I YEAR I SEMESTER

For Telangana University

FINANCIAL
MANAGEMENT

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 FINANCIAL MANAGEMENT SYLLABUS

UNIT-I: FINANCIAL MANAGEMENT - BASIC CONCEPTS:

Financial Management - Meaning, Goals and Objectives - Functions of a finance
manager - Financial decision-making; Concept and relevance of Time Value of Money
- Compounding technique - Discounting technique (Simple applications of the time
value of money).

UNIT-II: INVESTMENT DECISIONS:

Nature of Investment decision - Features and significance of Capital budgeting - Types
of Capital budgeting decisions - Capital budgeting process - Cash flows estimation -
Methods/Techniques of Evaluation -Traditional techniques - Payback period method -
Accounting Rate of Return (ARR) method - Discounted Cash Flows (DCF)
methods/techniques - Net Present Value (NPV) method - Internal Rate of Return (IRR)
method - Reciprocal Rate of return method - Profitability Index - Criteria for Selection
of a project - Evaluation and Interpretation of all the methods - Issues in Capital
budgeting. Financial feasibility aspects - Capital rationing (including problems).

UNIT-III: RISK ANALYSIS IN CAPITAL BUDGETING AND COST OF

CAPITAL:
Risk: meaning and nature - Risk adjusted discount rate - Certainty Equivalent
(including Problems) -Statistical Techniques to handle risk - Probability Assignments -
Standard Deviation and Coefficient of Variation - Probability Distribution approaches -
Decision Tree Analysis (theory only)
Cost of Capital: Concepts - Importance - Specific cost of capital for various sources of
finance - Cost of Debt - Cost of Preference Capital - Cost of Equity Capital - Cost of
External Equity - Cost of Retained Earnings - Weighted Average Cost of Capital - Book
Value and Market Value Weights and Marginal Cost of Capital (including problems)

UNIT-IV: FINANCING AND DIVIDEND DECISIOINS:

Leverage: Concepts - Operating Leverage: Meaning and measurement - Financial
leverage: Meaning and measurement - Degree of Financial and Operating Leverages -
Combined Leverage: Meaning, measurement and importance EBIT- EPS Analysis with
different financing patterns - Indifference point/level of EBIT. (Including simple
problems) Capital structure: Meaning - Determinants of Capital Structure - Optimum
Capital Structure
- Capital Structure Theories - Net Income Approach. Net Operating Income approach -
Traditional view - M.M.Hypothesis (theory only).
Dividend decisions: Concept and significance - Types - Dividend policy and value of
the firm - Determinants of dividend decision - Relevance of dividend decision (Walter‘s
Model - Gordon‘s Model) - Irrelevance of dividend policy (Residuals theory of
dividends, MM Approach - Dividend policy and share value - Legal and procedural
considerations
(Including Simple Problems on approaches to Dividend policy).

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UNIT-V: WORKING CAPITAL MANAGEMENT:
Concepts of Working Capital - Determinants of Working Capital -Optimum level of
current assets - Liquidity vs. Profitability - Risk Return Trade off. Estimating Working
Capital needs (including Simple Problems). Objectives and importance of Cash
Management, Receivables Management and Inventory Management (including
problems on cash management and receivables management).

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 UNIT-1 (THEORY)

FINANCIAL MANAGEMENT DEFINITION

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement of funds in the most economic manner and
employment of those funds in the most optimum way.

It means applying general management principles to financial resources of the

enterprise.

SCOPE / ELEMENTS OF FINANCIAL MANAGEMENT:

1. Financial Decisions

2. Investment Decisions

3. Dividend Decisions

Financial Decisions

Financial Decisions relate to the raising of funds from various resources. It

depends on the type of source (debt or equity), the period of financing, cost of financing
and the returns thereby.

Investment Decisions

Investment Decisions includes investment in fixed assets (known as capital

budgeting). Investment in current assets (working capital) is also a part of investment
decision.

Dividend Decisions

The Finance Manager has to take a decision with regards to the net profit
distribution. Net profits are generally divided into two parts:

 The dividend for Shareholders: Dividend and the rate of the dividend need to
be decided.
 Retained Earnings: Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.

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FUNCTIONS OF FINANCIAL MANAGEMENT / MANAGER:

1. Estimation of Capital Requirement: Estimation depends upon expected costs,

profits, future programs and policies of a firm. Estimation must be adequate, as it can
increase the earning capacity of the firm.

2. Determination of Capital Composition: It is based on long term-short term debt

equity analysis. This will depend upon the proportion of equity capital a company is
processing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: Choice of funds depends upon the relative merits and
demerits of each resource. Various sources of funds are:

 Issue of shares and debentures

 Loans to be taken from banks and financial institutions
 Public deposits to be drawn, like in the form of bonds

4. Investment of Funds: Financial Manager has to decide to allocate funds into

profitable ventures so that there is safety on investment and regular returns are possible.

5. Disposal of surplus: It refers to the decisions on the net profits made about the
dividend declaration and retained earnings.

6. Management of cash: The Financial manager has to make decisions with regards to
cash management. It is required for many purposes like payment of wages and salaries,
bills, creditors, maintenance of stock, raw materials, etc.

7. Financial Control: Financial Manager not only has to plan, procure and utilize funds
but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

OBJECTIVES OF FINANCIAL MANAGEMENT:

1. Wealth Maximization: The one of the most important objective of financial managers
is to maximize the value of shares of their shareholders.

2. Profit Maximization

3. Focus on stakeholders: Stakeholders are those entities who have invested in shares
and the interest of those people that a firm can’t ignore.

4. Estimation of capital requirement

5. Arranging of required funds

6. Optimum utilization of funds

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7. Management of cash position or balance

8. Coordination with other functions or department

GOALS OF FINANCIAL MANAGEMENT

All businesses aim to maximize their profits, minimize their expenses and maximize
their market share. Here is a look at each of these goals.

Maximize Profits A company's most important goal is to make money and keep it.
Profit-margin ratios are one way to measure how much money a company squeezes
from its total revenue or total sales.

There are three key profit-margin ratios: gross profit margin, operating profit margin
and net profit margin.

1. Gross Profit Margin

The gross profit margin tells us the profit a company makes on its cost of sales or cost
of goods sold. In other words, it indicates how efficiently management uses labour and
supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales

The gross profit margin is used to analyze how efficiently a company is using its raw
materials, labour and manufacturing-related fixed assets to generate profits. A higher
margin percentage is a favourable profit indicator.

Gross profit margins can vary drastically from business to business and from industry to
industry. For instance, the airline industry has a gross margin of about 5%, while the
software industry has a gross margin of about 90%.

2. Operating Profit Margin

By comparing earnings before interest and taxes (EBIT) to sales, operating profit
margins show how successful a company's management has been at generating income
from the operation of the business:

Operating Profit Margin = EBIT / Sales

This ratio is a rough measure of the operating leverage a company can achieve in the
conduct of the operational part of its business. It indicates how much EBIT is generated
per dollar of sales. High operating profits can mean the company has effective control
of costs, or that sales are increasing faster than operating costs. Positive and negative
trends in this ratio are, for the most part, directly attributable to management decisions.
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3. Net Profit Margin

Net profit margins are those generated from all phases of a business, including taxes. In
other words, this ratio compares net income with sales. It comes as close as possible to
summing up in a single figure how effectively managers run the business:

Net Profit Margins = Net Profits after Taxes / Sales

In the software business, gross margins are very high, while net profit margins are
considerably lower. This shows that marketing and administration costs in this industry
are very high, while cost of sales and operating costs are relatively low.

Minimize Costs

Companies use cost controls to manage and or reduce their business expenses. By
identifying and evaluating all of the business's expenses, management can determine
whether those costs are reasonable and affordable. Then, if necessary, they can look for
ways to reduce costs through methods such as cutting back, moving to a less expensive
plan or changing service providers. The cost-control process seeks to manage expenses
ranging from phone, internet and utility bills to employee payroll and outside
professional services.

To be profitable, companies must not only earn revenues, but also control costs. If costs
are too high, profit margins will be too low, making it difficult for a company to
succeed against its competitors. In the case of a public company, if costs are too high,
the company may find that its share price is depressed and that it is difficult to attract
investors.

Maximize Market Share

Market share is calculated by taking a company's sales over a given period and
dividing it by the total sales of its industry over the same period. This metric provides a
general idea of a company's size relative to its market and its competitors. Companies
are always looking to expand their share of the market, in addition to trying to grow the
size of the total market by appealing to larger demographics, lowering prices or through
advertising. Market share increases can allow a company to achieve greater scale in its
operations and improve profitability.

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FUNCTIONS OF A FINANCIAL MANAGER (MANAGEMENT)

The functions of Financial Manager are discussed below:

1. Estimating the Amount of Capital Required:

This is the foremost function of the financial manager. Business firms require capital
for:

(i) purchase of fixed assets,

(ii) Meeting working capital requirements, and

(iii) Modernisation and expansion of business.

The financial manager makes estimates of funds required for both short-term and long-
term.

2. Determining Capital Structure:

Once the requirement of capital funds has been determined, a decision regarding
the kind and proportion of various sources of funds has to be taken. For this, financial
manager has to determine the proper mix of equity and debt and short-term and long-
term debt ratio. This is done to achieve minimum cost of capital and maximise
shareholders wealth.

3. Choice of Sources of Funds:

Before the actual procurement of funds, the finance manager has to decide the
sources from which the funds are to be raised. The management can raise finance from
various sources like equity shareholders, preference shareholders, debenture- holders,
and banks and other financial institutions, public deposits, etc.

4. Procurement of Funds:

The financial manager takes steps to procure the funds required for the business.
It might require negotiation with creditors and financial institutions, issue of prospectus,
etc. The procurement of funds is dependent not only upon cost of raising funds but also
on other factors like general market conditions, choice of investors, government policy,
etc.

5. Utilisation of Funds:

The funds procured by the financial manager are to be prudently invested in

various assets so as to maximise the return on investment: While taking investment

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decisions, management should be guided by three important principles, viz., safety,
profitability, and liquidity.

6. Disposal of Profits or Surplus:

The financial manager has to decide how much to retain for ploughing back and
how much to distribute as dividend to shareholders out of the profits of the company.
The factors which influence these decisions include the trend of earnings of the
company, the trend of the market price of its shares, the requirements of funds for self-
financing the future programmes and so on.

7. Management of Cash:

Management of cash and other current assets is an important task of financial

manager. It involves forecasting the cash inflows and outflows to ensure that there is
neither shortage nor surplus of cash with the firm. Sufficient funds must be available for
purchase of materials, payment of wages and meeting day-to-day expenses.

8. Financial Control:

Evaluation of financial performance is also an important function of financial

manager. The overall measure of evaluation is Return on Investment (ROI). The other
techniques of financial control and evaluation include budgetary control, cost control,
internal audit, break-even analysis and ratio analysis.

FINANCIAL MANAGEMENT DECISION-MAKING

1. Investment Decision:

It is the decision for creation of assets to earn income. Selection of assets in which
investment is to be made is the investment decision. It has to be decided how the funds
realized will be utilized on various investments.

Generally, the assets of a company are of two types those which yield income spread-
ing over a year or so and assets which are easily convertible into cash within a short
time. The first type of investment decision is capital budgeting and the second one is the
working capital management.

Capital budgeting is the allocation of funds on a new asset or reallocation of capital

when an old asset becomes non-profitable. The worthiness of different investment
proposals forms a vital part of capital budgeting exercise.

Risks of investment are there, so the management has to consider it with sufficient cau-
tion and prudence. Capital budgeting decision has another important aspect. It is to
determine the norm or standard against which benefits are to be judged. This is known
as cut-off rate, hurdle rate, minimum rate of return etc. This is actually cost of capital.

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2. Financing Decision:

This decision relates to how, when and where funds are to be acquired to meet
investment needs. It is related to the capital structure or financial leverage. This is debt-
equity ratio. If more recourse is taken to debt capital, shareholders’ risk is lessened and
the prospects of their dividend earning are reduced. So, in financing decision, the
crucial point is the trade-off between returned risks.

The financing decision unlike investment decision relates to the determination of the
capital structure the proper balance between debt and equity.

Financing decision has two important dimensions:

(1) Is there an optimum capital structure, and

(2) In what proportion should funds be raised to maximize the return to the
shareholders? Once the best debt-equity mix is determined, the finance manager will be
on the lookout for appropriate sources for raising loans and selling shares.

3. Dividend Decision:

The profit of a company can be dealt with in two alternative ways to distribute them as
dividends to shareholders or to retain them in the business. If sufficient dividend is not
paid, shareholders will not be satisfied, the market value of shares will come down and
there may be financial crisis.

If the profits, on the other hand, are distributed to the maximum extent, the company
will lose on important source of self financing. So a judicious decision is a must. There
should be a good combination of distribution and retention.

The dividend decision boils down to the determination of net profits to be paid out to
shareholders as dividends. Here the management is to consider two major factors
preference of the shareholders and the investment opportunities in the company.

The functions of financial management can be discussed from different angles but the
fact remains that finance plays the pivotal role in the whole organization. Whatever has
to be done needs money and that money procurement is the financial manager’s
function.

TIME VALUE OF MONEY

Definition

Time Value of Money is a concept that recognizes the relevant worth of future cash
flows arising as a result of financial decisions by considering the opportunity cost of
funds.

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Concept

Money loses its value over time which makes it more desirable to have it now rather
than later. There are several reasons why money loses value over time. Most obviously,
there is inflation which reduces the buying power of money.

Time Value of Money concept attempts to incorporate the above considerations into
financial decisions by facilitating an objective evaluation of cash flows from different
time periods by converting them into present value or future value equivalents. This
ensures the comparison of 'like with like'.

The present or future value of cash flows is calculated using a discount rate (also known
as cost of capital, WACC and required rate of return) that is determined on the basis of
several factors such as:

Higher the rate of inflation, higher the return that investors

Rate of inflation ●
would require on their investment.

Higher the interest rates on deposits and debt securities, greater

Interest Rates ● the loss of interest income on future cash inflows causing
investors to demand a higher return on investment.

Greater the risk associated with future cash flows of an

Risk Premium ●
investment, higher the rate of return required by an investors.

TECHNIQUES OF TIME VALUE OF MONEY

There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques/Future Value Techniques
2. Discounting/Present Value Techniques

Compounding technique (Future Value):

is the method of calculating the future values of cash flows and involves calculating
compound interest. Under this process, interest is compounded when the amount
earned on an initial deposit (the initial principal) becomes part of the principal at the
end of the first compounding period. Principal refers to the amount of money on which
interest is received that is, in compounding, future values of cash flows at a given
interest rate at the end of the specified period of time are found. The future value (F) of
a lump sum today (P) for n periods at i rate of interest is given by the formula

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 Fn = P (1+i)n= P(CVFn,i).

or

Formula: FVn = PV (1 + r) n
In this equation (1 + r) n is called the future value interest factor (FVIF).
Where, FVn = Future value of the initial flow n year hence
PV = Initial cash flow
R = Annual rate of Interest
N = number of years
Discounting technique (Present Value): is a way to compute the present value of
future money. Compounding is helpful to know the future values, of the cash flow, at
the end of the particular period, at a definite rate. Contrary to this, Discounting is used
to determine the present value of the future cash flow, at a certain interest rate.

P0 = FVn (1+i)-n
or
P0 = FVn / (1+i)n

Where ,

FVn = Future value n years

i = Rate of interest per annum
n = no . of years

(PROBLEMS AND SOLUTIONS)

Compounding or Future Value:

Simple interest

Problem 1:

A loan of 10,000 has been issued for 6-years. Compute the amount to be repaid to
the lender if simple interest is charged @ 5% per year.

P = 10,000; I = 5%; n = 6
By putting the values of P, I and n into the simple interest formula:
Si = P(i)(n)
= 10,000 × 5% × 6
= 10,000 × .05 × 6
= 3,000
=13,000 (10,000 principal + 3,000 accumulated
interest)

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Problem 2:
If you invest 10000 in a bank at simple interest of 7% per annum , what will be the
amount at the end of three years ?

Solution:
P = 10000; I = 7%; n = 3
By putting the values of P, I and n into the simple interest formula:
Si = P(i)(n)
= 10,000 × 7% × 3
= 10,000 × 0.07 × 3
= 2100
=10000+2100 =12100

Problem 3:

A woman has deposited 6,000 in a saving account. Bank pays interest at a rate of
9% per year. Compute the amount of interest that will be earned over 12-year
period:

1. If the interest is simple?

2. If the interest is compounded annually?

Solution:

(1) Simple interest:

= 6,000 × 0.09 × 12

= 6,480

(2) Compound interest:

= 6,000 × (1 + 9%) 12

= 6,000 × 2.813*

= 16,878

Interest: 16878 – 6,000 = 10,878

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Notice that compound interest is more than simple interest by 4,398 (10,878 – 6,480).

*Value of (1 + 9%) 12 from future value of 1 table: 12 periods; 9% interest rate.

Problem 4:

Rs. 2000 is invested at annual rate of interest of 10%. What is the amount after 2
years if the compounding is done:

a) Annually b) semi-annually c) monthly d) daily ?

Solution:
a) The annual compounding is given by :

FV = P(1+i)n,

= 2000 (1+0.1)2
= 2000 x 1.21 = 2420

b) For semi annual compounding is given by :

FV = P(1+i)n, i=0.1/2 = 0.05, n= 2x2=4

= 2000 (1+0.05)4
= 2000 x 1.2155 = 2431

c) For monthly compounding is given by :

FV = P(1+i)n, i=0.1/12 = 0.00833, n=1 2x2=24

= 2000 (1+0.00833)24
= 2000 x 1.22029 = 2440.58

a) For daily compounding is given by :

FV = P(1+i)n, i=0.1/365 = 0.00027, n=365x2=730

= 2000 (1+0.00027)730
= 2000 x 1.22135 = 2442.7

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Problem 5:

Suppose you invest 1000 for three years in a saving Account that pays 10 percent
interest per year. If you let your interest income be reinvested, your investment
will grow as follows:

Formula: FVn = PV(1 + r)n

In this equation (1 + r)n is called the future value interest factor (FVIF).
where,
FVn = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
FVn = PV (1 + r)n
= 1,000 (1.10)3
= 1331

Problem 6:

If you deposit 55,650 in a bank which is paying a 12percent rate of interest on a 10

year time deposit, how much would the deposit grow at the end of ten years?

Solution:
FVn = PV(1 + r)n
FVn = PV(FVIF12%,10 yrs)
FVn = 55, 650 (1.12)10
= 55,650 × 3.106
= 1,72,848.90

Problem 7:
Mr. Ravi Prasad and Sons invests 500, 1,000, 1,500, Rs 2,000 and 2,500 at the end
of each year. Calculate the compound value at the end of the 5th year,
compounded annually, when the interest charged is 5% per annum.
Solution:
Statement of the compound value end of Amount Number of Years Compounded
Interest Future the Year Deposited Compounded Factor (FVIFr, n) Value
(1) (2) (3) (4) (2) × (4)
1 500 4 1.216 608.00
2 1,000 3 1.158 1,158.00
3 1,500 2 1.103 1,654.50
4 2,000 1 1.050 2,100.00
5 2,500 0 1.000 2,500.00
Amount at the end of 5th year is Future Value = 8020.50

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Discounting or present value

Problem 8:
Find the present value of Rs. 10000 to be required after 5 years if the rate of
interest 9%.
Solution:

P0 = FVn (1+i)-n or P0 = FVn / (1+i)n

FVn = 10000
i = 0.09
n =5
P0 = FVn (1+i)-n

= 10000 (1+0.09)-5
= 10000 (1.09)-5
= 10000 x 0.65 = 6500

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 UNIT-II (THEORY)

FEATURES OF CAPITAL BUDGETING

The features of capital budgeting is briefly explained below:

1. Capital budgeting involves the investment of funds currently for getting benefits in
the future.
2. Generally, the future benefits are spread over several years.
3. The long term investment is fixed.
4. The investments made in the project is determining the financial condition of
business organization in future.
5. Each project involves huge amount of funds.
6. Capital expenditure decisions are irreversible.
7. The profitability of the business concern is based on the quantum of investments
made in the project.

SIGNIFICANCE OF CAPITAL BUDGETING

(a) Long-term Applications:

Implies that capital budgeting decisions are helpful for an organization in the long run
as these decisions have a direct impact on the cost structure and future prospects of the
organization. In addition, these decisions affect the organization’s growth rate.

Therefore, an organization needs to be careful while making capital decisions as any

wrong decision can prove to be fatal for the organization. For example, over-investment
in various assets can cause shortage of capital to the organization, whereas insufficient
investments may hamper the growth of the organization.

(b) Competitive Position of an Organization:

Refers to the fact that an organization can plan its investment in various fixed assets
through capital budgeting. In addition, capital investment decisions help the
organization to determine its profits in future. All these decisions of the organization
have a major impact on the competitive position of an organization.

(c) Cash Forecasting:

Implies that an organization needs a large amount of funds for its investment decisions.
With the help of capital budgeting, an organization is aware of the required amount of
cash, thus, ensures the availability of cash at the right time. This further helps the
organization to achieve its long-term goals without any difficulty.

(d) Maximization of Wealth:

Refers to the fact that the long-term investment decisions of an organization helps in
safeguarding the interest of shareholders in the organization. If an organization has
invested in a planned manner, shareholders would also be keen to invest in the
organization. This helps in maximizing the wealth of the organization. Capital

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budgeting helps an organization in many ways. Thus, an organization needs to take into
consideration various aspects.

TYPES OF CAPITAL BUDGETING DECISIONS

Generally the business firms are confronted with three types of capital budgeting
decisions.

1. Accept-reject decisions: Business firm is confronted with alternative investment

proposals. If the proposal is accepted, the firm incur the investment and not otherwise.
Broadly, all those investment proposals which yield a rate of return greater than cost of
capital are accepted and the others are rejected. Under this criterion, all the independent
proposals are accepted.

2. Mutually exclusive decisions: It includes all those projects which compete with each
other in a way that acceptance of one precludes the acceptance of other or others. Thus,
some technique has to be used for selecting the best among all and eliminates other
alternatives.

3. Capital rationing decisions: Capital budgeting decision is a simple process in those

firms where fund is not the constraint, but in majority of the cases, firms have fixed
capital budget. So large amount of projects compete for these limited budgets. So the
firm rations them in a manner so as to maximize the long run returns. Thus, capital
rationing refers to the situations where the firm has more acceptable investment
requiring greater amount of finance than is available with the firm.

CAPITAL BUDGETING PROCESS

Capital budgeting is a difficult process to the investment of available funds. The benefit
will attain only in the near future but, the future is uncertain. However, the following
steps followed for capital budgeting, then the process may be easier are

Identification of Various Investments

-- > Screening or Matching the Available Resources

-- > Evaluation of Proposals
-- > Fixing Property
-- > Final Approval
-- > Implementation

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1.Identification of various investments proposals :

The capital budgeting may have various investment proposals. The proposal for the
investment opportunities may be defined from the top manage me not or may be even
from the lower rank. The heads of various department analyse the various investment
decisions, and will select proposals sub mitted to the planning committee of competent
authority.

2. Screening or matching the proposals : The planning committee will analyse the
various proposals and screenings. The selected proposals are considered with the
available resources of the concern. Here resources referred as the financial part of the
proposal. This reduces the gap between the resources and the investment cost.

3.Evaluation: After screening, the proposals are evaluated with the help of
various methods, such as payback period proposal, net discovered present value
method, accounting rate of return and risk analysis.

4. Fixing property: After the evolution, the planning committee will predict which
proposals will give more profit or economic consideration. If the projects or proposals
are not suitable for the concern‘s financial condition, the projects are rejected without
considering other nature of the proposals.

5.Final approval: The planning committee approves the final proposals, with the help
of the following:

(a) Profitability,
(b) Economic
(c)Financial
6. Implementing: The competent authority spends the money and implements the
proposals. While implementing the proposals, assign responsibilities to the proposals,
assign responsibilities for completing it, within the time allotted and reduce the cost for
this purpose. The network techniques used such as PERT and CPM. It helps the
management for monitoring and containing the implementation of the proposals.

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7. Performance review of feedback: The final stage of capital budgeting is actual
results compared with the standard results. The adverse or unfavourable results
identified and removing the various difficulties of the project. This is helpful for the
future of the proposals.

EVALUATION OF INVESTMENT PROPOSALS

Traditional methods or Non-Discounted method 1Net Present Value method 2Internal

Rate of Return method 3 Rate of return method or accounting method

Evaluation of Investment Proposals

Traditional methods or Non-Discounted method

1Net Present Value method

2Internal Rate of Return method
3 Rate of return method or accounting method
Time-adjusted method or discounted methods
(i) Net Present Value method
(ii) Internal Rate of Return method
(iii)Profitability Index method

1 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.
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.

2 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.

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3 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.
1. First determine the rate of interest that should be selected as the minimum required
rate of return
2. Compute the present value of total investment outlay
3. Compute the present value of total cash inflows
4. Calculate Net Present Value by subtracting the present value of cash inflow by
present value of cash outflow.
5. NPV = is positive or zero the project is accepted
6. NPV= is negative then reject the proposal
7. 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

4 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.

21
1. 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
2. Determine the rate of discount at which the value of cash inflow is equal to the
present value of cash outflows
3. Accept the proposal if the internal rate of return is higher than or equal to the cost of
capital or cut off rate.
4. In case of alternative proposals select the proposal with the highest rate of return.

IRR = r1 + PV of Cash inflows at r1 - PV of Cash out flows (r2 – r1 )

PV of Cash inflows at r1 - PV of Cash inflows at r2

5 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

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.
PROBLEMS THAT ARE INVOLVED IN CAPITAL BUDGETING

Profitability (return on investment) of the firm. Capital budgeting involves mainly three
problems:

1. Demand for capital.

2. Supply of capital.
3. Rationing of capital.

1. Demand for capital:

The starting point for capital budgeting is a survey of the need of capital for the
company. The discovery and development of good investment proposals require efforts
and as such an imaginative search for such opportunities is very important part of the
programme.

22
2. Supply of capital:

This is a problem to find out where from the money will came. The distinction between
internal and external sources of funds must be made.
The chief internal sources are-
i) Depreciation charge, and
(ii) Retained earnings.

The external sources arc mainly the issue of shares and debentures to the public. It is
very important to correctly forecast (i) how much cash will be generated internally and
(ii) to decide how much cash is to be paid out of dividend and (iii) also to decide how
much of the remainder may be tied up in long-term projects.

Regarding the external sources much depends upon the state of capital market and
sound financial position and goodwill of the company

3. Rationing of capital

Capital is a scarce resource and is therefore, it has a cost. The return on investment must
be more than the cost of capital.

Only that investment should be considered for acceptance which yields a rate of return
in excess of cost of capital.

The cost of capital sets the minimum rate that the investment must promise to return.
This is in fact, a way to determine the cut off point in capital budgeting. The basic aim
of capital to maximize the firm long run profit potentials.

FINANCIAL FEASIBILITY ASPECTS

A financial feasibility study is an assessment of the financial aspects of something. If

this case, for starting and running a business.

A financial feasibility study can focus on one particular project or area, or on a group of
projects (such as advertising campaigns). However, for the purpose of establishing a
business or attracting investors, you should include at least three key things in your
comprehensive financial feasibility study:

 Start-Up Capital Requirements,

 Start-Up Capital Sources, and
 Potential Returns for Investors.

Start-Up Capital Requirements

Start-up capital is how much cash you need to start your business and keep it running
until it is self-sustaining. You should include enough capital funds (cash, or access to
cash) to run the business for one to two years.

23
Articles Related to Calculating Business Start-Up Costs

Finding Start-Up Capital Funding Sources

There are many ways to raise capital for your business, but no matter what route you
take, investors are more likely to invest, banks are more likely to approve loans, and
large corporations are more likely to give you contracts if you have personally invested
in the business yourself.

Potential Returns for Investors Feasibility Study

Investors can be a friends, family members, professional associates, client,

partners, share holders, or investment institutions. Any business or individual willing to
give you cash can be a potential investor. Investors give you money with the
understanding that they will receive "returns" on their investment, that is, in addition to
the amount that is invested they will get a percentage of profits.

CAPITAL RATIONING

Definition: Capital rationing is a strategy that firms implement to place limitations on

the cost of new investments. Normally, capital rationing is engaged when a firm has a
low return on investment (ROI) from its current investments due to high investment
costs.

The main objective of capital rationing is the maximization of shareholder wealth. In

this context, a firm may decide to implement capital rationing by seeking new
investment opportunities with a higher net present value as well as setting a higher
ceiling on the cost of capital. In doing so, the firm can assume control over its resources
and undertake fewer projects or projects with a higher expected return on investment.

(PROBLEMS AND SOLUTIONS)

Payback period formula – even cash flow:

When net annual cash inflow is even (i.e., same cash flow every period), the payback
period of the project can be computed by applying the simple formula given below:

*The denominator of the formula becomes incremental cash flow if an old asset (e.g.,
machine or equipment) is replaced by a new one.

24
Problem 1:

The Delta Company is planning to purchase a machine known as machine X.

Machine X would cost 25,000 and would have a useful life of 10 years with zero
salvage value. The expected annual cash inflow of the machine is 10,000. Compute
payback period of machine X and conclude whether or not the machine would be
purchased if the maximum desired payback period of Delta Company is 3 years.

Solution:

Since the annual cash inflow is even in this project, we can simply divide the initial
investment by the annual cash inflow to compute the payback period. It is shown below:

Payback period = 25,000/10,000

= 2.5 years

According to payback period analysis, the purchase of machine X is desirable because

it’s payback period is 2.5 years which is shorter than the maximum payback period of
the company.

Problem 2:

Rani Beverage Company is considering purchasing a new equipment to increase

the production and revenues. The useful life of the equipment is 10 years and the
company’s maximum desired payback period is 4 years. The inflow and outflow
of cash associated with the new equipment is given below:

Initial cost of equipment: 37,500

Annual cash inflows:
Sales: 75,000
Annual cash Outflows:
Cost of ingredients: 45,000
Salaries expenses: 13,500
Maintenance expenses: 1,500
Non cash expenses:
Depreciation expense: 5,000
Required: Should Rani Beverage Company purchase the new equipment? Use
payback method .

Solution:

Step 1: In order to compute the payback period of the equipment, we need to work out
the net annual cash inflow by deducting the total of cash outflow from the total of cash
inflow associated with the equipment.

Computation of net annual cash inflow:

25
75,000 – (45,000 + 13,500 + 1,500)= 15,000

Step 2: Now, the amount of investment required to purchase the equipment would be
divided by the amount of net annual cash inflow (computed in step 1) to find the
payback period of the equipment.

= 37,500/15,000

=2.5 years

Depreciation is a non-cash expense and has therefore been ignored while calculating the
payback period of the project.

According to payback method, the equipment should be purchased because the payback
period of the equipment is 2.5 years which is shorter than the maximum desired
payback period of 4 years.

Payback method with uneven cash flow:

When projects generate inconsistent or uneven cash inflow (different cash inflow in
different periods), the simple formula given above cannot be used to compute payback
period. In such situations, we need to compute the cumulative cash inflow and then
apply the following formula:

Problem 3:

An investment of $ 200,000 is expected to generate the following cash inflows in six

years:
Year 1:$ 70,000
Year 2: $ 60,000
Year 3:$ 55,000
Year 4:$ 40,000
Year 5:$ 30,000
Year 6:$ 25,000
Compute payback period of the investment. Should the investment be made if
management wants to recover the initial investment in 3 years or less?

Solution:

26
(1). because the cash inflow is uneven, the payback period formula cannot be used to
compute the payback period. We can compute the payback period by computing the
cumulative net cash flow as follows:

Payback period = 3 + (15,000*/40,000)

= 3 + 0.375

= 3.375 Years

*Unrecovered investment at start of 4th year:

= Initial cost – Cumulative cash inflow at the end of 3rd year

= 200,000 – 185,000

= 15,000

The payback period for this project is 3.375 years which is longer than the maximum
desired payback period of the management (3 years). The investment in this project is
therefore not desirable.

Problem 4:

Let us determine the ARR for the following 2 alternative investments:

Machine A: Machine B:
Cost 56,125 58,125
Annual estimated income after
depreciation & tax
Year 1 3,375 11,375
Year 2 5,375 9,375

27
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
Total earnings 36,875 36,875
Estimated life 5 years 5 years
Estimated salvage value 3,000 3,000

Solution:

ARR = Annual average net earnings after taxes X 100

Average investment over the life of the project

Average earnings = Total earnings / Estimated life in years

For machines A: - 36,875 / 5 = 7,375

For machines B: - 36,875 / 5 = 7,375

Average investment = (Initial investment - Salvage Value) / 2 + Working capital +
Salvage value.
For Machine A: (56,125 - 3000) / 2 + 0 + 3000 = 29,562.50

For Machine B: (58,125 - 3000) / 2 + 0 + 3000 = 30,562.50

ARR for Machine A : 7375/29562.50 * 100 = 24.95% or 25%

ARR for Machine B : 7375/30,562.50 * 100 = 24.13% or 24%

.
Machine A would be preferred as ARR is higher.

Problem 5:

A project of 650,000 is expected to generate the following cash flows over its useful
life:

Cash Cash
Year
outflows inflows
Initial
0 (650,000) 0
investment
1 – 150,000
2 – 220,000
3 – 300,000
4 – 250,000

28
5 – 180,000
6 – 112,000
6 Salvage value – 20,000

The project does not require any cash expenses. Depreciation is to be provided
using straight line method. According to accounting policies of the company, the
salvage value is treated as the reduction in depreciable basis. Compute accounting
rate of return from the above information.

Solution:

Step 1: Computation of annual depreciation expenses:

(Cost – salvage value) / Life of the asset

(650,000 – 20,000) /6

=1,05000

Step 2: Computation of average incremental annual income:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Expected revenues (cash inflows) 150,000 220,000 300,000 250,000 180,000 112,000
Depreciation expenses 10,5000 10,5000 10,5000 10,5000 10,5000 10,5000
——– ——– ——– ——– ——– ——–
Net operating income 45,000 115,000 195,000 145,000 75,000 7,000
——– ——– ——– ——– ——– ——–

Average income = (45,000 + 115,000 + 195,000 + 145,000 + 75,000 + 7,000) / 6

= 97,000

Step 3: Computation of accounting rate of return:

If initial investment is used as denominator:

= 97,000 / 650,000

= 14.92%

29
If average investment is used as denominator:

*(650,000 + 20,000)/2
= 335,000

97,000 / 335,000*

= 28.96%

Problem 6:

A stone crushing company is planning to purchase a Wheel Loader to be used for

conveying raw stone to a large Stone Crushing Machine and loading crushed stone
in trucks. A new Wheel loader can be purchased directly from Caterpillar
Company for 150,000. The new Wheel Loader will reduce the annual cost by
25,500 and increase annual operating expenses by 4,500. The useful life of the
Wheel Loader is 20 years. After 20 years it will have a salvage value of 30,000.
Company uses straight line method of depreciation for all assets.

Compute accounting rate of return of wheel loader using average investment

approach.

Solution:

Step 1; Computation of depreciation:

Annual depreciation = (Cost of the asset – Salvage value)/Useful life
= (150,000 – 30,000)/20
= 6,000
Step 2; Computation of annual net cost saving:
Annual net cost saving = 25,500 – (4,500 + 6,000)
= 15,000
Step 3; Computation of average investment in asset:
Because the company uses straight line method of depreciation, the average investment
can be computed by adding cost of the asset to the residual value and then dividing by
2. It is shown below:
Average investment = (Cost of the asset + Residual value)/2
= (150,000 + 30,000)/2
= 90,000
Step 4; Computation of accounting rate of return:
Accounting rate of return = Annual net cost saving / average investment

= 15,000 / 90,000
= 16.67%

Problem 7:
30
A project requires an initial investment of 225,000 and is expected to generate the
following net cash inflows:

Year 1:$ 95,000

Year 2:$ 80,000

Year 3:$ 60,000

Year 4: $55,000

Compute net present value of the project if the minimum desired rate of return is
12%.

Solution:

The cash inflow generated by the project is uneven. Therefore, the present value would
be computed for each year separately

Problem 8:

A project with a net investment of Rs. 100000 and the following cash flows if the
company cost of capital is 10% ? Net cash flows for year one is 55000 for two year
is 80000 and for three year is 15000. Compute

i. Net Present Value

ii. Profitability Index (PVIF @10% for three years are 0.909,0.826and 0.751)

Solution

31
Year Net Cash Flows PVIF@ 10% Discounted Cash Flows

1 55000 0.909 49995

2 80000 0.826 66080

3 15000 0.751 11265

127340

i. NPV= Present value of cash inflow – present value of cash outflow/Initial

127340 - 100000 =27340

ii. Profitability Index = Present value of cash inflow

Present value of cash outflow
127340
100000
= 1.27

Problem 10:

Calculate the internal rate of returns of an investment of Rs. 400000. Scrap value
is zero and tax rate is 50%, calculate depreciation on straight line method and
estimated profits are as under

Year CFBT
1 100000
2 150000
3 200000
4 250000
5 300000
Solution :

CFBT = PBT+ Depreciation

PBT = CFBT - Depreciation
CFAT = PAT+ Depreciation
Depreciation = Investment /no. of years
= 400000/ 5 = 80000

32
CFBT Dep PBT Tax 50% CFAT
100000 80000 20000 10000 90000
150000 80000 70000 35000 115000
200000 80000 120000 60000 140000
250000 80000 170000 85000 165000
300000 80000 220000 110000 190000

Cash flows are not equal so that we calculate weighted avg.

Weight avg : (90000 x 5 )+ (115000 x4) + (140000 x3)+(165000 x2) +(190000 x1)
1850000 / 15 = 123333.33
Artificial payback period = 400000 /123333.33 =3.2432
The corresponding figure and interest rates are 16% and 18% look in the present value
table.

CFAT PV@16%(r1) PV of CFAT PV@18% (r2) PV of CFAT

90000 0.8621 77586 0.8475 76271
115000 0.7432 85464 0.7182 82591
140000 0.6407 89692 0.6086 85208
165000 0.5523 91128 0.5158 85105
190000 0.4761 90461 0.4371 83051
434332 412227

IRR = r1 + PV of Cash inflows at r1 - PV of Cash out flows (r2 – r1 )

PV of Cash inflows at r1 - PV of Cash inflows at r2

= 16 + 434332 – 400000 (18% -16%)

434332 - 412227
= 16 + 34332 x2
22105
= 16 + 3.11 = 19.11%

Problem 11:

Calculate the internal rate of returns of an investment of Rs. 136000 which yields
the following cash inflows

Year Cash inflows

1 30000
2 40000
3 60000

33
 4 30000
5 20000

Solution :
Average cash inflows per year = 180000 / 5 = 36000

Artificial payback period = 136000 /36000 = 3.78

The corresponding figure and interest rates are 10% and 12% look in the present value
table.

Cash inflows PV@10%(r1) Present value PV@12% (r2) Present value

30000 0.909 27270 0.893 26790
40000 0.826 33040 0.797 31880
60000 0.751 45060 0.712 42720
30000 0.683 20490 0.636 19080
20000 0.621 12420 0.567 11340
138280 131810

IRR = r1 + PV of Cash inflows at r1 - PV of Cash out flows (r2 – r1 )

PV of Cash inflows at r1 - PV of Cash inflows at r2
= 10 + 138280 – 136000 (12% -10%)
138280 - 131810
= 10 + 2280 x2
6470
= 10+ 0.7 = 10

34
 UNIT-III (THEORY)

RISK MEANING:

Business risk may be defined in terms of the possibility of occurrence of un-favourable

events; which maximize chances of losses and minimize chances for gain, in business.

NATURE OF BUSINESS RISK:

Nature of business risks could be highlighted with reference to its following features:
(i) Opportunities for Gains are hidden in Business Risks:
If the management of the business enterprise is able to successfully handle and manage
business risks; these provide many opportunities for gains to the business enterprise.
(ii) Business Risks Depend on Time:
In ancient times, business risks were less and limited. In the present-day-times-
characterized by intense competition, advanced technology and globalization of the
economy; business risks are quite severe. Further, in times to come, business risks are
likely to increase in intensity.
(iii) Business Risks Depend on Size of the Business Enterprise:
Small businesses are less exposed to business risks; because they enjoy flexibility of
operations and can easily adapt themselves to changing circumstances. On the other
hand, the bigger is the size of business; the lesser is the flexibility possessed by it.
Hence bigger businesses are more exposed to business risks.
(iv) Business Risks Depend on the Nature of Business:
In case of business enterprises engaged in the manufacture/purchase of necessary items
e.g. salt, sugar, oil, cloth etc. there is lesser risk, because demand for most of the
necessary item is inelastic or less elastic. On the other hand, business enterprises
engaged in the manufacture/purchase of luxury items are more exposed to business
risks; because demand for luxury items is highly elastic.
(v) Business Risk Depends on Terms of Sales:
In case of business enterprises conducting sales only on cash basis, business risks are
nil; so far as the possibility of bad debts is concerned. On the other hand, business
enterprises conducting large scale credit sales are severely exposed to the risk of bad
debts.
(vi) Business Risk Depends on the Degree of Competition:
In those lines of business activities, where there is intense competition; business
enterprises are exposed to severe risks caused by the actions and reactions of
competitors. As such, business enterprises characterized by monopolistic situations face
little risk on account of competition. Actually in a perfectly monopolistic situation, the
business enterprise has no risk caused by competition.
(vii) Business Risks Depend on Competence of Management:
The more competent the management of business enterprises is; the lesser is the
possibility of losses to be caused as a result of business risks, and vice-versa.

35
RISK-ADJUSTED DISCOUNT RATE
An estimation of the present value of cash for high risk investments is known as risk-
adjusted discount rate. A very common example of risky investment is the real estate.
Risk adjusted discount rate is representing required periodical returns by investors for
pulling funds to the specific property. It is generally calculated as a sum of risk free rate
and risk premium. The variation of risk premium is depending on the risk aversion of
investor and the perception of investor about the size of property’s investment risk.
Risk-adjusted discount rate = Risk free rate + Risk premium
Under CAPM or capital asset pricing model
Risk premium= (Market rate of return - Risk free rate) x beta of the project
The risk-adjusted discount rates declare for that by altering the rate depending on
possibility of risks of investment projects. For higher risk investment project a higher
rate will be used and for a lower risk investment project, a low rate will be used. The
net present value is inversely proportional to risk-adjusted discount rate as an increase
in adjusted rate will decrease net present value, representing that the task is less
acceptable and perceived as riskier one. A rate which would be used to discount the
cash flow is the sum of risk free rate and compensation for investment risk. Suppose
risk free rate is 10% and compensation of investment risk is 5%, then a rate of 15% will
be use for discount cash flow.

Plus points of adjusted rate

 It is quite simple and easy to understand.

 Risk adjusted rate has a good deal of intuitive appeal in the eyes of risk averse
business person.
 It integrates an attitude towards uncertainty.

Limitations of adjusted rate

 There is no easy way of obtaining an adjusted rate. Capital asset pricing model
offers a basis of computing the risk adjusted rate. Its use has still to pickup n
practice.
 It is completely relay on the assumption that investors are risk averse. Through it
is mostly true; however, a group of seekers also exists who never demand
premium for risk assumption. They willingly paying premium to take risks.
Accordingly, with the level of increase, discount rate will decrease.

HANDLE RISK FACTOR OF CAPITAL BUDGETING

Risk-Adjusted Discount Rate:
Generally, against risk the businessman requires a premium over and above the
existing one which is risk-free. As such, the more uncertain will be the future return, the
more will be the risk and the greater will be the premium and vice-versa. As a result, the
risk premium is being introduced in capital budgeting decisions with the help of
discount rate.

36
 In short, if the time preference for money is to be recognized by discounting
estimated future cash flows, at some risk-free rate, to their present value, then, to allow
for the riskiness, of those future cash flows a risk premium rate may be added to risk-
free discount rate. For example, a very low rate of risk- adjusted discount rate may be
considered if investment is made on Govt. bonds where there is no risk of estimated
future returns.

. Probability Assignment:
(i) It is not possible to know the uncertainty surroundings, i.e., the probability
distribution the range of the forecast and the probability estimates related to it.

(ii) The terms “best estimates” or ‘most likely forecast’ are not so clear, i.e., which
measures of central tendency is being applied (i.e.…Mean Median or Mode).

Therefore, instead of taking a single figure, it is better to have a range, i.e. a range, of
estimates and its related probability.

Probability means he likelihood of the happening of an event. When the event is bound
to happen, it may be said that it has a probability of I. And if it is certain that the event
will not occur at all it will have a 0 probability.

As such, the probabilities will always lie between 0 and I. It should be remembered that
the probability distribution consists of a number of estimates, but the simple form is to
consider a few estimates.

Objective Probability:

According to Classical Probability Theory, when the happening or non-happening of an

event can be repeatedly performed over a very long period of time under independent
and identical conditions, the probability estimates depending on a very large number of
observations is called objective probability.

Subjective Probability:

The objective probability referred to above is not widely used in capital budgeting
decisions since the decisions are non-repetitive and they are hardly performed under
independent identical conditions. That is why, at present, another view is being
considered which is known as personal or subjective probabilities.

A personal or subjective probabilities based on the personal judgment as there is no

larger number of independent and identical observations.

37
Standard deviation (an absolute measure of dispersion):

The immediate earlier approach, viz., the Probability Assignment Approach, through
the calculation of expected monetary value, does not supply a precise value about the
variability of cash flows to the decision maker.

In order to overcome this limitation and for a better insight into the risk analysis, we are
to find out the dispersion of Cash flows which is nothing but the difference between the
expected monetary values and the possible cash flows which may occur. It indicates the
degree of risk.

The most widely used measure of dispersion is the Standard Deviation method. It is the
square root of squared deviation calculated from the mean. In short, it measures the
deviation or variance about the expected cash flows of each possible cash flow.

The formula for calculating Standard Deviation is noted below:

The following steps must be taken into consideration while calculating Standard
Deviation:

(i) At first, the mean value of possible cash flow should be computed.

(ii) Find out the deviation between the mean value and the possible cash flows.

(iii) Deviations are squared.

(iv) Multiply the squared deviation by the probability assignment in order to find out
the weighted squared deviation.

(v) Finally, make a total of the weighted squared deviation and find out this square root
which will be known as Standard Deviation

Co-Efficient of Variation (A Relative Measure of Dispersion)

Co-efficient of variation is a relative measure of risk. It is defined as Standard Deviation

of the probability distribution divided by its expected value and is expressed in terms of
percentage.

The formula is:

Co-efficient of Variation (C.V.) = Standard Deviation /Mean or Expected cash flows ×

100

38
This is particularly useful where projects involve different cash flows outlay or different
expected (mean) values, i.e., where Standard Deviation fails to compare. In other
words, the C V. (Co-efficient of variation) is applicable where the Standard Deviation is
same but the expected values are different or, where Standard Deviation is different but
expected values are same, or where both of them are different.

DECISION TREES:

Decision tree analysis is also another useful technique for tackling risky investment
proposals. Under this approach, all probabilistic estimates of potential outcomes and
their effects are taken into consideration, i.e., all the possible outcome is weighted in
probabilistic terms and are evaluated thereafter.

In short, the approach is particularly applicable where decision at point of time affects
the decisions at a subsequent date, i.e., current investment decision has implication
against future investment decisions. In other words, this investment decisions involve a
sequence of decisions over time.

If Massey’s argument (which is given in footnotes) is accepted, investment expenditure

must be viewed not from the standpoint of isolated period commitments, but as links in
a chain of present and future commitments. Needless to mention that application of
decision tree analysis is to tackle the sequential decisions.

A decision tree is a pictorial representation in tree form which indicates the magnitude,
probability and inter-relationship of all possible outcomes’. In other words, it is a
graphic display of the relationship between a present decision and possible future
events, future decisions and their consequences. The sequence of events is mapped out
over time in a format resembling branches of a tree.

Thus, the decision tree reveals the sequential cash flow and the NPV of the proposed
projects under different circumstances. It must be remembered in this respect that its
outstanding feature is to link events chronologically with forecast probabilities.
Therefore, it presents us a systematic appearance of decisions and their forecasted
results.

CONSTRUCTION OF A DECISION TREE:

While constructing a decision tree the following steps should carefully be considered:

(i) Definition of the Proposal:

The investment proposals should be defined e.g., to enter a new market or to produce a
new product.

39
(ii) Identification of Alternatives:

This decision alternative should be identified, i.e., there may be more than two
alternatives. For instance, a company is considering to purchase a plant for
manufacturing a new product.

It may have the following alternatives:

(a) Purchase large plant,

(b) Purchase a small plant,
(c) Purchase a medium size plant,
(d) Not to purchase a plant at all.
Each alternative may have different consequences:
(iii) Graphing the Decision-Tree:
The decision-tree is then graphed indicating:
(a) Decision points,
(b) Decision branches,
(c) Other data.
(iv) Forecasting Cash Flows:

The necessary data, viz., projected cash flow , probability distribution total expected
present value etc. should be located on the decision tree branches for the purpose of
taking up decisions.

(v) Evaluating Results:

After ascertaining the expected value for each decision, the results are analysed. The
firm should proceed with the profitable alternative, i.e., the best alternative should be
selected.

COST OF CAPITAL

The cost of funds used for financing a business. Cost of capital depends on the mode of
financing used. it refers to the cost of equity if the business is financed solely through
equity, or to the cost of debt if it is financed solely through debt. Many companies use
a combination of debt and equity to finance their businesses, and for such companies,
their overall cost of capital is derived from a weighted average of all capital sources,
widely known as the weighted average cost of capital (WACC). Since the cost of capital
represents a hurdle rate that a company must overcome before it can generate value, it is
extensively used in the capital budgeting process to determine whether the company
should proceed with a project.

CONCEPTS OF COST OF CAPITAL

The cost of capital of a company is the average rate of return required by investors who
provide long term funds (equity, preference, and long term debt). A central concept in
financing decisions, the cost of capital is important for two reasons:
40
1. For evaluating capital investment proposals an estimate of the cost of capital is
required. As we have seen, the cost of capital is the discount rate in NPV calculation
and also the financial benchmark against which the internal rate of return is compared

2. To maximize the value of the firm, costs of all inputs (including the capital input)
must be minimized. In the context the firm should what its cost of capital is and what
are its key determinants.

BASIC CONCEPTS:

Cost of capital is the weighted arithmetic average of the cost of various sources of long
term finance employed by it.

Cost of Capital = {Proportion of equity}{Cost of equity} + {Proportion of

preference}{Cost of preference} + {Proportion of debt}{Cost of debt}

From the above example, it is clear that three basic steps are involved in calculation
cost of capital:

1.Determine the cost of different components of capital.

2.Establish a set of weights (proportions).
3. Calculate the weighted average cost of capital.

SIGNIFICANCE OF COST OF CAPITAL:

The concept of cost of capital plays a vital role in decision-making process of financial
management. The financial leverage, capital structure, dividend policy, working capital
management, financial decision, appraisal of financial performance of top management
etc. are greatly influenced by the cost of capital.

IMPORTANCE OF COST OF CAPITAL

The cost of capital is very important concept in the financial decision making. Cost of
capital is the measurement of the sacrifice made by investors in order to invest with a
view to get a fair return in future on his investments as a reward for the postponement
of his present needs. On the other hand from the point of view of the firm using the
capital, cost of capital is the price paid to the investor for the use of capital provided by
him. Thus, cost of capital is reward for the use of capital. The progressive management
always likes to consider the importance cost of capital while taking financial decisions
as it’s very relevant in the following spheres:

Designing the capital structure: The cost of capital is the significant factor in
designing a balanced and optimal capital structure of a firm. While designing it, the
management has to consider the objective of maximizing the value of the firm and
minimizing cost of capital. Comparing the various specific costs of different sources of

41
capital, the financial manager can select the best and the most economical source of
finance and can designed a sound and balanced capital structure.

Capital budgeting decisions: The cost of capital sources as a very useful tool in the
process of making capital budgeting decisions. Acceptance or rejection of any
investment proposal depends upon the cost of capital. A proposal shall not be accepted
till its rate of return is greater than the cost of capital. In various methods of discounted
cash flows of capital budgeting, cost of capital measured the financial performance and
determines acceptability of all investment proposals by discounting the cash flows.

Comparative study of sources of financing: There are various sources of financing a

project. Out of these, which source should be used at a particular point of time is to be
decided by comparing costs of different sources of financing. The source which bears
the minimum cost of capital would be selected. Although cost of capital is an important
factor in such decisions, but equally important are the considerations of retaining
control and of avoiding risks.

Evaluations of financial performance: Cost of capital can be used to evaluate the

financial performance of the capital projects. Such as evaluations can be done by
comparing actual profitability of the project undertaken with the actual cost of capital of
funds raise to finance the project. If the actual profitability of the project is more than
the actual cost of capital, the performance can be evaluated as satisfactory.

Knowledge of firms expected income and inherent risks: Investors can know the
firms expected income and risks inherent there in by cost of capital. If a firms cost of
capital is high, it means the firms present rate of earnings is less, risk is more and
capital structure is imbalanced, in such situations, investors expect higher rate of return.

Financing and Dividend Decisions: The concept of capital can be conveniently

employed as a tool in making other important financial decisions. On the basis,
decisions can be taken regarding dividend policy, capitalization of profits and selections
of sources of working capital.

COMPUTATION OF SPECIFIC SOURCE OF FINANCE

Computation of each specific source of finance, viz, debt, preference share

capital equity share capital and retained earnings is discussed as below:
A. Cost of Debt:
The capital structure of a firm normally includes the debt capital. Debt may be in the
form of debentures bonds, term loans from financial institutions and banks etc. The
amount of interest payable for issuing debenture is considered to be the cost of
debenture or debt capital (Kd). Cost of debt capital is much cheaper than the cost of
capital raised from other sources, because interest paid on debt capital is tax deductible.

42
The cost of debenture is calculated in the following ways:

(i) When the debentures are issued and redeemable at par: Kd = r (1 – t)

Where Kd = Cost of debenture

r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at
par

Kd = I/NP (1 – t)

Where, Kd = Cost of debenture

I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.

(iii) When the debentures are redeemable at a premium or discount and are
redeemable after ‘n’ period:

Kd
I (1-t) +1/N (Rv – NP) / ½ (RV – NP)
Where
Kd = Cost of debenture.
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity

Example 1:

ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs. 60 lakh. The
floating charge of the issue is 5% on face value. The interest is payable annually
and the debentures are redeemable at a premium of 10% after 10 years. What will
be the cost of debentures if the tax is 50%?

43
B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost, since it is this
amount which the company wants to pay against the preference shares. Like debentures,
the issue expenses or the discount/premium on issue/redemption are also to be taken
into account.

(i) The cost of preference shares (KP) = DP / NP

Where, DP = Preference dividend per share

NP = Net proceeds from the issue of preference shares.

(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference
shares (KP) will be:

where , NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed
deduction from income for income tax purposes.

Example 2:

Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par redeemable after
10 years at 10% premium. What will be the cost of preference share capital?

44
Example 3:

A company issues 12% redeemable preference shares of Rs. 100 each at 5%

premium redeemable after 15 years at 10% premium. If the floatation cost of each
share is Rs. 2, what is the value of KP (Cost of preference share) to the company?

C. Cost of Equity Capital:

The funds required for a project may be raised by the issue of equity shares which are of
permanent nature. These funds need not be repayable during the lifetime of the
organisation. Calculation of the cost of equity shares is complicated because, unlike
debt and preference shares, there is no fixed rate of interest or dividend payment.

Cost of equity share is calculated by considering the earnings of the company, market
value of the shares, dividend per share and the growth rate of dividend or earnings.

(i) Dividend/Price Ratio Method:

An investors buys equity shares of a particular company as he expects a certain return

(i.e. dividend). The expected rate of dividend per share on the current market price per
share is the cost of equity share capital. Thus the cost of equity share capital is
computed on the basis of the present value of the expected future stream of dividends.

45
Thus, the cost of equity share capital (Ke) is measured by:

Ke = D/P + g.
where ,
D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share
capital
(Ke) will be Ke = D/P + g.

This method is suitable for those entities where growth rate in dividend is relatively
stable. But this method ignores the capital appreciation in the value of shares.

Example 4:

XY Company’s share is currently quoted in market at Rs. 60. It pays a dividend of

Rs. 3 per share and investors expect a growth rate of 10% per year.
You are required to calculate:
(i) The company’s cost of equity capital.
(ii) The indicated market price per share, if anticipated growth rate is 12%.
(iii) The market price, if the company’s cost of equity capital is 12%, anticipated
growth rate is 10% p.a., and dividend of Rs. 3 per share is to be maintained.

Example 5:

The current market price of a share is Rs. 100. The firm needs Rs. 1,00,000 for
expansion and the new shares can be sold at only Rs. 95. The expected dividend at
the end of the current year is Rs. 4.75 per share with a growth rate of
6%.Calculate the cost of capital of new equity.

Solution:

We know, cost of Equity Capital (Ke) = D/P + g

(i) When current market price of share (P) = Rs. 100

K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.

46
(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or, 11%.

Example 6:

A company’s share is currently quoted in the market at Rs. 20. The company pays
a dividend of Rs. 2 per share and the investors expect a growth rate of 5% per
year. You are required to calculate (a) Cost of equity capital of the company, and
(b) the market price per share, if the anticipated growth rate of dividend is 7%.

Solution:

(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% = 15%

(b) Ke = D/P + g

or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.

Example 7:

Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock exchange at
a market price of Rs. 28. A constant expected annual growth rate of 6% and a
dividend of Rs. 1.80 per share has been paid for the current year. Calculate the
cost of equity share capital.

Solution:

D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06

= 0.0681 + 0.06 = 12.81%

(ii) Earnings/Price Ratio Method:

This method takes into consideration the earnings per share (EPS) and the market price
of share. Thus, the cost of equity share capital will be based upon the expected rate of
earnings of a company. The argument is that each investor expects a certain amount of
earnings whether distributed or not, from the company in whose shares he invests.

If the earnings are not distributed as dividends, it is kept in the retained earnings and it
causes future growth in the earnings of the company as well as the increase in market
price of the share.

Thus, the cost of equity capital (Ke) is measured by:

Ke = E/P where E = Current earnings per share

47
P = Market price per share.

If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share
capital (Ke) will be

Ke = E/P+ g.

This method is similar to dividend/price method. But it ignores the factor of capital
appreciation or depreciation in the market value of shares. Adjustment of Floatation
Cost These costs are to be adjusted with the current market price of the share at the time
of computing cost of equity share capital since the full market value per share cannot be
realised. So the market price per share will be adjusted by (1 – f) where ‘f’ stands for
the rate of floatation cost.

Thus, using the Earnings growth model the cost of equity share capital will be:

Ke = E / P (1 – f) + g

D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the business also entail
cost. When earnings are retained in the business, shareholders are forced to forego
dividends. The dividends forgone by the equity shareholders are, in fact, an opportunity
cost. Thus retained earnings involve opportunity cost.

If earnings are not retained they are passed on to the equity shareholders who, in turn,
invest the same in new equity shares and earn a return on it. In such a case, the cost of
retained earnings (Kr) would be adjusted by the personal tax rate and applicable
brokerage, commission etc. if any.

Many accountants consider the cost of retained earnings as the same as that of the cost
of equity share capital. However, if the cost of equity share capital i9 computed on the
basis of dividend growth model (i.e., D/P + g), a separate cost of retained earnings need
not be computed since the cost of retained earnings is automatically included in the cost
of equity share capital.

Therefore, Kr = Ke = D/P + g.

Example 8:

It is given that the cost of equity of a company is 20%, marginal tax rate of the
shareholders is 30% and the Broker’s Commission is 2% of the investment in

48
share. The company proposes to utilise its retained earnings to the extent of Rs.
6,00,000. Find out the cost of retained earnings.

Weighted Average Cost of Capital:

A firm may procure long-term funds from various sources like equity share capital,
preference share capital, debentures, term loans, retained earnings etc. at different costs
depending on the risk perceived by the investors.

When all these costs of different forms of long-term funds are weighted by their relative
proportions to get overall cost of capital it is termed as weighted average cost of capital.
It is also known as composite cost of capital. While taking financial decisions, the
weighted or composite cost of capital is considered.

The weighted average cost of capital is used by an enterprise because of the

following reasons:

(i) It is useful in taking capital budgeting/investment decisions.

(ii) It recognises the various sources of finance from which the investment proposal
derives its life-blood (i.e., finance).
(iii) It indicates an optimum combination of various sources of finance for the enhance-
ment of the market value of the firm.
(iv) It provides a basis for comparison among projects as a standard or cut-off rate.
I. Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity, preference shares,
debts, retained earnings etc.) is to be calculated.
(ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be
computed and assigned to each type of funds. This implies multiplication of each source
of capital by appropriate weights.
Generally, the-following weights are assigned:
(a) Book values of various sources of funds
(b) Market values of various sources of capital
(c) Marginal book values of various sources of capital.

Book values of weights are based on the values reflected by the balance sheet of a
concern, prepared under historical basis and ignoring price level changes. Most of the
financial analysts prefer to use market value as the weights to calculate the weighted
average cost of capital as it reflects the current cost of capital.

49
BOOK VALUE AND MARKET VALUE

Book value of an asset denotes its accounting value, which is nothing but the historical
cost less accumulated depreciation/amortization.

Market value of an asset represents the actual market price of the asset that is traded in
the market place. It can also be understood as the actual worth of the firm relating to
other firms in the marketplace. Book Value, as the name signifies, is the value of the
commercial instrument or asset, as entered in the financial books of the firm. On the
other hand, Market Value is defined as the amount at which something can be bought or
sold on a given market.

People find it a bit difficult to identify, which one will prove the best for an investor to
consider before investing his money in the company. These two values may vary, or
they may be same but above all, you must know that the difference between book value
and market value will show you the profit or loss. Conversely, if the values tally then
there would be no profit no loss.

Comparison Chart
Basis for
Book Value Market Value
Comparison
Book Value means the value Market Value is that maximum price
Meaning recorded in the books of the at which an asset or security can be
firm for any asset. sold in the market.
It is the actual worth of the asset It is a the highest estimated value of
What is it?
or company. the asset or company.
Reflects Firm's equity Current market price
Frequency of Infrequent, i.e. at periodical
Frequent
Fluctuations interval
Basis of Tangible assets present with the Tangible and intangible assets,
calculation company. which the company possesses.
Readily Yes No

MARGINAL COST OF CAPITAL

Sometimes, we may be required to calculate the cost of additional funds to be raised,

called the marginal cost of capital. The marginal cost of capital is the weighted average
cost of new capital calculated by using the marginal weights. The marginal weights
represent the proportion of various sources of funds to be employed in raising additional
funds.

In case, a firm employs the existing proportion of capital structure and the
component costs remain the same the marginal cost of capital shall be equal to the
weighted average cost of capital. But in practice, the proportion and/or the component

50
costs may change for additional funds to be raised. Under this situation, the marginal
cost of capital shall not be equal to the weighted average cost of capital. However, the
marginal cost of capital concept ignores the long-term implications of the new financing
plans, and thus, weighted average cost of capital should be preferred for maximisation
of shareholder’s wealth in the long-run.

( PROBLEMS AND SOLUTIONS)

Problem 1:

Jamuna Ltd has the following capital structure and, after tax, costs for the
different sources of fund used:

Problem 2:

Excel Ltd. has assets of Rs. 1,60,000 which have been financed with Rs. 52,000 of
debt and Rs. 90,000 of equity and a general reserve of Rs. 18,000. The firm’s total
profits after interest and taxes for the year ended 31st March 2006 were Rs.
13,500. It pays 8% interest on borrowed funds and is in the 50% tax bracket. It
has 900 equity shares of Rs. 100 each selling at a market price of Rs. 120 per share.

What is the Weighted Average Cost of Capital?

51
Problem 3:

A firm has the following capital structure and after-tax costs for the different
sources of funds used:

Source of Funds Amount Proportion After-tax cost

Rs. % %
Debt 15,00,000 25 5
Preference Shares 12,00,000 20 10
Equity Shares 18,00,000 30 12
Retained Earnings 15,00,000 25 11
Total 60,00,000 100

You are required to compute the weighted average cost of capital

52
Solution:
Computation of Weighted Average Cost of Capital
Source of Funds Proportion % Cost % Weighted Cost %
Proportion Cost
(W) (X)
(XW) %
Debt 25 5 1.25
Preference shares 20 10 2.00
Equity Shares 30 12 3.60
Retained Earnings 25 11 2.75
Weighted Average Cost 9.60%
of Capital

Problem 4:
The firm has 18,000 equity shares of Rs. 100 each outstanding and the current
market price is Rs. 300 per calculate the market, value weighted average cost of
capital assuming that the market values and book values of the debt and
preference capital are same.

Solution:
Amount Proportion Cost Weighted Cost
(Rs.) %W %X Proportion Cost
Sources of Funds
XW
Debt 15,00,000 18.52 5 0.93
Preference Capital 12,00,000 14.81 10 1.48
Equity Share Capital
(18000 shares @ Rs. 300) 54,00,000 66.67 12 8.00
81,00,000 100
Weighted Average Cost of Capital 10.41%

Problem 5:
A firm has the following capital structure and after-tax costs for the different
sources of funds used:

53
Source of Funds Amount(Rs.) Proportion (%) After-tax Cost(%)
Debt 4,50,000 30 7
Preference Capital 3,75,000 25 10
Equity Capital 6,75,000 45 15
15,00,000 100

(a) Calculate the weighted average cost of capital using book-value weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the
project as below.
Debt Rs. 3,00,000
Preference Capital Rs. 1,50,000
Equity Capital Rs. 1,50,000
Assuming that specific costs do not change, compute the weighted marginal cost
of capital.

Solution:

Computation of Weighted Marginal Cost of Capital (WMCC)

Source of Funds Marginal Weights After tax cost (%) Weighted
Proportion (%) (X) Marginal Cost %
(W)
Debt 50 7 3.50
Preference 25 10 2.50
Capital
25 15 3.75
Equity Capital
Weighted Marginal Cost of Capital (WMCC) 9.75%

54
 UNIT-IV (THEORY)

CONCEPT AND DEFINITION OF LEVERAGE

The financial objective of every firm is to maximize value of the business and this can
be done through maximizing profit or net present value.

This is done through magnifying the Earnings before Interest and Tax (EBIT) and the
Earning per Share (EPS). Here comes the essence of leverage, because it is related to a
profit measure, which may be a return on investments or earnings before taxes. Its cost
is concerned with two important decisions: Cost structure decision and capital structure
decision. Cost structure decisions involve an appropriate choice of amount of fixed
costs and variable costs.

A mix of fixed and variable cost that maximizes EBIT is referred to as appropriate cost
structure. On the other hand, capital structure decisions involve an appropriate choice
between the owner’s fund and the outsider’s fund. A financing mix that maximizes
shareholder’s earnings can be referred to as the appropriate capital structure mix.
Therefore leveraging is the magnification of EBIT and the return of shareholders with
appropriate mix of fixed and variable costs and debt-equity mix, respectively.

CONCEPT OF LEVERAGE:

The term leverage indicates the ability of a firm to earn higher return by employing
fixed assets or debt. It shows the effects of the investment patterns or financing patterns
adopted by the firm. The employment of an asset or source of funds for which the firm
has to pay a fixed cost or interest has a considerable influence on the earnings available
for equity shareholders.

'OPERATING LEVERAGE'

Operating leverage is a measurement of the degree to which a firm or project incurs a

combination of fixed and variable costs. A business that makes sales providing a very
high gross margin and fewer fixed costs and variable costs has much leverage. The
higher the degree of operating leverage, the greater the potential danger from
forecasting risk, where a relatively small error in forecasting sales can be magnified into
large errors in cash flow projections.

Operating Leverage = Contribution Margin / Net Operating Income

High and Low Operating Leverage

It is essential to compare operating leverage among companies in the same industry, as

some industries have higher fixed costs than others. The concept of a high or low ratio
is then more clearly determined.

55
Most of a company’s costs are fixed costs that occur regardless of sales volume. As
long as a business earns a substantial profit on each sale and sustains adequate sales
volume, fixed costs are covered and profits are earned. Other company costs are
variable costs incurred when sales occur. The business earns less profit on each sale but
needs a lower sales volume for covering fixed costs. However, the business does not
generate greater profits unless it increases its sales volume.

Measuring Operating Leverage or Degree of Operating Leverage (DOL)

Operating leverage measures the percentage change in operating profit with respect to
changes in the sales. Therefore, operating leverage is determined through the
relationship of the firm's sales and its operating profit (earnings before interest and tax).
The relationship between contribution margin and EBIT is called degree of operating
leverage. It may be defined as the rate of changes in EBIT due to the change in the rate
of sales. Degree of operating leverage (DOL) is measured by using any one of the
following approaches.

Measuring Degree of Operating Leverage (DOL) By Income Statement Approach:

DOL = Contribution Margin/EBIT

Measuring Degree of Operating Leverage By Formula Approach:

DOL = Sales - Variable Cost/Sales - Variable Cost - Fixed Cost

= S-VC/S-VC-FC

Measuring Financial Leverage or Degree of Financial Leverage (DFL)

Degree of financial leverage is the relationship between percentage change in earning

per share and percentage change in earnings before interest and tax (EBIT). It can also
be determined by the relationship between EBIT and EBT (earnings before tax). It
measures the percentage change in earning per share (EPS) due to percentage change in
EBIT. The financial leverage can be determined as given below.

Calculation of DFL on The Basis of Income Statement:

DFL = EBIT/EBIT-I = EBIT/EBT

Calculation of DFL By Using Formula:

DFL = (Sales-variable cost- fixed cost/sales - variable cost-fixed cost-interest)

= S-VC-FC/S-VC-FC-I

56
Calculation of DFL By Using Percentage Change Method:

DFL = % change in EPS/% change in EBIT

Where,
DFL = degree of financial leverage

EBIT = earnings before interest and tax

EBT = earnings before tax

EPS = earnings per share

I = Interest

Measuring Combined Leverage or Degree of Combined Leverage (DCL)

The combination of operating leverage and financial leverage is called combined

leverage or total leverage. Operating leverage measures operating or business risk
where as financial leverage measures financial risk. Combined leverage measures total
risk of the business.

Operating leverage is measured by the percentage change in earnings before interest

and tax due to percentage change in sales where as financial leverage is measured by
percentage change in earning before tax or earning per share due to percentage change
in earnings before interest and tax. Thus, the combined leverage is measured by
percentage change in earning per share (EPS) due to percentage change in sales.
Measuring Degree of Combined Leverage (DCL) on the basis of Income Statement

DCL = DOL x DFL = (CM/EBIT) x (EBIT/EBT) = CM/EBT

Where,
DCL = degree of combined leverage

DOL = degree of operating leverage

DFL = degree of financial leverage

CM = contribution margin

EBIT= earnings before interest and tax

EBT = earnings before tax

Measuring Degree of Combined Leverage By Using Formula

57
DCL = Sales- variable cost/Sales - variable cost - fixed cost – interest

= S-VC/S-VC-FC-I

MEANING OF EBIT

A measure of a company's ability to produce income on its operations in a given year. It

is calculated as the company's revenue less its expenses (such as overhead) but not
subtracting its tax liability or interest paid on debt. It is important to note that EBIT
does not account for one-off or otherwise unusual revenues and expenses, only
recurring ones. EBIT represents cash available to pay off creditors in the event of
liquidation and, as such, it is closely watched, especially when the company incurs little
depreciation or amortization. It is also called operating profit.

IMPORTANCE OF EBIT
1.Financial leverage of Trading on Equity: The use of long term fixed interest
bearing debt and preference share capital along with equity share capital is called
financial leverage or trading on equity. The use of long-term debt increases, magnifies
the earnings per share if the firm yields a return higher than the cost of debt.

2. Cost of Capital. Every rupee invested in a firm has a cost. Cost of capital refers to
the minimum return expected by its suppliers. The capital structure should provide for
the minimum cost of capital. The main sources of finance for a firm are equity,
preference share capital and debt capital. The return expected by the suppliers of
capital depends upon the risk they have to undertake.

3. Minimisation of Risk: A firm’s capital structure must be developed with an eye

towards risk because it has a direct link with the value. Risk may be factored for two
considerations: (a) the capital structure must be consistent with the business risk,
and (b) the capital structure results in certain level of financial risk. Business risk may
be defined as the relationship between the firm's sales and its earnings before interest
and taxes (EBIT). In general, the greater the firm's operating leverage – the use of fixed
operating cost – the higher its business risk
4. Control: The determination of capital structure is also governed by the management
desire to retain controlling hands in the company. The issue of equity share involve the
risk of losing control. Thus in case the company is interested in – retaining control, it
should prefer the use of debt and preference share capital to equity share capital.
However, excessive use of debt and preference capital may lead to loss of control and
other bad consequences.

58
5. Flexibility: The term flexibility refers to the firm’s ability to adjust its capital
structure to the requirements of changing conditions. A firm having flexible capital
structure would face no difficulty in changing its capitalization or source of fund. The
degree of flexibility in capitals structure depends mainly on (i) firm’s unused debt
capacity, (ii) terms of redemption (iii) flexibility in fixed charges, and (iv) restrictive
stipulation in loan agreements.
6. Profitability: A capital structure should be the most profitable from the point of
view of equity shareholders. Therefore, within the given constraints, maximum debt
financing (which is generally cheaper) should be opted to increase the returns available
to the equity shareholder.
7. Cash Flow Ability: The EBIT – EPS analysis, growth of earnings and coverage ratio
are very useful indicator of a firm’s ability to meet its fixed obligations at various levels
of EBIT. Therefore, an important feature of a sound capital structure is the firm’s ability
to generate cash flow to service fixed charges.
EBIT – EPS ANALYSIS
The financial leverage affects the pattern of distribution of operating profit
among various types of investors and increases the variability of the EPS of the firm.
Therefore, in search for an appropriate capitals structure for a firm, the financial
manager must analysis the effects of various alternative financial leverages on the EPS.
Given a level of EBIT, EPS will be different under different financing mix depending
upon the extent of debt financing. The effect of leverage on the EPS emerges because
of the existence of fixed financial charge i.e., interest on debt financial fixed dividend
on preference share capital. The effect of fixed financial charge on the EPS depends
upon the relationship between the rate of return on assets and the rate of fixed charge.
If the rate of return on assets is higher than the cost of financing, then the increasing use
of fixed charge financing (i.e., debt and preference share capital) will result in increase
in the EPS. This situation is also known favourable financial leverage or Trading on
Equity. On the other hand, if the rate of return on assets is less than the cost of
financing, then the effect may be negative and therefore, the increasing use of debt and
preference share capital may reduce the EPS of the firm.
The fixed financial charge financing may further be analyzed with reference to
the choice between the debt financing and the issue of preference shares. Theoretically,
the choice is tilted in favour of debt financing because of two reasons: (i) the explicit
cost of debt financing i.e., the rate of interest payable on debt instruments or loans is
generally lower than the rate of fixed dividend payable on preference shares, and (ii)
interest on debt financing is tax-deductible and therefore the real costs (after-tax) is
lower than the cost of preference share capital.
Thus, the analysis of the different capital structure and the effect of leverage on
the expected EPS will provide a useful guide to select a particular level of debt
financing. The EBIT-EPS analysis is of significant importance and if undertaken
properly, can be an effective tool in the hands of a financial manager to get an insight
into the planning and designing the capital structure of the firm.

59
FINANCING PATTERNS:
Holding the EBIT constant while varying the financial leverage or financing patterns,
one can imagine the firm increasing its leverage by issuing bonds and using the
proceeds to redeem the capital, or doing the opposite to reduce leverage.

Indifference Point/Level of EBIT

The indifference level of EBIT is one at which the EPS remains same
irrespective of the debt equity mix. While designing a capital structure, a firm may
evaluate the effect of different financial plans on the level of EPS, for a given level of
EBIT. Out of several available financial plans, the firm may have two or more financial
plans which result in the same level of EPS for a given EBIT. Such a level of EBI at
which the firm has two or more financial plans resulting in same level of EPS, is known
as indifference level of EBIT.

The use of financial break-even level and the return from alternative capital structures is
called the indifference point analysis. The EBIT is used as a dependent variable and the
EPS from two alternative financial plans is used as independent variable and the
exercise is known as indifference point analysis. The indifference level of EBIT is a
point at which the after tax cost of debt is just equal to the ROI. At this point the firm
would be indifferent whether the funds are raised by the issue of debt securities or by
the issue of share capital.

NET INCOME APPROACH EXPLAINED

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

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

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

WACC = Debt
Total Amount of Capital (Debt + Equity)

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

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

Net Income Approach makes certain assumptions which are as follows.

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

NET OPERATING INCOME APPROACH (NOI APPROACH)

This approach was put forth by Durand and totally differs from the Net Income
Approach. Also famous as traditional approach, Net Operating Income Approach
suggests that change in debt of the firm/company or the change in leverage fails to
affect the total value of the firm/company. As per this approach, the WACC and the
total value of a company are independent of the capital structure decision or financial
leverage of a company.

As per this approach, the market value is dependent on the operating income and the
associated business risk of the firm. Both these factors cannot be impacted by the
financial leverage. Financial leverage can only impact the share of income earned by
debt holders and equity holders but cannot impact the operating incomes of the firm.
Therefore, change in debt to equity ratio cannot make any change in the value of the
firm.

It further says that with the increase in the debt component of a company, the company
is faced with higher risk. To compensate that, the equity shareholders expect more
returns. Thus, with an increase in financial leverage, the cost of equity increases.

Assumptions / Features of Net Operating Income Approach:

1. The overall capitalization rate remains constant irrespective of the degree of

leverage. At a given level of EBIT, value of the firm would be “EBIT/Overall
capitalization rate”
2. Value of equity is the difference between total firm value less value of debt
i.e. Value of Equity = Total Value of the Firm – Value of Debt
3. WACC (Weighted Average Cost of Capital) remains constant; and with the
increase in debt, the cost of equity increases. An increase in debt in the capital
structure results in increased risk for shareholders. As a compensation of
investing in the highly leveraged company, the shareholders expect higher return
resulting in higher cost of equity capital.

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Features of NOI approach:

1. At all degrees of leverage (debt), the overall capitalization rate would remain
constant. For a given level of Earnings before Interest and Taxes (EBIT), the
value of a firm would be equal to EBIT/overall capitalization rate.
2. The value of equity of a firm can be determined by subtracting the value of debt
from the total value of the firm. This can be denoted as follows:
Value of Equity = Total value of the firm - Value of debt

M.M HYPOTHESIS

The MM, in their first paper (in 1958) advocated that the relationship between leverage
and the cost of capital is explained by the net operating income approach. They argued
that in the absence of taxes, a firm's market value and the cost of capital remains
invariant to the capital structure changes. The arguments are based on the following
assumptions:

(a) Capital markets are perfect and thus there are no transaction costs.
(b) The average expected future operating earnings of a firm are represented by
subjective random variables.

(c) Firms can be categorized into "equivalent return" classes and that all firms within
a class have the same degree of business risk.

(d) They also assumed that debt, both firms and individual's is riskless.

(e) Corporate taxes are ignored.

Proposition I

The value of a firm is independent of its leverage.

The weighted cost of capital to any firm levered or not is

Completely independent of its capital structure .

As a firm's use of debt increases, its cost of equity also rises. The MM showed that a
firm's value is determined by its real assets, not the individual securities and thus capital
structure decisions are irrelevant as long as the firm's investment decisions are taken as
given. This proposition allows for complete separation of the investment and financial
decisions. It implies that any firm could use the capital budgeting procedures without
worrying where the money for capital expenditure comes from. The proposition is
based on the fact that, if we have two streams of cash, A and B, then the present value
of A +B is equal to the present value of A plus the present value of B. This is the
principle of value additively. The value of an asset is therefore preserved regardless of
the nature of the claim against it. The value of the firm therefore is determined by the

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assets of the firm and not the proportion of debt and equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to
substitute personal for corporate leverage, thereby replicating any capital structure the
firm might undertake. They used the arbitrage process to show that two firms alike in
every respect except for capital structure must have the same total value. If they don't,
arbitrage process will drive the total value of the two firms together.

DIVIDEND DECISIONS CONCEPT AND SIGNIFICANCE

The dividend decision is one of the three basic decisions which a financial
manager may be required to take, the other two being the investment decisions and the
financing decisions. In each period any earning that remains after satisfying obligations
to the creditors, the government and the preference shareholders can either be retained
or paid out as dividends or bifurcated between retained earnings and dividends. The
retained earnings can then be invested in assets which will help the firm to increase or
at least maintain its present rate of growth.
In dividend decision, a financial manager is concerned to decide one or more of the
following:
- Should the profits be ploughed back to finance the investment decisions?
- Whether any dividend be paid? If yes, how much dividend be paid?
- When these dividend be paid? Interim or final.
- In what form the dividend be paid? Cash dividend or Bonus shares.
All these decisions are inter-related and have bearing on the future growth plans
of firm. If a firm pays dividend it affects the cash flow position of the firm but earns the
goodwill among investors who therefore may be willing to provide additional funds for
financing of investment plans of firm. On the other hand, the profits which are not
distributed as dividends become an easily available source of funds at no explicit costs.
TYPES OF DIVIDEND POLICY
The various types of dividend policies are discussed as follows:
(a) Regular Dividend Policy: Payment of dividend at usual rate is termed as regular
Dividend. The investors such as retired persons, widows, and other economically
weaker persons prefer to get regular dividends. A regular dividend offer following
Advantages.

 It establishes profitable record of company.

 It creates confidence among shareholder.
 It stabilises market value of shares
 It aids in long term financing and renders financing easier.
 The ordinary shareholders view dividends as a source of funds to meet their day-
to-day living expenses.

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 Regular dividend can be maintained only by companies of long standing and stable
earnings.
(b) Stable Dividend Policy: The term ‘Stability of Dividend’ means consistency or
lack of variability in stream of dividend payments. A stable dividend policy may be
established in any of following three forms
(i) Constant Dividend per Share: Some companies follow a policy of paying fixed
dividend per share irrespective of level of earnings year after year. Such firms usually
create a ‘Reserve for Dividend Equalisation’ to enable them pay fixed dividend even in
year when earnings are not sufficient or when there are losses. A policy of constant
dividend per share is most suitable to concerns whose earnings are expected to remain
stable over number of years.
(ii) Constant Payout ratio: It means payment of fixed percentage of net earnings as
dividends every year. The amount of dividend in such a policy fluctuates in direct
proportion to earnings of company. The policy of constant payout is preferred by the
firms because it is related to their ability to pay dividends.
(iii) Stable rupee Dividend plus extra dividend: Some companies follow a policy of
paying constant low dividend per share plus an extra dividend in the years of high
profit. Such a policy is most suitable to the firm having fluctuating earnings from year
to year.
Determinants of Dividend Policy
The payment of dividend involves some legal as well as financial considerations.
It is difficult to determine a general dividend policy which can be followed by different
firms at different times because dividend decision has to be taken considering the
special circumstances of an individual case. The following are important factors which
determine dividend policy of a firm:

THE RELEVANCE CONCEPT OF DIVIDEND

The advocates of this school of thought include Myron Gordon, James Walter
and Richardson. According to them dividends communicate information to the investors
about the firm’s profitability and hence dividend decision becomes relevant. Those
firms which pay higher dividends will have greater value as compared to those which
do not pay dividends or have a lower dividend payout ratio. It holds that dividend
decisions affect value of the firm.
We have examined below two theories representing this notion: (i) Walter’s
Approach and (ii) Gordon’s Approach.

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(i) Walter’s Approach: Prof. Walter’s model is based on the relationship
between the firms (a) return on investment i.e. r and (b) the cost of capital or required
rate of return i.e. k.
According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of return on
its investment than the required rate of return, the firm should retain the earnings. Such
firms are termed as growth firms and the optimum pay-out would be zero which would
maximize value of shares.
In case of declining firms which do not have profitable investments i.e. where
r<k, the shareholder would stand to gain if the firm distributes it earnings. For such
firms, the optimum payout would be 100% and the firms should distribute the entire
earnings as dividend.
In case of normal firms where r=k the dividend policy will not affect the market
value of shares as the shareholders will get the same return from the firm as expected by
them. For such firms, there is no optimum dividend payout and value of firm would not
change with the change in dividend rate.

Assumptions of Walter’s model

(i) The firm has a very long life.
(ii) Earnings and dividends do not change while determining the value.
(iii) The Internal rate of return ( r ) and the cost of capital (k) of the firm are constant.
(iv) The investments of the firm are financed through retained earnings only and the
firm does not use external sources of funds.
Walter’s formula for determining the value of share

Where P = Market price per share

D = Dividend per share
r = internal rate of return
E = earnings per share
ke = Cost of equity capital.
Criticism of Walter’s Model
Walter’s model has been criticised on account of various assumptions made by Prof
Walter in formulating his hypothesis.
(i) The basic assumption that investments are financed through retained earnings
only is seldom true in real world. Firms do raise fund by external financing.
(ii) The internal rate of return i.e. r also does not remain constant. As a matter of
fact, with increased investment the rate of return also changes.

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 (iii) The assumption that cost of capital (k) will remain constant also does not hold
good. As a firm’s risk pattern does not remain constant, it is not proper to
assume that (k) will always remain constant.

(ii) Gordon’s Approach: Another theory which contends that dividends are
relevant is Gordon’s model. This model which opinions that dividend policy of a firm
affects its value is based on following assumptions:-
1. The firm is an all equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate,
(g=br) is also constant.
5. ke >br
Gordon argues that the investors do have a preference for current dividends and
there is a direct relationship between the dividend policy and the market value of share.
He has built the model on basic premise that investors are basically risk averse and they
evaluate the future dividend/capital gains as a risky and uncertain proposition. Investors
are certain of receiving incomes from dividend than from future capital gains. The
incremental risk associated with capital gains implies a higher required rate of return for
discounting the capital gains than for discounting the current dividends. In other words,
an investor values current dividends more highly than an expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that dividend policy is
relevant, as investors prefer current dividends as against the future uncertain capital
gains. When investors are certain about their returns they discount the firm’s earnings at
lower rate and therefore placing a higher value for share and that of firm. So, the
investors require a higher rate of return as retention rate increases and this would
adversely affect share price.

Symbolically:
where P = Market price of equity share
E = Earnings per share of firm.
b = Retention Ratio (1 – payout ratio)
r = Rate of Return on Investment of the firm.
Ke = Cost of equity share capital.
br = g i.e. growth rate of firm.
THE IRRELEVANCE CONCEPT OF DIVIDEND

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 The other school of thought on dividend policy and valuation of the firm argues
that what a firm pays as dividends to share holders is irrelevant and the shareholders are
indifferent about receiving current dividend in future. The advocates of this school of
thought argue that dividend policy has no effect on market price of share. Two theories
have been discussed here to focus on irrelevance of dividend policy for valuation of the
firm which are as follows:
1. Residual’s Theory of Dividend
According to this theory, dividend decision has no effect on the wealth of
shareholders or the prices of the shares and hence it is irrelevant so far as valuation of
firm is concerned. This theory regards dividend decision merely as a part of financing
decision because earnings available may be retained in the business for re-investment.
But if the funds are not required in the business they may be distributed as dividends.
Thus, the decision to pay dividend or retain the earnings may be taken as residual
decision. This theory assumes that investors do not differentiate between dividends and
retentions by firm. Their basic desire is to earn higher return on their investment. In
case the firm has profitable opportunities giving higher rate of return than cost of
retained earnings, the investors would be content with the firm retaining the earnings to
finance the same. However, if the firm is not in a position to find profitable investment
opportunities, the investors would prefer to receive the earnings in the form of
dividends. Thus, a firm should retain earnings if it has profitable investment
opportunities otherwise it should pay them as dividends.
Under the Residuals theory, the firm would treat the dividend decision in three
steps:

o Determining the level of capital expenditures which is determined by the

investment opportunities.
o Using the optimal financing mix, find out the amount of equity financing need to
support the capital expenditure in step (i) above
o As the cost of retained earnings kr is less than the cost of new equity capital, the
retained earnings would be used to meet the equity portions financing in step (ii)
above. If available profits are more than this need, then the surplus may be
distributed as dividends of shareholder. As far as the required equity financing is in
excess of the amount of profits available, no dividends would be paid to the
shareholders.

Hence, in residual theory the dividend policy is influenced by (i) the company’s
investment opportunities and (ii) the availability of internally generated funds, where
dividends are paid only after all acceptable investment proposals have been financed.
The dividend policy is totally passive in nature and has no direct influence on the
market price of the share.

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2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner in
support of theory of irrelevance. They maintain that dividend policy has no effect on
market prices of shares and the value of firm is determined by earning capacity of the
firm or its investment policy. As observed by M.M, “Under conditions of perfect capital
markets, rational investors, absence of tax discrimination between dividend income and
capital appreciation, given the firm’s investment policy, its dividend policy may have
no influence on the market price of shares”. Even, the splitting of earnings between
retentions and dividends does not affect value of firm.
Assumptions of MM Hypothesis
(1) There are perfect capital markets.
(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to affect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates applicable
to dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in
value of the firm results from payment of dividend, will be exactly off set by achieve in
market price of shares because of external financing and there will be no change in total
wealth of the shareholders. For example, if a company, having investment opportunities
distributes all its earnings among the shareholders, it will have to raise additional funds
from external sources. This will result in increase in number of shares or payment of
interest charges, resulting in fall in earnings per share in future. Thus whatever a
shareholder gains on account of dividend payment is neutralized completely by the fall
in the market price of shares due to decline in expected future earnings per share. To be
more specific, the market price of share in beginning of period is equal to present value
of dividends paid at end of period plus the market price of shares at end of period plus
the market price of shares at end of the period. This can be put in form of following
formula:-
P0 = D1 + P 1
1 + Ke
where
PO = Market price per share at beginning of period.
D1 = Dividend to be received at end of period.
P1 = Market price per share at end of period.
Ke = Cost of equity capital.

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 The value of P1 can be derived by above equation as under.

The MM Hypothesis can be explained in another form also presuming that

investment required by the firm on account of payment of dividends is financed out of
the new issue of equity shares.
In such a case, the number of shares to be issued can be computed with the help
of the following equation:

Further, the value of the firm can be ascertained with the help of the following formula:

where,
m = number of shares to be issued.
I = Investment required.
E = Total earnings of the firm during the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity capital.
n = number of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.
nPO = Value of the firm.

This equation shows that dividends have no effect on the value of the firm when
external financing is used. Given the firm’s investment decision, the firm has two
alternatives, it can retain its earnings to finance the investments or it can distribute the
earnings to the shareholders as dividends and can arise an equal amount externally. If
the second alternative is preferred, it would involve arbitrage process. Arbitrage refers
to entering simultaneously into two transactions which exactly balance or completely
offset each other. Payment of dividends is associated with raising funds through other
means of financing. The effect of dividend payment on shareholder’s wealth will be
exactly offset by the effect of raising additional share capital. When dividends are paid
to the shareholder, the market price of the shares will increase. But the issue of
additional block of shares will cause a decline in the terminal value of shares. The
market price before and after the payment of the dividend would be identical. This
theory thus signifies that investors are indifferent about dividends and capital gains.
Their principal aim is to earn higher on investment. If a firm has investment
opportunities at hand promising higher rate of return than cost of capital, investor will
be inclined more towards retention. However, if the expected return is likely to be less
than what it would cost, they would be least interested in reinvestment of income.

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Modigiliani and Miller are of the opinion that value of a firm is determined by earning
potentiality and investment policy and never by dividend decision.
DIVIDEND POLICY AND BONUS SHARES
The main consideration in determining the dividend policy is the objective of
maximization of wealth of shareholders. Thus, a firm should retain earnings if it has
profitable opportunities, giving a higher rate of return than cost of retained earnings,
otherwise it should pay them as dividends. It implies that a firm should treat retained
earnings as the active decision variable, and dividends as the passive residual.
Bonus shares are the shares issued by a company free of costs by capitalisation
of its profits and reserves. The issue of bonus shares results in increase in number of
shares and hence increases the paid up capital of company without involving any
monetary transaction. Such shares are issued to all existing equity shareholders in
proportion of their holding of share capital of company. Since, the number of shares
increases as a result of bonus shares, the book value and earnings per share of company
will decrease.

(PROBLEMS AND SOLUTIONS)

Problem 1:
Alpha company is contemplating conversion of 500 bonds .14% convertible bonds
of Rs.1,000 each. Market price of bond is Rs. 1,080. Bond indenture provides that
one bond will be exchanged for 10 shares. Price earnings ratio before redemption
is 20:1 and anticipated price earnings ratio after redemption is 25:1.Number of
shares outstanding prior to redemption are 10,000. EBIT amounts to Rs 2,00,000.
The company is in the 35% tax bracket. Should the company convert bonds into
share? Give reasons.

Solutions:

Present Position After Conversion

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EBIT Rs.2,00,000 Rs.2,00,000
Less interest @ 14% 70,000 ---
1,30,000 2,00,000
less tax @15% 45,500 70,000
Number of share 10,000 15,000
EPS Rs. 8.45 Rs. 8.67
P E Ratio 20 25
Expected market Price Rs. 169.00 Rs. 216.75

The company may opt for conversion of bonds into equity shares as this will result in
increase in market price of share from Rs.169 of Rs.216.75.

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

Option 1 Option 2 Option 3 Option 4

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

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

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

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

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

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

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

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

Problem 3:
There are three firm X & Co., Y & Co. and Z & Co. These firms are alike
in all respect except the leverage. The financial position of the three firms is
presented as follows:
Capital Structure X & Co. Y & Co. Z & Co.

Share Capital (of Rs.100 each) Rs.2,00,000 Rs.1,00,000 Rs.50,000

6% Debenture --- 1,00,000 1,50,000

Total 2,00,000 2,00,000 2,00,000

These firms are expected to earn a ROI at different levels depending upon
the economic conditions. In normal conditions, the ROI is expected to be 8%
which may fluctuate by 3% on either side on the occurrence of bad economic
conditions or good economic conditions. How return is available to the
shareholders of the three firms is going to be affected by the variations in the level
of EBIT due to differing economic conditions? The relevant presentations have
been shown as follows:

Poor Normal Good

Eco. Cond. Eco. Cond. Eco. Cond.

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Total Assets Rs.2,00,000 Rs.2,00,000 Rs.2,00,000

ROI 5% 8% 11%

EBIT Rs.10,000 Rs.16,000 Rs.22,000

Solution :
X & Co. (No Financial Leverage) (Figures in Rs.)
EBIT 10,000 16,000 22,000

- Interest --- --- ---

Profit before Tax 10,000 16,000 22,000

- Tax @ 50% 5,000 8,000 11,000

Profit After Tax 5,000 8,000 11,000

Number of Shares 2,000 2,000 2,000

EPS (Rs.) 2.5 4 5.5

Y & Co. (50% Leverage) (Figures in Rs.)

EBIT 10,000 16,000 22,000

- Interest 6,000 6,000 6,000

Profit before Tax 4,000 10,000 16,000

- Tax @ 50% 2,000 5,000 8,000

Profit After Tax 2,000 5,000 8,000

Number of Shares 1,000 1,000 1,000

EPS (Rs.) 2 5 8

Z & Co. (75% Leverage) (Figures in Rs.)

EBIT 10,000 16,000 22,000

- Interest 9,000 9,000 9,000

Profit before Tax 1,000 7,000 13,000

- Tax @ 50% 500 3,500 6,500

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Profit After Tax 500 3,500 6,500

Number of Shares 500 500 500

EPS (Rs.) 1 7 13

On the basis of the figures given above, it may be analyzed as to how the
financial leverage affects the returns available to the shareholders under varying EBIT
level. For this purpose, the normal rate of return i.e. 8% and EPS of different firms in
normal economic conditions, both may be taken at 100 and position of other figures of
EBIT and EPS may be shown on relative basis as follows:

Poor Eco. Cond. Normal Eco. cond. Good Eco.

cond.
EBIT 62.5 100 137.5
X & Co.
EPS 62.5 100 137.5
% change from normal - 37.5% ---- + 37.5%
Y & Co.
EPS 40 100 160
% change from normal -60% ----- +60%
Z & Co.
EPS 14.3 100 185.7
% change from normal -85.7% ----- +85.7%

Problem 4:
PQR & Co. is expecting an EBIT of Rs.55,00,000 after implementing the
expansion plan for Rs.50,00,000. The funds requirements needed to implement the
plan can be raised either by the issue of further equity share capital at an issue
price of Rs.5,000 each, or by the issue of 10% debenture. Find out the EPS under
these two alternative plans if the existing capital structure of the firm stands at
10,000 shares. The above situation can be analyzed as follows:

Particulars Financial Plan 1 Financial Plan 2

Number of existing shares 10,000 10,000

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Number of new shares 1,000 ---
Total Number of shares 11,000 10,000
10% Debenture --- Rs.50,00,000
EBIT (Given) Rs.55,00,000 Rs.55,00,000
- Interest --- 5,00,000
Profit before Tax 55,00,000 50,00,00
Tax @ 50% 27,50,000 25,00,000
Profit after Tax 27,50,000 25,00,000
EPS (Rs.) 250 250

So, at the EBIT level of Rs.55,00,000, the EPS is expected to be Rs.250

irrespective of the fact whether the additional funds are raised by the issue of
equity share capital or by the issue of 10% debt. This EBIT level of Rs.55,00,000 is
known as the indifference level of EBIT. However, in case the company is
expecting EBIT of Rs.50,00,000 or Rs.60,00,000, the EPS for both the financial
plans has been calculated in the following table.
Solution :

Financial Plan 1 Financial Plan 2

EBIT Rs.50,00,000 Rs.60,00,000 Rs.50,00,000 Rs.60,00,000
- Interest --- --- 5,00,000 5,00,000
Profit before Tax 50,00,000 60,00,000 45,00,000 55,00,000
Tax @ 50% 25,00,000 30,00,000 22,50,000 27,50,000
Profit after Tax 25,00,000 30,00,000 22,50,000 27,50,000
Number of Equity shares 11,000 11,00 10,000 10,000
EPS (Rs.) 227 272 225 275

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Problem 5:
The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amount

Equity share capital 60,000 Fixed Assets 1,50,000

Retained Earnings 20,000 Current Assets 50,000

10% long term debt 80,000

Current Liabilities 40,000
2,00,000 2,00,000

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

Sales 6,00,000
Variable Operating Cost (40%) 2,40,000
Contribution 3,60,000
Less Fixed cost 1,00,000
EBIT 2,60,000
Less interest (10% of 80,000) 8,000
PBT 2,52,000
Taxat50% 1,26,000
PAT 1,26,000
Number of shares 6,000
EPS Rs.21

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Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT / PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage =1.38 x 1.03 = 1.42

Problem 6:
The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed Costs 7,00,000
Calculate % change in EPS if the sales are expected to increase by 5%.
Solution: In order to find out the % change in EPS as a result of % change in
sales, the combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs.11,20,000 + Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT / Profit before Tax
= Rs. 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/ Profit before Tax = OL x FL
= 1.625 x 3.5 = 5.69
The combined leverage of 5.69 implies that for 1% change in sales level, the %
change in EPS would be 5.69% So, if the sales are expected to increase by 5%, then the
% increase in EPS would be 5 x 5.69 = 28.45%.
Problem 7:
The data relating to two companies are as given below:

Company A Company B
Capital Rs.6,00,000 Rs.3,50,000
Debentures Rs. 4,00,000 6,50,000

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Output (units) per annum 60,000 15,000
Selling price/unit 30 250
Fixed costs per annum 7,00,000 14,00,000
Variable cost per unit 10 75

You are required to calculate the Operating leverage, financial leverage and
Combined Leverage of two companies.
Solution:
Computation of Operating leverage, Financial Leverage and Combined leverage

Company A Company B
Output (units) per annum 60,000 15,000
Selling price/unit .30 250
Sales Revenue 18,00,000 37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
on debentures 48,000 78,000
PBT 4,52,000 11,47,000
DOL Contribution/EBIT 12,00,000/5,00,000 26,25,000/12,25,000
= 2.4 = 2.14
DFL = EBIT/ PBT 5,00,000/4,52,000 12,25,000/11,47,000
=1.11 =1.07
DCL = DOL x DFL 2.14 x 1.11 = 2.66 2.14 x 1.07 = 2.2

Problem 8:
X Corporation has estimated that for a new product its break-even point is 2,000
units if the item is sold for Rs. 14 per unit, the cost accounting department has
currently identified variable cost of Rs. 9 per unit. Calculate the degree of
operating leverage for sales volume of 2,500 units and 3,000 units. What do you
infer from the degree of operating leverage at the sales volume of 2,500 units and
3,000 units and their difference if any?
Solution:

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 Statement of Operating Leverage

Particulars 2500 units 3000 units

Sales Rs.14 per unit 35,000 42,000
Variable cost 22,500 27,000
Contribution 12,500 15,000
Fixed Cost 10,000 10,000
EBIT 2,500 5,000
DOL=C/EBIT 12,500/2,500 15,000/5,000
=5 =3

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 UNIT V (THEORY)

MEANING OF WORKING CAPITAL

Business organization require adequate capital to establish business and operate their
activities. The total capital of a business can be classified as fixed capital and working
capital. Fixed capital is required for the purchase of fixed assets like building, land,
machinery, furniture etc. Fixed capital is invested for long period; therefore it is known
as long-term capital .Similarly, the capital, which is needed for investing in current
assets, is called working capital.

The capital which is needed for the regular operation of business is called working
capital. Working capital is also called circulating capital or revolving capital or short-
term capital. Working capital is used for regular business activities like for the purchase
of raw materials, for the payment of wages, payment of rent and of other expenses.
Working capital is kept in the form of cash, debtors, raw materials inventory, stock of
finished goods, bills receivable etc.

CONCEPT OF WORKING CAPITAL

Generally, there are two concepts of working capital i.e. gross concept and net concept.
1. Gross Concept of Working Capital
According to gross concept, working capital refers to all the current assets and
represents the amount of funds invested in current assets. Thus, gross working capital is
the capital invested in current assets. Current assets are those assets which can be
converted into cash within the short-time period.
Gross Working Capital = Total current assets

In this way, gross working capital refers to the firm's investment in current assets. Gross
working capital represents total of current assets which includes cash in hand, cash at
bank, inventory, prepaid expenses, bills receivable etc.

2. Net Concept of Working Capital

According to the net concept, working capital is the excess of current assets over
current liabilities. In other words, the difference between current assets and current
liabilities is called net working capital
. Net Working Capital = Current Assets - Current liabilities
In this way, net working capital is the difference of current assets and current liabilities.

DETERMINANTS OF WORKING CAPITAL :

A company, as a general policy, wants to hold in balance as small a quantity of working

capital as possible so long as undue solvency risks are not imposed on it. This is a
logical approach indicating that working capital is a means to an end and not an end in
itself.
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Quantitative amounts of working capital can hardly be set for individual firms. The
corporate management has to consider the various factors in making decision regarding
balances. An appraisal of these would provide guidance to management in estimating
prospective needs. These are called as determinants of working capital.
1. Nature of business:
A company’s working capital requirements are basically related to the kinds of business
it conducts. Generally speaking, trading and financial firms require relatively large
amounts of working capital, public utilities comparatively small amounts, whereas
manufacturing concerns stand between these two extremes, their needs depending upon
the character of industry of which they are a part.
2. Production policies:
Depending upon the kind of items manufactured, a company is able to offset the effect
off- seasonal fluctuations upon working capital by adjusting its production schedules.
The choice rests between varying output in order to adjust inventories to seasonal
requirements and maintaining a steady rate of production and permitting stocks of
inventories to build up during off-season periods. It will thus be obvious that a level
production plan would involve a higher investment in working capital.
3. Manufacturing process:
If the manufacturing process in an industry entails a longer period because of its
complex character, more working capital is required to finance that process. The longer
it takes to make an approach and the greater its cost, the larger the Inventory tied up In
Its manufacture and, therefore, higher the amount of working capital.
4. Turnover of circulating capital:
The speed with which the circulating capital completes its round I.e., conversion of cash
into inventory of raw material Into Inventory of finished goods. Inventory of finished
goods into book debts or accounts receivables and book debt into cash account, plays an
Important and decisive role in judging the adequacy of working capital.
5. Growth and expansion of business:
As a company grows, it is logical to expect that larger amount of working capital will
be required though It Is difficult to draw up firm rules for the relationship between the
growth in the volume of a company’s business and the growth of its working capital.
6. Business cycle fluctuations:
Requirements of working capital of a company vary with the business variation. At a
time when the price level comes up and boom condition prevail, the psychology of the
management is to pile up a big stock of raw material and other goods likely to be used
in the business operations as there is an expectation to take advantage of lower prices.
The expansion of business units caused by the inflationary conditions creates demand
for more and more capital.
7. Terms of purchase and sales:
A business unit, making purchases on credit basis and selling its finished products on
cash basis, will require lower amount of working capital, on the contrary, a concern
having no credit facilities and at the same time forced to grant credit to its customers
may find itself in a tight position.

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8. Dividend policy:
A desire to maintain an established dividend policy may affect working capital, often
changes in working capital bring about an adjustment of dividend policy. The
relationship between dividend policy and working capital is well established and very
few companies declare a dividend without giving due consideration to its effects on
cash and their needs for cash.

DIFFERENCE BETWEEN PROFITABILITY AND LIQUIDITY

Profitability and liquidity are the two terms which are most widely watched by both the
investors and owners in order to gauge whether the business is doing good or not. Given
below are the differences between profitability and liquidity –

1. Profitability refers to profits which the company has made during the year which
is calculated as difference between revenue and expense done by the company,
whereas liquidity refers to availability of cash with the company at any point of
time.
2. A profitable company may not have enough liquidity because most of the funds
of the company are invested into projects and a company which has lot of cash or
liquidity may not be profitable because of lack of opportunities for putting idle
cash.
3. Gross profit, net profit, operating profit, return on capital employed are some of
the ratios which are used to calculate profitability of the firm while current ratio,
liquid ratio and cash debt coverage ratio are some of the ratios which are used to
calculate liquidity of the firm.
4. A company which is profitable can go bankrupt in the short term if it does not
have liquidity whereas a company which has liquidity but is not profitable
cannot go bankrupt in the short term.

Hence as one can see from the above that profitability and liquidity are not same and
the company has to maintain a fine balance between the two because if company
focuses on too much profitability then it runs the risk of not able to pay its creditors,
employees and other parties whereas on the other hand if company focuses on liquidity
and then it runs the risk of going into loss.

DEFINITION OF 'RISK RETURN TRADE OFF'

Definition: Higher risk is associated with greater probability of higher return and lower
risk with a greater probability of smaller return. This trade off which an investor faces
between risk and return while considering investment decisions is called the risk return
trade off.

However, if he invests in equities, he faces the risk of losing a major part of his capital
along with a chance to get a much higher return than compared to a saving deposit in a
bank.

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WORKING CAPITAL ESTIMATION METHODS

The following points highlight the top three methods of working capital estimation. The
methods are: 1. Percentage of Sales Method 2. Regression Analysis Method 3.
Operating Cycle Method.

1. Percentage of Sales Method:

It is a traditional and simple method of determining the level of working capital and its
components. In this method, working capital is determined on the basis of past
experience. If, over the years, the relationship between sales and working capital is
found to be stable, then this relationship may be taken as a base for determining the
working capital funds.
2. Regression Analysis Method:
It is a useful statistical technique applied for forecasting working capital requirements.
It helps in making working capital requirement projections after establishing the
average relationship between sales and working capital and its various components in
the past years. The method of least squares is used in this regard.
3. Operating Cycle Method:
The operating cycle concept can be used in estimation of working capital. The longer
the length of operating cycle, the higher the requirement for working capital and vice
versa.

Under this method each individual items of current assets and current liabilities
are estimated as follows:

Raw Material Stock:

It is to be ensured that there is no excess holding of raw material inventory over the
required level of quantity. The proper level of stock holding is determined taking into
consideration the rate of production, safety stock level, economic order quantity, stock
holding costs, lead time for material supplies, amount of working capital required for
maintaining stock of raw materials, availability of material etc.
The level of investment in raw material stock is determined taking into
consideration the average period for which it is held in stock, e.g., raw materials are
held in stock, on an average, for 2 months.

Work-in-Progress Stock:
In process industries there is likely to be partly completed units lying in stocks, which
require working capital. The production cycle should be reduced to the most optimum
level to reduce the level of investment in work-in-progress. In partly completed items,

83
some portion of raw material, labour and overhead costs are incurred, the balance is to
be incurred for conversion of it into finished item.

Finished Goods Stock:

At the end of production process, the units are converted into finished products, which
are held in stock for some time until it is despatched to the customers on sale. The
reduction in time lag between completion of production and its sale to ultimate
customer should be minimum and production planning should be done to achieve the
goal.

To meet the seasonal demand, it might be necessary to hold more stocks of finished
goods. The investment in stock of finished goods is determined at cost of goods sold,
e.g., finished goods remain in warehouse, on an average, for 2 months.

Investment in Debtors:

The cash sale does not require working capital. But the credit sales will tied- up the
funds for some time, until the debtors balance is realized. A proper credit policy has to
be established based on creditworthiness of customer. An effective administration of
debtors has to be established and properly monitored.
The economics of cash sales, credit sales, cash discounts, trade discounts, factoring etc.
should be considered. The actual funds locked-up in debtors balances is only to the
extent of cost of goods sold. It would be more practical, if investment in debtors
balances is ascertained at cost of sales, not at selling price, e.g., credit allowed to
debtors is 2 months from the date of despatch, 20% of sales are on cash basis.

Cash Balances:
The required cash balance can be determined with the help of preparation of cash
budget. Proper cash budget should be prepared and continuous monitoring of the same
is required. It should be kept in view that cash balances are the most liquid assets and
temporary cash surplus should be properly invested in short-term marketable
investments to maximize the return on capital employed.

Prepaid Expenses:
Sometimes, the expenses are to be paid in advance, which require the working capital,
e.g., sales promotion expenses paid quarterly in advance.

84
Sundry Creditors:
Generally the suppliers of raw materials, consumables, stores etc. will allow credit
period for payment called as ‘trade credit’. Creditors provide the company with working
capital requirement. The company should negotiate with the supplier’s maximum credit
period at lowest overall cost.

Credit period should be negotiated for purchases in such a manner that the timings of
cash availability is taken into account. The trade credit reduces the level of working
capital requirement, e.g., suppliers of materials extend a month credit, cash purchases
are 25%.

Creditors for Wages and Expenses:

The wages and expenses may not be required to pay immediately, which will also ease
the working capital requirement e.g., there is a time lag in payment of wages of a month
and half-a-month in case of overheads.

Steps in Determination of Working Capital:

The individual components method of estimation of working capital involves the

following steps:

Step 1:
Identify the various items of current assets and current liabilities which consist in
determination of working capital. The current assets include inventory of raw materials,
WIP and finished goods, sundry debtors, prepaid expenses, desired cash balance etc.
The current liabilities include creditors for raw materials, stores and consumables,
creditors for wages, creditors for expenses, etc.
Step 2:
(a) Estimate the holding period of each item stock i.e., raw materials, work-in- progress
and finished goods.
(b) Estimate the collection period of sundry debtors.
(c) Estimate the desired cash balance for meeting the requirements of day to day
operations.
(d) Estimate the payment deferral period of creditors for raw materials.
(e) Estimate the lag in payment of wages and expenses.
Step 3:
(i) Determine the raw material, labour and overheads cost per unit.
(ii) Determine the operating level.
85
(iii) Determine the percentage of conversion cost incurred on WIP.
(iv) Determine the cost of sale and selling price per unit.
Step 4:
Ascertain the value of each item of current assets and current liabilities taking into
account the information in step (2) and step (3).
Step 5:
Put the values of current assets and current liabilities in a statement form and ascertain
the net working capital (ie. current assets – current liabilities) after adding up the
desired cash balance and amount needed for meeting contingencies.

CASH MANAGEMENT

Cash is considered as vital asset and its proper management support company
development and financial strength. An effective cash management program designed
by companies can help to realise this growth and strength. Cash is vital element of any
company needed to acquire supply resources, equipment and other assets used in
generating the products and services. Marketable securities also come under near cash,
serve as back pool of liquidity

OBJECTIVE OF CASH MANAGEMENT

1. To make Payment According to Payment Schedule: Firm needs cash to meet its
routine expenses including wages, salary, taxes etc.
2. To minimise Cash Balance: The second objective of cash management is to
reduce cash balance. Excessive amount of cash balance helps in quicker
payments, but excessive cash may remain unused & reduces profitability of
business. Contrarily, when cash available with firm is less, firm is unable to pay
its liabilities in time. Therefore optimum level of cash should be maintained

IMPORTANT OF CASH MANAGEMENT

1. Cash management guarantees that the firm has sufficient cash during peak times
for purchase and for other purposes.
2. Cash management supports to meet obligatory cash out flows when they fall due.
3. Cash management helps in planning capital expenditure projects.
4. Cash management helps to organize for outside financing at favourable terms
and conditions, if necessary.
5. Cash management helps to allow the firm to take advantage of discount, special
purchases and business opportunities.
6. Cash management helps to invest surplus cash for short or long-term periods to
keep the idle funds fully employed.

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Benefits of Cash Management System

In the period of technology progression, the Cash Management System provides

following Benefits to its customers:
1. Funds availability as per need on day zero, day one, day two, day three etc. i.e.
Corporate can plan their cash flows.
2. Bank interest saved as instruments are collected faster.
3. Affordable and competitive rates.
4. Single point enquiry for all queries.
5. Pooling of funds at desired locations.
To summarize, Cash Management denotes to the concentration, collection and
disbursement of cash. The major role for managers is to maintain the flow of cash. Cash
Management include a series of activities aimed at competently handling the inflow and
outflow of cash. This mainly involves diverting cash from where it is to where it is
needed. It is established that cash management is the optimization of cash flows,
balances and short-term investments.

RECEIVABLE MANAGEMENT

Accounts receivable typically comprise more than 25 percent of a firm's assets. The
term receivables is described as debt owed to the firm by the customers resulting from
the sale of goods or services in the ordinary course of business. There are the funds
blocked due to credit sales. Receivables management denotes to the decision a business
makes regarding to the overall credit, collection policies and the evaluation of
individual credit applicants. Receivables Management is also known as trade credit
management. Robert N. Anthony, explained it as "Accounts receivables are amounts
owed to the business enterprise, usually by its customers. Sometimes it is broken down
into trade accounts receivables; the former refers to amounts owed by customers, and
the latter refers to amounts owed by employees and others".

87
ADVANTAGES OF RECEIVABLE MANAGEMENT:

Accounts Receivables Management has numerous benefits. These include:

1. Increased Sales: Offering goods or services on credit enhances sales, by holding
old customers and attraction potential customers.
2. Increased Market Share: When the firm is able to maintain old customers and
attract new customers automatically market share will be bigger to the extent
new sales.
3. Increase in profits: Increase sales, leads to increase in profits, because it need to
produce more products with a given fixed cost and sales of products with a given
sales network in both cost per unit comes down and the profit will be better.

INVENTORY MANAGEMENT

Inventory management is basically related to task of controlling the assets that are
produced to be sold in the normal course of the firm's procedures. In supply chain
management, major variable is to effectively manage inventory. The significance of
inventory management to the company depends on the extent of its inventory
investment.
The objectives of inventory management are of twofold:
1. The operational objective is to uphold enough inventory, to meet demand for
product by efficiently organizing the firm's production and sales operations.
2. Financial interpretation is to minimize unproductive inventory and reduce
inventory, carrying costs.
Effective inventory management is to make good balance between stock
availability and the cost of holding inventory.

Advantages of Inventory Management

There are several advantages of managing inventory in proper way.
1. Inventory management guarantees adequate supply of materials and stores to
minimize stock outs and shortages and avoid costly interruption in operations.
2. It keeps down investment in inventories, inventory carrying costs, and
obsolescence losses to the minimum.
3. It eases purchasing economies throughout the measurement of requirements on
the basis of recorded experience.

88
 4. It removes duplication in ordering stock by centralizing the source from which
purchase requisition emanate.
5. It allows better utilization of available stock by enabling inter-department
transfers within a firm.
6. It offers a check against the loss of materials through carelessness or pilferage.
7. Perpetual inventory values provide a stable and reliable basis for preparing
financial statements a better utilization.

(Problems and solutions)

Problem 1:
From the following information, prepare a statement in column form showing ·
the working capital requirements. (i) In total and (ii) as regards each constituent
part of working capital.

Budgeted sales ( 10 per unit) 2,60,000 p.a.

Analysis of Costs Rs.
Raw Materials 3.00
Direct Labour 4.00
Overheads 2.00
Total Cost 9.00
Profit 1.00
Sales 10.00

It is estimated that
(i) Raw materials are carried in stock for three weeks and finished goods for two
weeks.
(ii) Factory processing will take three weeks.
(iii) Suppliers will give full five weeks credit.
(iv) Customers will require eight weeks credit.
It may be assumed that production and overheads accrue evenly throughout
the year.

Solution:

Statement of Working Capital Requirement

Current Assets

Raw Materials 78,000 x 3/52 4,500

Work in Progress (Note) 9,000
Finished Goods 2, 34,000 x 2/52 9,000
Debtors 2, 60,000 x 8/52 40,000

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 62500
Less : Current Liabilities
Trade Creditors (5 weeks) 5/52 x 78,000 7,500
Working Capital Required 55,000

Working Notes:

(i) Number of Units 26,000

(ii) Finished Goods
Raw Materials 26,000 x 3 78,000
Direct Labour 26,000 x 4 1, 04,000
Overheads 26,000 x 2 52,000
Finished Goods 2, 34,000

(iii) Work in Progress

Raw Material 78,000 x 3/52 4,500
Labour 1, 04,000 x 3/52 x 112 3,000
Overhead 52,000 x 3/52 x 112 1,500
Work in Progress 9,000

Problem 2:

From the following estimates of Sethal Ltd you are required to prepare a forecast
of working capital requirements.
(i) Expected level of production for the year 15,600 units
(ii) Cost per unit: Raw Materials 90, direct labour 40, overheads 75.
(iii) Selling Price per unit 265
(iv) Raw Materials in stock on an average for 1 month
(v) Materials are in process on an average for 2 weeks.
(vi) Finished goods in stock on an average for 1 month.
(vii) Credit allowed by suppliers is one month.
(viii) Time lag in payment from debtors is 2 months.
(ix) Lag in payment of wages 11/2 weeks.
(x) Lag in payment of overheads is one month. All sales are on credit.
(xi) Cash in hand and at Bank is expected to be 60,000.

It is assumed that production is carried on evenly throughout the year. Wages and
overheads accrued evenly and a period of 4 weeks is equivalent to a month.

Solution :

Statement of working capital Requirement

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Current Assets
Raw materials 1,08,000 x 1 1,08,000
Finished goods 2,46,000 x 1 2,46,000
Debtors 2 months 2,46,000 X 2 4,92,000
Work in progress 88,500
Cash in hand and at Bank 60,000
9,94,500

Less : Current Liabilities 1,08,000

Creditors 1,08,000 x 1
Lag in payment of wages 1112 weeks
48 000 X 3/2 x 1/4 18,000
Lag in payment of overheads (90,000 x 1) 90,000
2,16,000
Working capital required 7,78,500
[9,94,500 – 2,16,000]

Working notes :

Estimated sales = 15,600

units
A period of 4 weeks is taken as equivalent to one month.
1200 units
Therefore, sales per month = 15,600 x 52 3,18,000
Estimated sales per month = 265 x 1,200 1,08,000
Raw Materials p.m. 1,200 x 90 48,000
Direct Labour p.m. 1,200 x 40 90,000
Overheads p.m. 1,200 x 75 2,46,000
Cost of Sales/Finished Goods
54,000
Work in progress 12,000
Raw materials (2 weeks) 1,08,000 x 1/2 22,500
Labour (2 weeks) 48,000 x 1/2 88,500
Overhead (2 weeks) 90,000 x1/2 x 1/2

NOTE: Labour and overheads are reduced to one half as they accrue evenly during the
year.
Problem 3:
A proforma cost sheet of a company provides the following particulars:

Elements of Cost Amount per unit

Rs.
Raw Material 80
Direct Labour 30

91
 Overheads 60
Total Cost 170
Profit 30
Selling Price 200
The following further particulars are available:
Raw materials are in stock on an average for one month. Materials are in
process on an average for half a month. Finished goods are in stock on an average
for one month. Credit allowed by suppliers is one month. Credit allowed to
customers is two months. Lag in payment of wages is 1½ weeks. Lag in payment of
overhead expenses is one month. One-fourth of the output is sold against cash.
Cash in hand and at bank is expected to be Rs.25,000.
You are required to prepare a statement showing the working capital
needed to finance a level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year,
wages and overheads accrue similarly and a time period of 4 weeks is equivalent to
a month.

Solution:
Statement Showing the Working Capital Needed
Current Assets Rs.
Minimum cash balance 25,000
(i) Stock of raw materials (4 weeks)
1,60,000 x 4 6,40,000
Rs.
(ii) Work-in-Process (2 weeks):
Raw materials 1,60,000 x 2 3,20,000
Direct Labour 60,000 x 2 1,20,000
Overheads 1,20,000 x 2 2,40,000 6,80,000
(iii) Stock of Finished goods (4 weeks):
Raw Materials 1,60,000 x 4 6,40,000
Direct Labour 60,000 x 4 2,40,000
Overheads 1,20,000 x 4 4,80,000 13,60,000
(iv) Sundry Debtors (8 weeks):
Raw materials 1,60,000 x 3/4 x 8 9,60,000
Direct Labour 60,000 x 3/4 x 8 3,60,000
Overheads 1,20,000 x 3/4 x 8 7,20,000 20,40,000
47,45,000
Less Current Liabilities:
(i) Sundry Creditors (4 weeks)
1,60,000 x 4 6,40,000
90,000

(ii) Wages outstanding (1-1/2 weeks): 60,000 x

(iii) Lag in payment of overheads (4 weeks)
1,20,000 x 4 4,80,000 12,10,000
Net Working Capital Needed 35,35,000

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Working Notes:
(i) It has been assumed that a time period of 4 weeks is equivalent to one month.
(ii) It has been assumed that direct labour and overheads are in process, on average,
half a month.
(iii) Profit has been ignored and debtors have been taken at cost.
(iv) Weekly calculations have been made as follows:
(a) Weekly average of raw materials = 1,04,000 x 80/52 = 1,60,000
(b) Weekly labour cost = 1,04,000 x 30/52 = 60,000
(c) Weekly Overheads = 1,04,000 x 60/52 = 1,20,000

Problem 4:
The Board of Directors of Ruby Ltd. requests you to prepare a statement showing
the working capital requirements forecast for a level of activity of 1,56,000 units of
production. The following information is available for your calculation:

(a) Raw materials are in stock on average one month.

(b) Materials are in process, on average 2 weeks.
(c) Finished goods are in stock, on average one month.
(d) Credit allowed by suppliers – one month.
(e) Time lag in payment from debtors – 2 months.
(f) Lag in payment of wages – 1 week.
(g) Lag in payment of overheads – one month.
20% of the output is sold against cash. Cash in hand and at bank is expected to be
Rs. 60,000. It is to be assumed that production is carried on evenly throughout the
year. Wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
Solution:

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Problem 5:
Prepare an estimate of working capital and projected Balance Sheet for the year
ended on 31.12.2002 from the following information.
i).Share capital 5, 00,000, 15% Debentures of 2, 00,000, Fixed assets at cost of 3,
00,000.
ii). The expected ratios of cost to selling price are Raw materials 60%, Labour
10%,Overheads 20%.
(iii) Raw materials are in stores for an average of 2 months.
(iv) Finished goods are kept in warehouse for 3 months.
(v) Expected level of production 1, 20,000 units per year.
(vi) Each unit of production is expected to be in process for 1 month.
(vii) Credit given by suppliers is 2 months.
(viii) 20% of the output is sold against cash. Time lag in payment from debtors is 3
months.

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 (ix) Selling price is 5 per unit
(x) Labour and overheads will accrue evenly during the year.

Solution:

Statement of Working Capital requirement

Current Assets
Raw Materials (2 months)
Work in progress
Stock of finished goods (3 months)
Debtors 3 months
Total Current Assets

Less : Current Liability

Creditors 2 months
Working Capital required [3,40,500 – 60,000]

Working Notes:

Estimated production units 1,20,000 / 12

Sales p.m. 10,000 units x 5

(i) Finished goods :

Raw Materials 60% = 50,000 x 60/100
Direct Labour 10% = 50,000 x 10/100
Overheads 20% = 50,000 x 20/100

Finished goods/Cost of sales

(ii) Work in progress (1 month)

Raw materials
Labour 5000 x 1/2
Overheads 10,000 x 1/2
W.I.P

(iii) Debtors (3months) at cost equivalent

Cost of sales pm
Less : Cash sales 20%
Cost of sales (credit) pm
Debtors (3 months) at cost equivalent
= 36,000 x 3

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Projected Balance Sheet as on 31.12.2002

Liabilities Rs. Assets Rs.

Share Capital 5,00,000 Fixed Assets at cost 3,00,000

15% Debentures 2,30,000 Current Assets :

Creditors 60,000 Raw Materials 60,000

Work in progress 37,500

Stock of Finished Goods 1,35,000

Debtors 1,20,000

Profit & Loss A/c 30,000

Cash (BF) 1,07,500

7,90,000 7,90,000

Problem 6:
From the following forecast of income and expenditure, prepare cash
budget for the months January to April, 1995.

Sales Purchases Wages Manufac- Adminis Selling

Months Expenses
ring trative
expenses expenses

1994
Nov 30,000 15,000 3,000 1,150 1,060 500
Dec 35,000 20,000 3,200 1,225 1,040 550
1995
Jan 25,000 15,000 2,500 990 1,100 600
Feb 30,000 20,000 3,000 1,050 1,150 620
March 35,000 22,500 2,400 1,100 1,220 570
April 40,000 25,000 2,600 1,200 1,180 710

Additional information is as follows: -

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1. The customers are allowed a credit period of 2 months.
2. A dividend of Rs. 10,000 is payable in April.
3. Capital expenditure to be incurred: Plant purchased on 15th January for Rs.
5,000; a Building has been purchased on 1stMarch and the payments are to be
made in monthly instalments of Rs. 2,000 each.
4. The creditors are allowing a credit of 2 months.
5. Wages are paid on the 1st of the next month.
6. Lag in payment of other expenses is one month.
7. Balance of cash in hand on 1st January, 1995 is Rs. 15,000.

Solution:
Details January February March April

Receipts
15,000 18,985 28,795 30,975
Opening Balance of
cash
Cash realized from 30,000 35,000 25,000 30,000
debtors
Payments
Payments to customers 15,000 20,000 15,000 20,000

Wages
Manufacturing 3200 2500 3000 2400
expenses 1225 990 1050 1100
Administrative
expenses 1040 1100 1150 1220
Selling expenses
Payment of dividend 560 600 620 570
Purchase of plant ------ ------ ------ 10,000
Instalment of building 5000 ----- ------ ------
plant ----- ---- 2,000 2,000
Total Payments

Closing Balance 26,015 25,190 22,820 37,290

18,985 28,795 30,975 23,685

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Problem 7:

A company has prepared the following projections for a year

Sales 21000 units

Selling Price per unit Rs.40
Variable Costs per unit Rs.25
Total Costs per unit Rs.35
Credit period allowed One month

The company proposes to increase the credit period allowed to its customers from
one month to two months .It is envisaged that the change in policy as above will
increase the sales by 8%. The company desires a return of 25% on its investment.
You are required to examine and advise whether the proposed credit policy should
be implemented or not?
Solution:
Particulars Present Proposed Incremental
Sales (units) 21000 22680 1680
Contribution per unit Rs.15 Rs.15 Rs.15
Rs.3,15,000 Rs.3,40,000 Rs.25,200
Total Contribution
5,25,000 5,67,000 42,000
Variable cost @ Rs.25 2,10,000 2,10,000 ------
Fixed Cost 7,35,000 7,77,000 42,000
1 month 2 month -----
Total Cost
Rs.61250 Rs.1,29,500 Rs.68,250
Credit period
Average debtors at cost

Incremental Return = Increased Contribution/Extra Funds

Blockage *100
= Rs.25,200/Rs.68,250*100 =36.92%

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