to pay for goods upon delivery but are
allowed a short deferment period before payment is due. During this period, the seller of
the goods extends credit to the buyer. Because suppliers generally are more liberal in the
extension of credit than are financial institutions, small companies in particular rely on
trade credit.

COD and CBD No, Extension of Credit: COD terms mean cash on delivery of the goods.
The only risk the seller undertakes in this type of arrangement is that the buyer may refuse
the shipment. Under such circumstances, the seller will be stuck with the shipping costs.
Occasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. Under
either COD or CBD terms, the seller does not extend credit. CBD terms must be
distinguished from progress payments, which are very common in certain industries. With
progress payments, the buyer pays the manufacturer at various stages of production prior
to actual delivery of the finished product. Because large sums of money are tied up in work
in progress, aircraft manufacturers request progress payments from airlines in advance of
the actual delivery of aircraft.

Net Period No Cash Discount: When credit is extended, the seller specifies the period of
time allowed for payment. The terms "net 30" indicate that the invoice or bill must be paid
within 30 days. If the seller bills on a monthly basis, it might require such terms as "net/15
EOM," which means that all goods shipped before the end of the month must be paid for
by the fifteenth of the following month.
Net Period with Cash Discount In addition to extending credit, the seller may offer a cash
discount if the bill is paid during the early part of the net period. The terms "2/10, net 30"
indicate that the seller offers a 2 percent discount if the bill is paid within 10 days;
otherwise, the buyer must pay the full amount within 30 days. Usually, a cash discount is
offered as an incentive to the buyer to pay early.

Bank Finance
Banks generally do not provide working capital finance without adequate security.
The nature and extent of security offered play an important role in influencing the decision
of the bank to advance working capital finance. The bank provides credit on the basis of
following modes of security:

Commercial Paper
Commercial paper is a fairly new instrument which was originated in US. It helps
private companies with good credit rating to raise money directly from the market and
investors. They raise money by issuing commercial papers in tight money market
conditions through sources other than banks. CP is a fairly popular instrument and exists in
most of the developed economies. Large corporate and private companies find CPs
cheaper, simpler and more flexible due to their better credit rating.

Main Characteristics of Commercial Paper are

● Commercial paper is a short term debt instrument (money market instrument) issued by
both financial and non-financial companies.
● These debt instruments are unsecured in nature, that is, they do not require any change
to be created on the company‘s assets.
● If the company fails to pay back the investors the amount of commercial papers after
their maturity, the investors cannot sell a particular asset and recover their dues.
● Commercial papers are discount instruments, which mean they are issued at discount
and redeemed at face value.
● IT can have different maturity periods but it varies within 1 year. In India, the mature
period varies between 90 days to 365 days.
● In India, RBI regulates the commercial paper instruments. Companies have to adhere to
the norms set by the RBI in order to raise money using commercial papers.
 RECEIVABLES MANAGEMENT

Concept of Receivables Management

The receivables are normally arising out of the credit sales of the firm.

What is meant by the accounts receivable?

It is an asset owed to the firm by the buyer out of the credit sales with the terms and
conditions of repayment on an agreed time period.

Meaning of the receivables management

The receivables out of the credit sales crunch the availability of the resources to
meet the day today requirements. The acute competition requires the firm to sustain among
the other competitors through more volume of credit sales and in the intention of retaining
the existing customers. This requires the firm to sell more through credit sales only in
order to encourage the buyers to grab the opportunities unlike the other competitors they
offer in the market.

Objectives of Accounts Receivables

● Achieving the growth in the volume of sales

● Increasing the volume of profits
● Meeting the acute competition

Cost of Maintaining the Accounts Receivables

Capital cost
Due to insufficient amount of working capital with reference to more volume of credit
sales which drastically affects the existence of the working capital of the firm. The firm
may be required to borrow which may lead to pay certain amount of interest on the
borrowings. The interest which is paid by the firm due to the borrowings in order to meet
the shortage of working capital is known as capital cost of receivables.

Administrative cost
Cost of maintaining the receivables.
Collection cost
Whatever the cost incurred for the collection of the receivables are known as collection
cost.

Defaulting cost
This may arise due to defaulters and the cost is in other words as cost of bad debts and so
on.
 Factors Affecting the Accounts Receivables

i) Level of sales
The volume of sales is the best indicator of accounts receivables. It differs from one firm
to another.

ii) Credit policies

The credit policies are another major force of determinant in deciding the size of the
accounts receivable. There are two types of credit policies viz lenient and stringent credit
policies.

Lenient credit policy

Enhances the volume of the accounts receivable due to liberal terms of the trade which
normally encourage the buyers to buy more and more.

Stringent credit policy

It curtails the motive buying the goods on credit due stiff terms of the trade put forth by
the supplier unlike the earlier.

iii) Terms of trade

The terms of the trade are normally bifurcated into two categories viz credit period and
cash discount

Credit period
Higher the credit period will lead to more volume of receivables, on the other side that will
lead to greater volume of debts from the side of buyers.

Cash discount
If the discount on sales is more, that will enhance the volume of sales on the other hand
that will affect the income of the enterprise.
 INVENTORIES

Inventories can be classified into five major categories.

Raw Material
● It is basic and important part of inventories. These are goods which have not yet been
committed to production in a manufacturing business concern. Work in Progress
● These include those materials which have been committed to production process but
have not yet been completed.

Consumables
● These are the materials which are needed to smooth running of the
● Manufacturing process.

Finished Goods
● These are the final output of the production process of the business
● concern. It is ready for consumers.

Spares
● It is also a part of inventories, which includes small spares and parts.

Objectives of Inventory Management

The major objectives of the inventory management are as follows:
● To efficient and smooth production process.
● To maintain optimum inventory to maximize the profitability.
● To meet the seasonal demand of the products.
● To avoid price increase in future.
● To ensure the level and site of inventories required.
● To plan when to purchase and where to purchase
● To avoid both over stock and under stock of inventory.

Techniques of Inventory Management

Inventory management consists of effective control and administration of inventories.

Inventory control refers to a system which ensures supply of required quantity and quality
of inventories at the required time and at the same time prevent unnecessary investment in
inventories. It needs the following important techniques.
Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is
the level when the business concern makes fresh order at this level.
Re-order level= maximum consumption × maximum Re-order period.

Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain.
If the quantity exceeds maximum level limit then it will be overstocking. Maximum level =
Re-order level + Re-order quantity
– (Minimum consumption × Minimum delivery period)

Danger Level
It is the level below the minimum level. It leads to stoppage of the production process.

Lead Time
Lead time is the time normally taken in receiving delivery after placing orders with
suppliers. The time taken in processing the order and then executing it is known as lead
time.

ABC ANALYSIS

ABC analysis is the technique of selective control over inventory. It is based on the
assumption that a firm does not exercise the same degree of control on all items of
inventory. It should keep greater control over the costly items than on the cheaper items.
Hence the inventories are divided into three categories.

Category A

The cost of these materials is high in value. Whereas the number of items is less.
Therefore, maximum attention should be paid to this category because it will increase the
cost of production.

Category B

The cost and the number of items of these materials are less. Therefore normal control
procedures may be followed.

Category C

The cost of these materials is very low whereas the number of items is high. Hence, it
needs simple and economic control procedures.
 Cash Management

Cash include coin, currency notes, cheques, bank draft and demand deposits
held by the firm.

Motive for Holding Cash

1. Transaction Motive
A firm has to involve in so many transactions in the course of the business.
These transactions may be either cash or credit transactions. If it is a cash
transaction, the firm needs cash to meet it out. For eg. Cash payment have to
be made for purchases, wages, operating expenses, interest, taxes and
dividend. At the same time, the firm may receive cash from sales and return
on investments, generally the inflow and out flow of cash do not coincide.
Therefore, it is the duty of the finance manager to plan for holding sufficient
cash to meet out the expenditure for the smooth conduct of the business.

2. Precautionary Motive
Precautionary motive refers to maintaining adequate cash to meet out the
unexpected cash needs at short notice. For eg. Strikes, dely in collection,
increase in cost of raw materials and the like are unexpected cash needs. To
meet such existence, cash balances are usually held in the form of marketable
securities so that they earn a return.

3. Speculative Motive
When the price of the raw material in the market is lower, naturally, the firm
may purchase in bulk and keep the same as stock. At the same time, when
price is higher, firm may delay the purchase of raw material expecting a
decline in the price. Hence to make a bulk purchase under such circumstances
the firm needs cash and holds for this purpose also. This is known as cash held
for speculative motive

4. Compensating Motive

It is the normal responsibility of the firm to maintain a minimum balance of

cash in the bank. This balance cant be utilized by the firm. It is used by the
bank to earn return. Since the bank renders services like collection of
cheques, arrangement of loan and overdraft, the firm is expected to hold a
 minimum balance of cash as a compensation for these services.

Objectives of cash management

Meeting the cash requirement

Meeting of cash requirements on time which normally involves in the

maintenance of the goodwill of the firm. The firm should keep the adequate
cash balances to meet the requirement which are greater in importance.

Minimizing the funds locked up in the cash balances

The funds locked up in the form of cash resources should be more, but it
should only to the tune of the requirement.

Basic Problems of Cash Management

Controlling level of cash

(a) Preparing the cash budget: Through the preparation of the budget, the cash
requirement could be identified which would normally facilitate the firm to
trim off the excessive cash in holding.
(b) Providing room for unpredictable discrepancies: The separate amount
should be maintained for the purpose to meet out the discrepancies which are
not easily foreseen.
Controlling of inflows of cash

(a) Concentration banking

The amount of collection from the local branches are normally deposited in a
particular account of the firm, as soon as the deposit has reached the certain
limit , the amount in the respective branch account will be transferred to the
account at where the firm maintains in the head office. This process of
transfer is normally taking place only through telegraphic transfer during the
early days but on now a day the anywhere banking is facilitated to transfer the
amount of deposit instantaneously.
Controlling of cash outflows
(a) Centralizing of disbursing the payments
The centralizing the process of payment may facilitate the enterprise to take
advantage of time in settling the payments i.e., reduces the need of immediate
cash requirements.
(b) Stretching payment schedule
 It is another methodology to avail the maximum possible credit period to
postpone the payment by making use of the cash resources most effectively.

Investing the excessive cash surplus

(a) Determine the need of the surplus cash

Identify the excessive cash resources which are kept simply idle more than
the requirement.

(b) Determination of the various avenues of investment

After identifying the various investment opportunities , the excessive cash
resources should be invested to earn appropriate rate of return during the
slack season at when the firm does not require greater volume of working
capital and vice versa.

Model of cash management

1. Baumol model

The basic objective of the Baumol model is to determine the minimum cost
amount of cash conversion and the lost opportunity cost.
It is a model that provides for cost efficient transactional balances and
assumes that the demand for cash can be predicated with certainty and
determines the optimal conversion size.

2. Orgler’s model
Orgler model provides for integration of cash management with production
and Other aspects of the business concern. Multiple linear programming
is used to determine the optimal cash management. Orgler‘s model is
formulated, based on the set of objectives of the firm and specifying the
set of constrains of the firm.
 Unit – IV IMPORTANT QUESTIONS

(2 Marks)

1. What is working capital management?

2.List out the concept of workingcapital

3. Mention the kinds of working capital

4. What are the different types of working capital policies?

5. Write any two factors determining working capital requirement?

6. Explain Gross Working capital concept?

7. Explain Net Working Capital Concept? 8.Write a note on inventory

management
9.Write about receivables management

10.What are the components of working

capital?

11.What is permanent or core working capital?

12.What is temporary working capital?
13. What is operating cycle?
14. What do you mean by management of inventory/stock?

15.What is cash management?

16.What is trade credit?

(16 Marks)
1. What are the important concepts of working capital?
2. Describe the essentials of working capital in manufacturing concern?
3. What are the factors which influence the amount of working capital
 requirements?
4. Describe the structure of working capital?
5. explain about inventory management
6. Discuss about cash management
7. Enumerate the concept of receivable management

8 Define factoring. State the mechanism involved in a factoring financial

service. 9.Explain Commercial Paper &bank finance
 UNIT 5

Venture Capital

Venture capital is understood in many ways. In a narrow sense, it refer to

investment in new and untried enterprises that are lacking a stable record of
growth. In border sense, venture capital refers to the commitment of capital as
shareholding for the formulation and setting up of small firms specializing in new
ideas or new technologies.

Meaning of Venture Capital

Venture capital is long term risk capital to finance high technology projects which
involve risk but at the same time has strong potential for growth. Venture
capitalists pool their resources including managerial abilities to assist new
entrepreneurs in the early years of the project. Once the project reaches the stage of
profitability, they sell their equity holdings at high premium.

Definitions

A venture capital company is defined as a financing institution which join an

entrepreneur as a co promoter in a project and shares the risks and rewards of the
enterprises.

Features

 Venture capital is usually in the form of an equity participation. It may also

take the form of convertible debt or long term loan.

 Investment is made only in high risk but high growth potential projects.

 Venture capital is available only for commercialization of new ideas or new

technologies and not for enterprises which are engaged in trading, broking,
financial services, agency, research and development.
  There is a continuous involvement in business after making an investment
by the investor.
 Investment is usually made in small and medium scale enterprises.

Scope of Venture capital

Venture capital may take various forms at different stages of the project. There are
four successive stages of development of project. Development of project idea,
implementation of the idea, commercial production and marketing and finally large
scale investment to exploit the economics of scale and achieve stability.

1.Development of an Idea – seed Finance

In the initial stage venture capitalist provide seed capital for translating an idea into
business proposition. At this stage investigation is made in-depth which normally
takes a year or more.

2.Implementation Stage – start up finance

When the firm is set up to manufacture a product or provide a service, start up

finance is provided by the venture capitalists. The first and second stage capital is
used for full scale manufacturing and further business growth.

3.Fledging Stage – additional finance

In the third stage, the firm has made some headway and entered the stage of
manufacturing a product but faces teething problems. It may not be able to
generate adequate funds and so additional round of financing is provided to
develop the marketing infrastructure.

4.Establishment stage – Establishment finance

At this stage the firm is established in the market and expected to expand at a
rapid place. It need further financing for expansion and diversification so that it
can reap economics of scale and attain stability. At the end of the establishment
stage, the firm is listed on the stock exchange and at this point the venture
capitalist disinvests their shareholdings through available exist routes.
Importance of venture capital

1. Advantages to investing public

 The investing public will be able to reduce risk significantly against
unscrupulous management. If the public invest in venture fund who in turn
will invest in equity of new business. With their expertise in the field and
continuous involvement in the business they would be able to stop
malpractices by management.

 Investor has no means to vouch for the reasonableness of the claims made by
the promoters about profitability of the business. The venture funds
equipped with necessary skills will be able to analyze the prospects of the
business.

 The investors do not have any means to ensure that the affairs of the
business are conducted prudently. the venture fund having representatives on
the board of directors of the company would overcome it.

2. Advantages to promoters
 The entrepreneur for the success of public issue is required to convince tens
of underwriters, brokers and thousands of investors but to obtain venture
capital assistance; he will be required to sell his idea to justify the officials
of the venture fund.

 Public issue of equity fund has to be preceded by a lot of efforts. Necessary

statutory sanctions, underwriting and brokers arrangement. Publicity of issue
etc.
 The entrepreneurs find it very difficult to make underwriting arrangement, as
nobody would take risk with them. All these arrangements require a great
deal of effort.

3. General
 A developed venture capital institutional set up reduces the time lag between
a technological innovation and its commercial exploitation.
  It helps in developing new processes / products in conducive atmosphere,
free from the dead weight of corporate bureaucracy, which helps in
exploiting full potential.

 A venture capital firm serves as an intermediary between investors looking

for high returns for their money and entrepreneurs in search of needed
capital for their start ups.

Method of Venture financing

Venture capital available in three forms in India.
1.Equity
2.Conditional Loan
3.Income Note

1.Equity: all venture capital finance in India provide equity but generally their
contribution does not exceed 49 percentage of the total equity capital. Venture
capital finances but equity shares of an enterprises with an intention to ultimately
sell off to make capital gain.

2.Conditional loan
A conditional loan is repayable in the form of royalty after the project generates
sales. No interest is paid on such loans. Venture capital finance charge royalty
ranging between 2 and 15 percent.

3.Income Note
An income note combines the features of both conventional loan and conditional
loan. The entrepreneur has to pay both interest and royalty on sales.

At present several venture capital firms are incorporated in India and they
promoted either by all India financial institutions like IDBI,ICICI,IFCI, State level
financial institution, public sector banks or promoted by foreign bank.

IDBI Venture capital fund

The initial impetus was given by IDBI technology division when venture capital
fund was set up in 1986 for encouraging commercial application of indigenously
developed technology and adopting imported technology.

Salient features
 1. Financial assistance under the scheme is available to projects whose
requirements range between Rs.5 lakhs and 2.5 crores. The promoters stake
should be at least 10 percent for the ventures below Rs.50 lakhs and 15
percent for those above Rs.50 lakhs.
2. Assistance was extended in the form of unsecured loan involving minimum
legal formalities. Interest at a concessional rate of 9 percent is charged
during technology development and trial run production and 17 percent once
the product is introduced in the market.

2.Technology Development and Information Company of India Limited

(TDICI -1988)

 The venture capital fund was jointly created by industrial credit and
Investment Corporation of India and unit trust of India to finance projects of
professional technologies in the small and medium size industries who take
initiatives in designing and developing indigenous crores was subscribed
equally by ICICI and UTI under the new venture capital unit scheme I of
UTI.

 The TDICI second venture fund of Rs.100 crores has been contributed by
UTI,ICICI, other financial institutions, banks, corporate sector etc. by 31,
March 1993. TDICI had provided a cumulative financial assistance of Rs.
79.29 crore. The scheme II in a variety of industries such as computers,
electronics, bio technology, medical, non conventional energy etc. many of
these projects are set up by first generation entrepreneurs.

3.Gujarath Venture Finance Ltd

 The Gujarath industrial investment corporation promoted Gujarat venture
finance ltd. The first state level venture finance company to begin venture
finance activities since 1990. It provides financial support to the ventures
whose requirements range between 25 lakhs and 2 crore. GUFL provides
finance through equity participation and quasi equity instruments. The firm
engaged in bio technology, surgical instruments, conversion of energy and
food processing industries are covered by GUFL.

4.Canara Bank
 Canara bank has set up a venture capital fund called canbank venture capital
fund worth Rs.10 crore. It has sanctioned Rs.10 crores to 33 projects as on
March 1992 in diverse fields like chemicals, machines, food stuffs etc.
5.Credit Capital venture fund limited
 The first private sector venture capital fund called credit capital venture fund
ltd. was set up by credit Capital Corporation limited in April 1989 with an
authorized capital of Rs.10 lakhs. It provides entrepreneurs who have ideas
and ability, but no finance, with equity capital for new Greenfield projects. It
main thrust area would be export oriented industries and technology orated
projects.

LEASE FINANCING

Lease financing is one of the popular and common methods of assets based
finance, which is the alternative to the loan finance. Lease is a contract. A
contract under which one party, the leaser (owner) of an asset agrees to grant
the use of that asset to another leaser, in exchange for periodic rental
payments.
Lease is contractual agreement between the owner of the assets and user of
the assets for a specific period by a periodical rent.
Definition
Lease may be defined as a contractual arrangement in which a party owning
an asset provides the asset for use to another, the right to use the assets to the
user over a certain period of time, for consideration in form of periodic
payment, with or without a further payment.

Elements of Leasing
● Parties: These are essentially two parties to a contract of lease financing,
namely the owner and user of the assets.
● Leaser: Leaser is the owner of the assets that are being leased. Leasers
may be individual partnership, joint stock companies, corporation or
financial institutions.
● Lease: Lease is the receiver of the service of the assets under a lease
contract. Lease assets may be firms or companies
● Lease broker: Lease broker is an agent in between the leaser (owner) and
lessee. He acts as an intermediary in arranging the lease deals. Merchant
 banking divisions of foreign banks, subsidiaries Indian banking and private
foreign banks are acting as lease brokers.
● Lease assets: The lease assets may be plant, machinery, equipment’s,
land, automobile, factory, building etc.

Steps involved in Leasing Transaction

 The lessee has to decide the asset required and select the supplier, he has to
decide about the design specifications, the price, warranties, terms of
delivery, servicing etc.

 The lessee, then enters into a lease agreement with the lessor, the lease
agreement contains the terms and conditions of the lease such as

 (a). the basic lease period during which the lease is irrecoverable.

 (a). the timing and amount of periodical rental payments during the lease
period.

 Details of any option to renew the lease or to purchase the asset at the end
of the period.

 Details regarding payment of cost of maintenance and repairs, taxes,

insurance and other expenses.
Types of lease

1. Operating lease
 Operating lease is also called as service lease. Operating lease is one of
the short-term and cancelable leases. It means a lease for a time shorter
than the economic life of the assets, generally the payments over the
term of the lease are less than the leaser‘s initial cost of the leased
asset. For example: Hiring a car for a particular travel. It includes all
expenses such as driver salary, maintenance, fuels, repairs etc. this
means that the lease is for a limited period, may be a month, six
months, a year of few years. The lease is terminable by giving
stipulated notice as per the agreement. Normally, the lease rentals will
be higher as compared to other leases on account of short period of
primary lease.
  When the lease belongs to the owner of the assets and users of the
assets with direct relationship it is called as direct lease. Direct lease
may be Dipartite lease (two parties in the lease) or tripartite lease.
(Three parties in the lease)

 The operating lease is suitable for computers, copy machines and other
office equipments, vehicles, material handling equipments etc.

2. Financial Lease
 A financial lease is also known as capital lease, long term lease, net
lease and close ended lease. In a financial lease, the lessee selects the
equipments, settles the price and terms of sale and arranges with a
leasing company to buy it. He enters into a irrevocable and non
cancellable contractual agreement with the leasing company. The lessee
uses the equipment exclusively, maintains it, insures and avails of the
after sales service and warranty backing it. He also bears the risk of
obsolescence as it stands committed to pay the rentals for the entire
lease period.

 The financial lease could also be with purchase option. Where at the
end of the predetermined period. The lessee has the option to buy the
equipment at a predetermined value or at a nominal value or at fair
market price. The financial lease may also contain a non cancellable
clause which means that the lessor transfer the title to the lessee at the
end of the lease period. Financial lease is very popular in India as in
other countries like USA,UK and Japan. On an all India basis, at
present, approximately a lease worth Rs.75 to Rs.100 crores is
transacted as a tax planning device. The high cost equipments such as
office equipment, diesel generators, machine tools, textile machinery,
containers, are leased under financial lease.

3.Single investor lease

 When the lease belongs to only two parties namely leaser and it is
called as single investor lease. It consists of only one investor (owner).
Normally all types of leasing such as operating, financially, sale and
lease back and direct lease are coming under these categories.
4. Leverage lease
This type of lease is used to acquire the high level capital cost of assets and
equipment’s. Under this lease, there are three parties involved; the leaser, the
lender and the lessee. Under the leverage lease, the leaser acts as equity
participant supplying a fraction of the total cost of the assets while the lender
supplies the major part.

4.Domestic lease
In the lease transaction, if both the parties belong to the domicile of the same
country it is called as domestic leasing.

5.International lease
If the lease transaction and the leasing parties belong to the domicile of
different Countries, it is called as international leasing.

Advantages of Leasing

Leasing finance is one of the modern sources of finance, which plays a major
role in the part of the asset based financing of the company. It has the
following important advantages.

1. Financing of fixed asset

Lease finance helps to mobilize finance for large investment in land and
building, Plant and machinery and other fixed equipment’s, which are used in
the business concern.
Lease rent is fixed by the lease agreement and it is based on the assets which
are used by the business concern. Lease rent may be less when compared to
the rate of interest payable to the fixed interest leasing finance like debt or
loan finance.
 2. Simplicity
Lease formalities and arrangement of lease finance facilities are very simple
and easy. If the leaser agrees to use the assets or fixed equipment by the
lessee, the leasing arrangement is mostly finished.

3. Transaction cost
When the company mobilizes finance through debt or equity, they have to pay
some amount as transaction cost. But in case of leasing finance, transaction
cost or floating cost is very less when compared to other sources of finance.

Leasing by Specialized Institutions

Specialized financial institutions also provide lease finance to the industrial

concern.
Some of the lease finance providing institutions are as follows:
• Life Insurance Corporation of India (LIC)
• General Insurance Corporation of India (GIC)
• Unit Trust of India (UTI)
• Housing Development Finance Corporation of India (HDFC)
Private Sector Leasing Company

Private sector leasing companies also provide financial assistance to the

industrial concerns.
The following are the example of the private sector leasing companies in
India:
o Express Leasing Limited
o 20th Century Leasing Corporation Ltd.
o First Leasing Company of India
o Mazda Leasing Limited
o Grover Leasing Limited
 Private Sector Financial Company
Private sector financial companies also involve in the field of leasing finance.
The following are the example of the private sector finance companies:
• Cholamandal Investment and Finance Company Ltd.
• Dcl Finance Limited
• Sundaram Finance Limited
• Anagram Finance Limited
• Nagarjuna Finance Limited.

HIRE PURCHASE

Introduction
Hire purchase is a mode of financing the price of the goods to be sold on a
future date. In a hire purchase transaction, the goods are let on hire, the
purchase price is to be paid in installments and hirer is allowed an option to
purchase the goods by paying all the installments. Hire purchase is a method
of selling goods. In a hire purchase transaction the goods are let out on hire by
a finance company (creditor) to the hire purchase customer (hirer). The buyer
is required to pay an agreed amount in periodical installments during a given
period. The ownership of the property remains with creditor and passes on to
hirer on the payment of the last installment.

A hire purchase agreement is defined in the Hire Purchase Act,

1972 as peculiar kind of transaction in which the goods are let on hire with an
option to the hirer to purchase them, with the following stipulations:

a. Payments to be made in installments over a specified period.

b. The possession is delivered to the hirer at the time of entering into
the contract.
c. The property in goods passes to the hirer on payment of the last
installment.
 d. Each installment is treated as hire charges so that if default is made
in payment of any installment, the seller becomes entitled to take
away the goods, and
e. The hirer/ purchase is free to return the goods without being required
to pay any further installments falling due after the return.
Features
▪ Under hire purchase system, the buyer takes possession of
goods immediately and agrees to pay the total hire purchase
price in installments.
▪ Each installment is treated as hire charges.
▪ The ownership of the goods passes from the seller to the buyer
on the payment of the last installment.
▪ In case the buyer makes any default in the payment of any
installment the seller has right to repossess the goods from the
buyer and forfeit the amount already received treating it as
hire charges.
▪ The hirer has the right to terminate the agreement any time
before the property passes. That is, he has the option to return
the goods in which case he need not pay installments falling
due thereafter. However, he cannot recover the sums already
paid as such sums legally represent hire charges on the goods
in question.

H ire Purchase Agreement

● Nature of Agreement: Stating the nature, term and commencement of the

agreement.
● Delivery of Equipment: The place and time of delivery and the hirer‘s
liability to bear delivery charges.
● Location: The place where the equipment shall be kept during the period
of hire.
● Inspection: That the hirer has examined the equipment and is satisfied
with it.
● Repairs: The hirer to obtain at his cost, insurance on the equipment and to
hand over the insurance policies to the owner.
● Alteration: The hire not to make any alterations, additions and so on to
the equipment, without prior consent of the owner.
● Termination: The events or acts of hirer that would constitute a default
eligible to terminate the agreement.
● Risk: of loss and damages to be borne by the hirer.
● Registration and fees: The hirer to comply with the relevant laws, obtain
registration and bear all requisite fees.
● Indemnity clause: The clause as per Contract Act, to indemnify the lender.
● Stamp duty: Clause specifying the stamp duty liability to be borne by the
hirer.
● Schedule: of equipment forming subject matter of agreement.
● Schedule of hire charges: The agreement is usually accompanied by a
promissory note signed by the hirer for the full amount payable under the
agreement including the interest and finance charges.
DIFFERENCE BETWEEN LEASING AND HIRE-PURCHASE
INDIAN CAPITAL MARKET

Capital market is the market for long term funds. It refers to all the facilities
and the institutional arrangements for borrowings and lending term funds. It
does not deal in capital goods but is concerned with the raising of money
capital. The demand for long term money capital comes predominantly from
private sector manufacturing industries and from the government, largely for
the purpose of economic development and to very small extent from
agriculture. As the central and state governments are investing not only on
economic overheads as transport irrigation and power development but also
on basic industries and sometimes even consumer goods industries, they
require substantial sums from the capital market.

Capital Market in India

Government Securities Market

This is also known as the Gilt-edged market. This refers to the market for
government and semi- government securities backed by the Reserve Bank of
India (RBI).

Industrial Securities Market

This is a market for industrial securities i.e. market for shares and debentures
of the existing and new corporate firms. Buying and selling of such
instruments take place in this market. This market is further classified into
two types such as the New Issues Market (Primary) and the Old (Existing)
Issues Market (secondary). In primary market fresh capital is raised by
companies by issuing new shares, bonds, units of mutual funds and
debentures. However in the secondary market already existing i.e old shares
and debentures are traded. This trading takes place through the registered
stock exchanges. In India we have three prominent stock exchanges. They are
the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE) and
over the Counter Exchange of India (OTCEI).

Development Financial Institutions (DFIs) : This is yet another important

segment of Indian capital market. This comprises various financial
institutions. These can be special purpose institutions like IFCI, ICICI, SFCs,
IDBI, IIBI, UTI, etc. These financial institutions provide long term finance
for those purposes for which they are set up.

Features of the Indian Capital Market

1.Greater reliance on debt instruments as against equity and in particular,
borrowing from financial institutions.

2.Issue of debentures, particularly convertible debentures with automatic or

compulsory conversion into equity without the normal option given investors.

3.Avoidance of underwriting by some companies to reduce the costs and

avoid scrutiny by the FIs.

4.Fast growth of mutual funds and subsidiaries of banks for financial service
leading to larger mobilization of savings from the capital market.

Functions of Capital Market

1.Mobilize Savings
The capital market in India mobilizes savings of the members of public and
industrial concern. Such savings are then utilized for the economic
development of the country.

2.Leanding funds

The capital market facilities to lend fund to various industrial concerns. The
industrial concern can borrow long term funds from various financial
institutions.

3.Direct collection of funds

The primary market makes it possible to collect funds from the market.
Interested individuals or corporate bodies subscribe for the issue of shares and
debentures.

4.Acts as a link
The capital market acts as a link between those who save and who are
interested in investing these savings.
5.Profitable use of funds

Capital market makes it possible to make productive and profitable use of

funds. This is because the funds, which are lying idle with the owners, are
utilized by industrial enterprises in a profitable manner, thus bringing rewards
to the investors, user and the society.

Role of capital market in india’s Industrial Growth

1.Mobilisation of savings and acceleration of capital formation

In developing countries like India plagued by paucity of resources and

increasing demand for investments by industrial organizations and
governments, the importance of the capital market is self evident. In this
market, various type of securities help mobilize savings from various section
of the population.

2.Promotion of industrial growth

The stock exchange is a central market through which resources are

transferred to the industrial sector of the economy. The existence of such an
institution encourages people to invest in productive channel rather than in the
unproductive sector like real estate etc.

3.Raising the long term capital

The existence of a stock exchange enables companies to raise permanent

capital. The investor cannot commit their funds for a permanent period but
companies require funds permanently.

4.Ready to Continues market

The stock exchange provides a central convenient place where buyers and
sellers can easily purchase and sell securities. The element of easy
marketability makes investment in securities more liquid as compared to other
assets.
 5.Provision of a variety of services

 The financial institutions functioning in the capital market provide a

variety of services, the more important ones being the following

 Grant a long term and medium term loans to entrepreneurs to enable

them to establish, expand or modernize business units.

 Provision of underwriting facilities.

 Assistance in the promotion of companies.

 Participation in equity capital

 Expert advice on management of investment in industrial securities.

New Issue Market

New issue market is for sale of new securities. It made in appeal to investors to
purchase and supply capital. There are two parties in the new issue market.
Firstly, companies issuing new securities and secondly individuals and
institutional investors interested in purchasing securities. There are several
intermediary agencies such as promoters, underwriters, and brokers etc. who
bring the companies and investors closer to interaction. The demand for the
securities of a company comes from large number of investors like businessmen,
potential customer of the company, its employees, intuitional investors and
present holders of equity shares of the company.

Secondary Market

This is also known as stock market. In this market buying and selling of second
hand are transacted
Financial Intermediaries
The fourth important segment of the Indian capital market is the financial
intermediaries. This comprises various merchant banking institutions, mutual
funds, leasing finance companies, venture capital companies and other
financial institutions.

LONG TERM FINANCE

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

❖ Long-term sources of finance.

❖ It is also called as corporate securities.
❖ Security finance includes both shares and debentures.
❖ It plays a major role in deciding the capital structure of the company.
❖ Repayment of finance is very limited.
❖ It is a major part of the company‘s total capitalization.
SHARES
Equity Shares also known as ordinary shares, which means, other than
preference shares. Equity shareholders are the real owners of the company.
They have a control over the management of the company. Equity
shareholders are eligible to get dividend if the company earns profit.

Equity share capital cannot be redeemed during the lifetime of the

company. The liability of the equity shareholders is the value of unpaid
value of shares.

Features of Equity Shares

1. Maturity of the shares: Equity shares have permanent nature of capital,

which has no maturity period. It cannot be redeemed during the lifetime of
the company.
 2. Residual claim on income: Equity shareholders have the right to get
income left after paying fixed rate of dividend to preference shareholder.
The earnings or the income available to the shareholders is equal to the
profit after tax minus preference dividend.

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

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

4. Right to control
Equity shareholders are the real owner of the company. Hence, they have
power to control the management of the company and they have power to
take any decision regarding the business operations
5. Voting rights
Equity shareholder only has voting right in the company meeting

Preference Shares

The part of corporate securities are called as preference shares, which have
preferential right to get dividend and get take the initial investment at the time of
winding up of the company. Preference shareholders are eligible to get fixed rate
of dividend and they do not have voting rights.

Cumulative preference Shares

Cumulative preference shares have right to claim dividend for those year which
have no profit. If the company is unable to earn profit in any one or more years.
Cumulative preference shares are unable to get any dividend but they have right
to get comparative dividend for the previous years if the company earned profit.

Non Commutative Preference Shares

They are eligible to get only dividend , if the company earns profit during the
years otherwise they cannot claim any dividend.
Redeemable preference shares:

When, the preference shares have a fixed maturity period it becomes redeemable
preference shares. It can be redeemable during the lifetime of the company. The
Company Act has provided certain restrictions on the provided certain restrictions
on the return of the redeemable..
Irredeemable Preference Shares: Irredeemable preference shares can be
redeemed only when the company goes for liquidator. There is no fixed maturity
period for such kind of preference shares.

Participating Preference Shares: Participating preference shareholders have

right to participate extra profits after distributing the equity shareholders.

Non-Participating Preference Shares: Non-participating preference

shareholders are not having any right to participate extra profits after distributing
to the equity shareholders. Fixed rate of dividend is payable to the type of
shareholders.

Convertible Preference Shares: Convertible preference shareholders have right

to convert their holding into equity shares after a specific period. The articles of
association must authorize the right of conversion.

Non-convertible Preference Shares: There shares, cannot be converted into

equity shares from preference shares.

Features of Preference Shares: The following are the important features of the
preference shares:

● Maturity period: Normally preference shares have no fixed maturity

Period except in the case of redeemable preference shares. Preference
shares can be redeemable only at the time of the company
liquidation.

● Residual claims on income: Preferential shareholders have a residual

claim on income
Fixed rate of dividend is payable to the preference shareholders.
 ● Residual claims on assets: The first preference is given to the
preference shareholders at the time of liquidation. If any extra Assets
are available that should be distributed to equity shareholder.
● Control of Management: Preference shareholder does not have any
voting rights. Hence, they cannot have control over the management of
the company.

Advantages of Preference Shares

Preference shares have the following important advantages.

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

shares.

● Cumulative dividends: Preference shares have another advantage which is

called cumulative dividends. If the company does not earn any Profit in any
previous years, it can be cumulative with future period dividend.

● Redemption: Preference Shares can be redeemable after a specific period

except in the case of irredeemable preference shares. There is a fixed
maturity period for repayment of the initial investment.
● Participation: Participative preference shareholders can participate in the

● No voting right: Generally preference shareholders do not have any

voting rights. Hence they cannot have the control over the management of
the company.

● Fixed dividend only: Preference shares can get only fixed rate of
dividend. They may not enjoy more profits of the company.

● Permanent burden: Cumulative preference shares become a permanent

Burden so far as the payment of dividend is concerned. Because the
company must pay the dividend for the unprofitable periods also.
● Taxation: In the taxation point of view, preference shares dividend is not
a deductible expense while calculating tax. But, interest is a deductible
expense. Hence, it has disadvantage on the tax deduction point of view.
 DEFERRED SHARES
Deferred shares also called as founder shares because these shares were
normally issued to founders. The shareholders have a preferential right to get
dividend before the preference shares and equity shares. According to
Companies Act 1956 no public limited company or which is a subsidiary of a
public company can issue deferred shares. These shares were issued to the
founder at small denomination to control over the management by the virtue
of their voting rights.

Debenture
Creditor ship Securities also known as debt finance which means the finance
is mobilized from the creditors. Debenture and Bonds are the two major parts
of the Creditor ship Securities.

A Debenture is a document issued by the company. It is a certificate issued by

the company under its seal acknowledging a debt.
According to the Companies Act 1956,―debenture includes debenture
stock,
Bonds and any other securities of a company whether constituting a charge of
the assets of the company or not.

Types of Debentures
Debentures may be divided into the following major types:

1. Unsecured debentures: Unsecured debentures are not given any security on

assets of the company. It is also called simple or naked debentures. This type
of debentures are treaded as unsecured creditors at the time of winding up of
the company.

3. Redeemable debentures: These debentures are to be redeemed on the

debentures
6. Other types: Debentures can also be classified into the following types.
Some of the common types of the debentures are as follows:
▪ Collateral Debenture
▪ Guaranteed Debenture
▪ First Debenture
 ▪ Zero Coupon Bond
▪ Zero Interest Bond/Debenture

Features of Debentures
1. Maturity period: Debentures consist of long-term fixed maturity period.
Normally, debentures consist of 10–20 years maturity period and are
repayable with the principle investment at the end of the maturity period
preference shareholders.
3. Residual claims on asset: Debenture holders have priority of claims on
Assets of the company over equity and preference shareholders. The
Debenture holders may have either specific change on the Assets or floating
change of the assets of the company. Specific change of
Debenture holders are treated as secured creditors and floating change of
Debenture holders are treated as unsecured creditors.