Financial management

Disha Institute of IT & Management

I Disha Institute of IT & Management

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Financial Management Unit I Meaning of Financial Management:- Financial Management is such a managerial process which is concerned with the planning and control of Financial resources. It is being studied as a separate subject in 20th century. Till now it was used as a part of economics. Now, its scope has undergone some basic changes from time to time. In present time, it analyses all financial problems of a business. Financial Manager estimates the requirements of funds, plans the different sources of funds and perform functions of collection of funds and its effective utilisation. Finance is such a powerful source that it performs an important role to operate and coordinate the various economic activities of business. Finance is of two types:-

(1) Public finance. (2) Private finance.

1. Public Finance:- means government finance under which principles and practices relating to the procurement and management of funds for central government, state government and local bodies are covered. 2. Private Finance:- means procurement and management of funds by individuals and private institutions. Under it we observe as to how individuals and private institution procure funds and utilise it. Scope:- What is finance? What are a firm’s financial activities? How are they related? Firm create manufacturing capacities for production of goods, some provide services to customers. They sell goods or services to earn profit and raise funds to acquire manufacturing and other facilities. Thus, the 3 most important activities of business firm are:-

(1) Production (2) Marketing





(3) Finance. A firm secures whatever capital it needs and employs it (finance activity) in activities which generate returns on invested capital (production and marketing activities.) Real and financial Assets:-

A firm acquire real assets to carry on its business. Real assets can be tangible or intangible. Plant, machinery, factory, furniture etc. are examples of tangible real assets, while technical know-how, patents, copy rights are examples of intangible real assets.

The firm sells financial assets or securities such as shares and bonds or debentures, to investors in capital market to raise necessary funds. Financial assets also include borrowings from banks, finance institutions and other sources.

Funds applied to assets by the firm are called capital expenditure or investment. The firm expects to receive return on investment and distribute return as dividends to investors. EQUITY AND BORROWED FUNDS:- There are two types of funds that a firm can raise:- Equity funds and borrowed funds. A firm sells shares to acquire equity funds. Shares represent ownership rights of their holders. Buyers of shares are called share holders and they are legal owners of the firm whose share they hold share holders invest their money shares of a company in expectation of return on their invested capital. The return on shares holder’s capital consists of dividend and capital gain by selling their shares. Another important source of securing capital is creditors or lenders. Lenders are not the owners of the company. They make money available to firm on a lending basis and retain title to the funds lent. The return on loans or borrowed funds is called interest. Loans are furnished for a specified period at a fixed rate of interest. Payment of interest is a legal obligation. The amount of interest is allowed to be treated as expense for computing corporate income taxes. Thus the payment of interest on borrowings provides tax shied to a firm. The firm may borrow funds from a large number of sources, such as banks, financial institutions, public or by issuing bonds or debentures. A bond or





debenture is a certificate acknowledging the money lent by a bond holder to the company. It states the amount, the rate interest and maturity of bonds or dentures. FINANCE AND OTHER MANAGEMENT FUNCTIONS:- There exists an inseperable relationship between finance on the one hand and production, marketing and other functions on the other. Almost, all kinds of business activities, directly or indirectly, involve acquisition and use of funds. For example, recruitment and promotion of employees in production is clearly a responsibility of production department but it require payment of wages and salaries and other benefits and thus involve finance. Similarly, buying a new machine or replacing an old machine for the purpose of increasing productive capacity affects flow of funds. A company in tight financial position will of course, give more weight to financial considerations and devise its marketing and production strategies in light of financial constraint. On other hand, management of a company, which has a regular supply of funds, will be more flexible in formulating its production and marketing policies. In fact, financial policies will be devised to fit production & marketing decision of firms in practice. OBJECTIVES OF FINANCIAL MANAGEMENT:- It is the duty of management to clarify the objectives of business so that the departmental objectives could be determined accordingly. Financial objectives of a firm provide a concrete framework within which optimum financial decisions can be made. The main objective of any firm should be to maximise the economic welfare of its shareholders. Accordingly, there are 2 approaches in this regard.

(A) Profit maximisation Approach. (B) Wealth maximisation Approach.

(A) PROFIT MAXIMISATION APPROACH:-

According to this approach, a firm should undertake all those activities

which add to its profits and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:- financing, dividend and investment, should result in profit maximisation. Following arguments are given in favour of profit maximisation approach:-





(i) Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can be evaluated.

(ii) It helps in efficient allocation and utilisation of scarce means because only such resources are applied which maximise the profits.

(iii) The rate of return on capital employed is considered as the best measurement of the profits.

(iv) Profit acts as motivator which helps the business organisation to be more efficient through hard work.

(v) By maximising profits, social & economics welfare is also maximised. However this approach has been criticised on various counts:- (1) Ambiguity:- Profit can be expressed in various forms i.e it can be short term or long term or it can be profit before tax or after tax or it can be gross profit or net profit. Now the question arises, which profits can be maximised under profit maximisation approach. (2) Time Value of Money This approach is also criticised because it ignores time value of money i.e. under this approach income of different years get equal weight. But, in fact, the value of rupee today will be greater as compared to the value of rupee receivable after one year. In the same manner, the value of income received in the first year will be greater from that which will be received in later year e.g. the profits of 2 different projects are:- Example:- YEAR PROJECT1 PROJECT2 1 5,000 - 2 10,000 10,000 3 5,000 10,000 Both the projects have a total earnings of Rs 20,000 in 3 years and according to this approach both will be considered equally profitable. But Project 1 has greater profits in the initial years of the project & therefore, is more profitable in terms of value of income. The profits earned in initial years can be reinvested and more profits can be earned. (3) Risk Factor:-





This approach ignores risk factor. The certainity or uncertainity of income receivable in future can be high or less. High uncertainity increases risk and less uncertainity reduces risk. Less income with more certainity is considered better as compared to high income with greater uncertainity. Thus, this approach was more significant for sole trader & partnership firms because at that time when personal capital invested in business, they wanted to increase their assets by maximising profits. Companies are now managed by professional managers and capital is provided by shareholders, debenture holders, financial institutions etc. one of the major responsibilities of business management is to co-ordinate the conflicting interest of all these parties. In such a situation profit maximisation approach does not appear proper and practicable for financial decisions. B Wealth Maximisation Approach Value Maximisation Approach or Maximum net present worth. According to this approach , financial management should take such decision’s which increase net present value of the firm and should not undertake any activity which decrease net present value. This approach eliminates all the 3 basic crificisms of the profit maximisation approach. As the value of an asset is considered from view point of profit accruing from it, in the same manner the evaluation of an activity depends on the profits arising from it. Therefore, all 3 main decisions of financial manager-financing decision, investment decision dividend decision affect net present value of the firm. The greater the amount of net present value, the greater will be value of firm and more it will be in the interest of share holders. When the value of firm increases, the market price of equity shares also increase. Thus to maximise net present worth means to maximise the market price of shares. Net present worth can be calculated with the help of following equation. A1 A2 An -c

W = + + --------------------- + (1+k) (1+k)2 (1+k)n

n At = ∑ -C t=1 (1+k)t





Where W = Net present worth. A, A2--- An= Stream of expected cash benefits from a course of action over a period of time. K = Discount rate to measure risk & timing. C= Initial outlay to acquire that asset If W is positive, the decision should be taken & vice versa. If W is Zero, it would mean that it does not add or reduce the present value of the asset. This approach is considered good for the companies in present situation. This approach gives due consideration to the time value of expected income receivable over different period of time. Under this approach, risk and uncertainty is analysed with the help of interest rate. If uncertainity & time period are greater, higher rate of interest will be used to calculate present value of expected future cash benefits where as the interest rate will be lower for the projects with low risk & uncertainity. Besides, this approach uses cash flows instead of accounting profits which removes ambiguity associated the term profit. On the basis of above explanation, we can conclude that wealth maximisation approach is better to profit maximisation approach to establish mutual relation among the various data. It is possible only through statistics. Cash and inventory management, forecast of financial needs, credit policy decision all are based on the advanced techniques of statistics. Finance is also related to law. Any decision regarding financial policy should be in line with the laws of the country. Organisation of Finance Function The organisation of finance function implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. Therefore, to perform the functions of finance, we need a sound and efficient organisation. Although in case of companies, the main responsibility to perform finance function rests with the top management yet the top management (Board of Directors) for convenience can delegate its powers to any subordinate executive





which is known as Director Finance, Chief Financial Controller, Financial Manger or Vice President of Finance. Besides it is finally the duty of Board of Directors to perform the finance functions. There are various reasons to assign the responsibility to the Board of Directors. Financing decisions are quite significant for the survival of firm. The growth and expansion of business is affected by financing policies. The loan paying capacity of the business depends upon the financial operations. The organisation of finance function is not similar in all businesses but it is different from one business to another. The organisation of finance function for a business depends on the nature, size financial system and other characteristics of a firm. For a small business, no separate officer is appointed for the finance function. Owner of the business himself looks after the functions of finance including the estimation of requirements of funds, preparation of cash budget and arrangement of the required funds, examination of all receipts and payments, preparation of credit policy, collecting debtors etc. with the increase in the size of business, specialists were appointed for the finance function and the decentralisation of the finance function began. For a medium sized business, the responsibility of the finance function is given to a separate officer who is known as financial controller, finance manager, deputy chairman (finance), finance executive or treasurer. In a large sized company the finance function has become more difficult and complex and the position of financial manager has become very important. He is the member of top management of an organisation. For such large organisations it is not possible for a finance manager to perform all the finance functions or to co-ordinate with the various departments. Therefore, finance and financial control are separated and allocated to two different sub-departments. For the ‘finance’ sub-department treasurer is appointed and for the ‘financial control’ sub department, financial controller is appointed. Each of them have various sub-units under them. Financial planning and financial control are quite significant for a large sized organisation. Therefore, a finance committee is established between the Board of Directors and Managing Director. It includes the financial Manger, representatives of the directors and departmental heads of various departments. Managing Director is the chairman of the committee. Its main function is to advise the Board of Directors on financial planning and financial control and co-ordinate the activities of various departments. The following chart 1.1. explains the organisation of finance function.





From the chart 1.1. it is clear that treasurer and financial control work under finance Manager. Financial Manager is responsible to the Managing Director for his actions. Treasurer performs the functions of procurement of essential funds, their utilisation, investment, banking, cash management credit management, dividend distribution, pension, management etc. Financial, controller is responsible for

Board of Directors

Managing Directing Finance Committee

Production Manager

Personnel Manager

Financial Manager

Marketing Manager

Treasurer Controller

Banking Relations

Cash Magt.

Credit Analysis

Assets Protection

Securities Mgt.

Corporate Accounting

& Cost

Annual Reports

Internal Auding

Planning &Budgeting

Statistics





general accounting, cost accounting, auditing, budget, reporting and preparing financial statement etc. In India the function of financial manager is given to secretary in most of the companies. He performs the functions of treasurer and financial controller along with the routine functions of secretary. He collects necessary data and information and sends them to the Managing Director. Functions of the Chief Financial Manager. Chief Financial manager is the top officer of finance department. In America he is known as Vice-president finance and in India he is called Chief Financial Controller. He performs following functions: (1) Financial Planning :- He determines the capital structure and prepares financial plan. (2) Procurement of Funds:- Financial manager makes the necessary funds available from different sources. (3) Co-ordination:- Financial manager establishes co-ordination among the financial needs of various departments. He is a member of finance committee. (4) Control:- Financial manager examines whether the work is being performed as per pre-determined standards or not. He gets the reports prepared, controls the cost and analyses profits. (5) Business Forecasting:- Financial manager evaluates the effects of all national, international, economic, social and political events on industry and company. (6) Miscellaneous Functions:- It includes the management of assets, management of inventory, arrangement of data and management of bank deposits etc. Functions of Treasurer The following are the functions of treasurer.





(1) Provisions of finance:- It includes the estimation of funds necessary for procurement preparing programmes and implementing them, establishing relation among various sources of funds, issuing the securities and managing debt etc. (2) Banking Function:- It includes opening bank accounts, depositing cash, payment of company liabilities, accounting cash receipts & payments, responsibility for transacting actual assets etc. (3) Custody:- The treasurer is the custodian of funds and securities. (4) Management of credit and collection:- The treasurer determines credit risk of customers and arranges for collection. (5) Investments: It involves the investment of surplus funds. (6) Insurance:- The treasurer signs the cheques, agreement and other letters of company forecasts cash receipts and payments, pay property taxes and follows government regulations. Functions of controller The controller performs the following functions:- (1) Planning:- The controller prepares plan for controlling the business activities which are the main constituents of management and in which proper arrangement regarding profit planning, capital expenditure planning, sales forecasting and expenditure budgeting is made. (2) Accounting:- Controller determines the accounting system and arrangements for costing and management accounting systems and prepares financial statements. (3) Auditing:- Controller Manages internal auditing. (4) Reports :- Controller prepares financial reports according to various needs and presents them to the managers. He advises the management to correct the deviation between the standard performance and actual performance. (5) Government Reporting :- Controller sends essential information’s to the government by obeying the legal requirement. (6) Tax Administration :- Controller prepares statement on tax liability.





(7) Economic Appraisal :- He determines and analyses the effect of economic and social factors on business. Time Value of Money:- The evaluation of capital expenditure proposals involves the comparison between cash outflows & cash inflows. The pecularity of evaluation of capital expenditure proposals is that it involves the decision to be taken today where as the flow of funds, either outflow or inflow, may be spread over a number of years. It goes without saying that for a meaningful comparison between cash outflows and cash inflows, both the variables should be on comparable basis. As such, the question which arises is “that is the value of flows arising in future the same in terms of today.” For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is the value of this cash inflow really Rs 10,000 as on today when capital expenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’. The value of Rs 10000 received after one year is less than Rs 10,000 if received today. The reasons for this can be stated as below:- (i) There is always an element of uncertainety attached with the future cash flows. (ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today. (iii) There may be investment opportunities available if the amount is received today which cannot be exploited if equivalent sum is received after one year. Time Value of money: Example:- If Mr. X is given the option that he can receive an amount of Rs 10000 either on today or after one year, he will most obviously select the first option why? Because, if he receives Rs 10000 today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000 plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs 10,000) only after one year, the real value of same in terms of today is not Rs 10000 but something less than that. This concept is called time value of money.





Finance Functions:- (a) Financing decisions (b) Investment decisions (C) Dividend policy decision (d) Liquidity Decision (a) Financing Decisions are decisions regarding process of raising the funds. This function of finance is concerned with providing answers to various questions like - (a) What should be amount of funds to be raised. (b) What are the various sources available to organisation for raisaing the required amount of funds? For this purpose, the organisation can go for internal & external sources. (c) What should be proportion in which internal & external sources should be used by organisation? (d) If organisation, wants to raise funds from different sources, it is required to comply with various legal & procedural formalities. (e) What kinds of changes have taken place recently affecting capital market in the country? (b) Investment decisions:- are decisions regarding application of funds raised by organisation. These relate to selection of the assets in which funds should be invested. The assets in which funds can be invested are of 2 types (a) Fixed assets:- are the assets which bring returns to organisation over a longer span of time. The investment decisions in these types of assets are “capital budgeting decisions.” Such decisions include 1 How fixed assets should be selected to make investment ? What are various methods available to evaluate investment proposals in fixed assets? 2 How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity?





(b) Current assets:- are assets which get generated during course of operations & are capable of getting converted in form of cash with in a short period of one year. Such decisions include (1) What is meaning of Working Capital management & its objectives? (2) Why need for working capital orises? (3) What are factors affecting requirements of working capital? (4) How to quantity requirements of working capital? (5) What are sources available for financing the requirement of working capital? (c ) Dividend Policy Decisions:- Such decisions include (1) What are forms in which dividend can be paid to share holders? (2) What are legal & procedural formalities to be completed while paying dividend different forms? (d) Liquidity Decisions:- Current assets should be managed efficiently for safe guarding firm against of liquidity & insolvency. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets, the financial manager should develop sound technique of managing current assets.

DIVIDEND POLICY Meaning: Dividend is that part of business income which is distributed among share holders. Dividend can be paid in the form of shares or securities or cash. Dividend is given to share holders as a return on their investment in the company. If a company does not pay regular dividend to its share holders, they will not invest in it in future. Dividend is paid on equity as well as preference shares. But it is paid at fixed rate on preference shares where as no rate is fixed for equity shares. Business will either distribute its net profit among share holders or retain it in business. The part of profit which is retained in business is called retained earning & it is source of funds for business. Therefore, there is inverse relationship between the amount to be distributed as dividend and amount of profits to be retained in business.





Business should, therefore, determine as proper dividend policy. Definition Dividend policy means that decision of the management through which it is determined how much of net profits are to be distributed as dividend among the share holders and how much are to be retained in the business.

Factors determining Dividend Policy A External factors 1) Phase of Trade cycles 2) Legal Restrictions 3) Tax Policy 4) Investment Opportunities. 5) Restrictions Imposed by Lending Institutions.

B Internal Factors. 1) Attitude of Management 2) Composition of share holding 3) Age of Company. 4) Nature of Business 5) Growth Rate of Company 6) Liquidity Position 7) Customers & Traditions.

A External Factors:- 1) Phase of trade cycle:- During the phase of boom, company may not like to distribute huge amount of profit by way of dividend though earning capacity is more because company will like to retain more profit which can be used during depression. Similarly, during depression company will like to hold dividend payment in order to preserve its liquidity position. 2) Legal Restrictions:-





If a company wants to pay dividend in cash, provisions of companies act 1956, are required to be followed by company. If the company wants to issue bonus shares, relevant SEBI guide lines are required to be followed by the company. Tax Policy:- From companies point of view dividend can be paid out of profit after fax from share holders point of view, dividend received by them considered to be a taxable income which increases their individual tax liability. 4) Investment Opportunities:- If investment opportunities involve higher rate of return than cost of capital, the company will like to retain profits to be invested in these projects. 5) Restrictions imposed by lending institutions:- Sometimes, lending banks or financial institutions impose certain restrictions on the company preventing payment of dividend if certain conditions are not fulfilled such as interest on loan is not regularly paid by company. Internal Factors:- 1) Attitude of Management:- If attitude of management is aggressive, it may decide to pay more dividend as the management is interested in increasing income of share holders. Where as if the attitude of management is conservative, company will like to retain more profits to take care of contingencies. 2) Age of Company:- A growing concern will like to retain maximum profit in business in order to raise the funds while old company may follow high dividend policy. 3) Composition of Share Holders:- If a company is private ltd. Company having less number of shareholders, the company having less number of shareholders, the company will like to retain more profits and reduces dividend. If the company is a public limited company, tax brackets of individual shareholders may not have significant impact on dividend policy of company. 4) Nature of Business:- A stable company may follow long term dividend policy where as an unstable company may like to retain its profits during boom to ensure dividend policy is not affected by cyclical variations. 5) Growth rate of Company :- A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs. However, care





should be taken by management to invest only in those projects which yield more returns than its cost of capital. 6) Liquidity Positions:- Before formulating dividend policy due considerations should be given to liquidity position of company. Eg At present, company’s cash position may be comfortable, but it may need cash within a short time to pay installments of term loans or to pay creditors for materials. In such case, finance manager may not like to impair its liquidity for making dividend payment. 7) Customs & Traditions:- also affect dividend policy. For example:- if the company is following stable dividend policy for 20 years, it may like to maintain trend in 21st year also, inspite of adverse profitability or liquidity situations. Unit III Leverages:- The term leverages measures relationships between 2 variables. In financial analysis, the term leverage represents influence of one financial variable over some other financial variable. In financial analysis generally 3 types of leverages maybe computed:- 1) Operating leverage. 2) Financial leverage. 3) Combined leverage. 1) Operating Leverage:- It measures effect of change in sales quantity on Earning Before Interest and Taxes (EBIT). It is Computed As:

Sales- Variable Cost (i.e Contribution) Earnings before interest and tax.

Indications:-





A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure. A low degree of operating leverage means that the component of fixed cost is less in over all cost structure. In other words, it measures the impact of % increase or decrease in sales on earning before interest and taxes. For Example:- Sales= Rs 20000 Contribution = Rs 10000 Earnings before interest and tax Rs 5000 As such operating leverage is –

Contribution = Rs 10000 ____________________ = 2 EBIT Rs 5000

It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa. As such, when contribution = Rs 9000 Instead of Rs 10000 I.e. the contribution is reduced by 10% the EBIT is reduced by 20% i.e. the EBIT has became Rs 4000 instead of Rs 5000 Financial Leverage:- It indicates firm’s ability to use fixed financial charges to magnify effects of changes on EBIT on firm’s EPS. It indicates the extent to which Earnings per Share (EPS) will be affected with change in Earnings Before Interest and Tax (EBIT). It is computed as:-

EBIT __________

EBIT- Interest Indications:-

A high degree of financial leverage indicates high use of fixed income

bearings securities in capital structure of the company. A low degree of financial leverage indicates less use of fixed income bearing securities is capital structure of company. For Example





In case of A Ltd. EBIT is Rs 5000 and interest on debentures is Rs 900, When sales are Rs 20000 where as in case of B. Ltd. The EBIT is Rs 5000 and interest on debentures is Rs 100 when sales are Rs 20000. As such degree of financial leverage can be computed as EBIT ______________ EBIT-Interest A. Ltd B. Ltd Financial Leverage Rs 5000 Rs 5000 = =

Rs 5000- Rs 900 Rs 5000-Rs900 =1.22 = 1.02 High degree of financial leverage is supported by knowledge of fact that in capital structure of A Ltd 90% is the debt capital component, where as in case of B Ltd 10% is debt capital component. It means that in case of A Ltd every 1% increase in EBIT will increase EPS by 1.22% and vice versa. As such, when EBIT is reduced from Rs 5000 to Rs 4000 (i.e. 20% reduction), EPS of A Ltd, gets reduced from Rs 20.50 to Rs 15.50 (i.e.24.40 % reduction) & EPS of B Ltd, gets reduced from Rs 2.72 to Rs 21.6 (i.e 20.40% reduction) Uses of Financial Leverage The degree of financial leverage gives an indication regarding extent to which EPS may be affected due to every change in EBIT. As the use of debt capital in capital structure increase EPS, the company may like to use more & more debt capital in its capital structure by using financial. For Example:- EPS in case of A Ltd, is Rs 20.50 when sales are Rs 20000 as 90% of its capital is debt capital. But in case of B Ltd EPS is only Rs 2.72 when sales are





Rs 20000 as only 10% of its total capital is debt capital. As such, the phase is often used that financial leverage magnifies both profits and losses. Financial leverage also acts as a guide line in setting maximum limit upto which the company should use the debt capital. Limitations:- 1) It ignores implicit cost of debt. It assumes that the use of debt capital may be useful so long as company is able to earn more than cost of debt i.e. interest. But it is not always connect. Increasing use of debt capital makes the investment in the company a risky proposition, as such market price of shares may decline, which may not be maximising share holder’s wealth. Before considering capital structure, implicit cost of debt should be considered. 2) It assumes that cost of debt remain constant regardless of degree of leverage which is not true. With every increase in debt capital, interest rate goes on increasing due to increased risk involved with the same. 3) Combined Leverage:- The combined effect of operating leverage & financial leverage measures the impact of change in contribution on EPS. It is computed as:-

Operating leverage X Financial leverage.

Sales-Variable Cost EBIT = _______________ X___________ EBIT Ebit-Interest Sales-Variable Cost = __________________ EBIT- Interest For Example:-





In case of both A Ltd & B Ltd when sales are Rs 20000 contribution is Rs 10000 but earnings after interest and before tax are Rs 4100 and 4900. As such combined leverage can be Sales- Variable Cost (i.e. Contribution) ______________________________

EBIT-Interest A Ltd. B Ltd. _____ _____ 10000 10000 = ______ = ______ 4100 4900 = 2.44 = 2.04 It Means that in case of A Ltd every IX increase in contribution will increase EPS by 2.44% & vice versa while in case of B Ltd. Every 1% increase in contribution, will increase EPS by 2.04%. As such when contribution gets reduced from Rs 10000 to Rs 9000 i.e. 10% reduction, EPS of A Ltd gets reduced from Rs 20.50 to Rs 15.50 ( i.e. 24.4% reduction) & EPS of B Ltd gets reduced from Rs 2.72 to Rs 2.16 (i.e. 20.4 reduction) Indications:- (1) High Operating Leverage, High Financial Leverage:- It indicates very risky situation as a slight decrease in sales and contribution may affect EPS to great extant. So, this situation is should be avoided. (2) High Operating Leverage, Low Financial Leverage it indicates that a slight decrease in sales and contribution may affect EBIT to great extent due to existence of high fixed cost but this possibility is already taken care by low proportion of debt capital in overall capital structure. (3) Low Operating Leverage, High Financial Leverage It indicates decrease in sales/contribution will not affect EBIT to great extent. This situation may be considered an ideal situation.





(4) Low Operating Leverage, Low Financial Leverage It indicates decrease in sales/contribution will not affect EBIT to great extent as the component of fixed cost is negligible in overall cost structure. Unit II

Cost of Capital

The project’s cost of capital is minimum acceptable rate of return on funds committed to the project. The minimum acceptable rate or required rate of return is a compensation for time and risk in use of capital by project. Since investment projects may differ in risk, each one of them will have its own unique cost of capital. The firm represent aggregate of investment projects under taken by it. Therefore, the firm’s cost of capital will be overall, or average, required rate of return on aggregate of investment projects. Determining Component Cost of Capital:- 1) Cost of Debt:- A Company may raise debt in various ways. It may borrow funds from financial institutions or public either in form of public deposits or debentures for a specified period of time at certain rate of interest. A debenture or bond may be issued at per or at discount or premium. (a) Debt issued at Par:- The before tax cost of debt is rate of return required by lenders. It is easy to compute before tax cost of debt issued & to be redemed at par, it is simply equal to contractual interest. For example, a company decides to sell a new issue of 1 years 15% bond of Rs 100 Each at par. If company realises full face value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, the before tax cost of debt will simply be equal to rate of interest of 15%. Thus:- Kd= I= INT ___ Bo Where,





KD= before-tax cost of debt. I = coupan rate of interest. B = Issue price of debt. INT = amt. of interest. (B) Debt issued at Discount or Premium:- n INTt Bn Bo = ∑ _________ + _________ t=1 (1+kd)t (1+ kd)n Where Bn= repayment of debt on maturity and other variable as defined earlier. This equation is used to find out whether cost of debt issued at par or discount or premium. i.e. Bo= f or Bo>f or Bo<F. Tax adjustment:- The interest paid on debt is tax deductible. The higher the interest charges, the lower will be amount of tax payable by the firms. This implies that the government indirectly pays a part of lender’s required rate of return. As a result the interest tax shield, after tax cost of debt to the firm will be substantially less than investor’s required rate of return. The before tax cost of debt, kd should therefore, be adjusted for tax effect as follows. After-tax cost of debt = kd (I-T) Where T= Corporate tax rate. 2). Cost of Preference Capital:- The measurement of cost of preference capital poses some conceptual difficulty. In case of debt, there is binding legal obligation on the firm to pay interest & interest constitutes basis to calculate cost of debt. However, in case of preference capital, payment of dividends is not legally binding on the firm & even if the dividends are paid, it is not a charge on earnings, rather it is a distribution or appropriation of earnings to preference share holders. Irre Deemable Preference share:- The preference share may be treated as a perpetual security if it is irredeemable Thus, its cost is given by following equation:-





PDIV KP= _______ PO Where, Kp= Cost of Preference share PDIV= expected preference dividend Po= Issue price of preference shares. Redeemable Preference Share:- n PDIVt PN PO =∑ ____ + ________ T=1 (1+Kp)t (1+Kp)n Cost of Preference share is not adjusted for taxes because preference dividend is paid after corporate taxes have been paid. Preference dividends do not save any taxes. Thus cost of Preference share is automatically computed on an after tax basis. Since interest is tax deductible & preference dividend is not, the after tax cost of preference is substantially higher than after tax cost of debt. 3) Cost of Equity Capital:- Firms may raise equity capital internally by retained earnings. Alternatively, they could distribute the entire earnings to equity share holders & raise equity capital externally by issuing new shares. In both cases, shareholder are providing funds to the firm to finance their capital expenditures. Therefore, equity shareholders required rate of return will be same whether they supply funds by purchasing new shares or by for going dividends which could have been distributed to them. There is, however, a difference between retained earnings & issue of equity shares from firms point of view. Cost of Retained Earnings:- The opportunity cost of retained earnings (internal earnings) is the rate of return on dividends foregone by equity shareholders. The shareholders generally expect dividend and capital gain from their investment. The required rate of return of shareholder can be determined from dividend valuation model. Normal Growth:- A firm whose dividend are expected to grow at a constant rate of g is as follows





Divl Po =

Ke-g Where DWl= DIVo (1+g) Super normal growth:- Dividends may grow at different rates in future. The growth rate may be very high for a few years & after wards, it may, it may become normal indefinitely in future. The dividend valuation model can be used to calculate cost of equity under different growth assumptions. For example, If the dividends are expected to grow at a super normal growth rates g for n year & there after, at a normal perpetual growth rate of In beginning in year n+1 then cost of equity can be determined by following formula. n DIV0 (1+gs)t Pn

Po= ∑ __________ + ________ t=1 (1+ke)t (1+ke)n

Pn= Discounted value of dividend stream, beginning in year n+1 & growing at a constant, perpetual rate gn, at end of year n and therefore it is equal to :- DIV n+1 Pn = ________ Ke-gn Zero growth DIVl

Ke =______ Po

The growth rate g will be zero if firm does not retain any of its earnings.





Cost of External Equity The minimum rate of return which equity share holders require on funds supplied by them by purchasing new share to prevent a decline in existing market price of equity share is the cost of external equity. The firm can induce existing or potential share holders to purchase new shares when it promises to earn a rate of return equal to:- Divl Ke= ______ + g Po Weighted Average (Cost of Capital)

After calculating costs, they are multiplied by weights of various sources of capital to obtain a weighted cost of capital (WACC). The composite, cost of capital is the weighted average of costs of various sources of funds. It is relevant in calculating over all cost of capital. The following steps are involved to calculate weighted average cost of capital:- 1) Calculate cost of specific sources of funds (i.e. cost of debt, cost of equity, cost of preference capital etc). 2) Multiply cost of each sources by its proportion in capital structure. 3) Add weighed components costs to get firm’s weighted average cost of capital. In order to calculate weighted cost of capital component cost should be ofter tax costs. If we assume that a firm has only debt & equity in its capital structure, then its weighted average cost of capital, (Ro) Will be:- Ko= kd (1-T) Wd+kewe Ko= Kd (1-T) D+ + ke S ____ ___ D+S D+S Where Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt & equity D= amount of debt, S= amount of equity.





Unit- III

Theories of Capital Structure (1) Net Income Approach:- The essence of net income approach is that the firm can increase its value or lower the overall cost of capital by increasing proportion of debt in capital structure. The assumption of this approach are:- 1) The use of debt does not change the risk perception of investors, as a result equity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant with changes in leverage. 2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i.e. kd < ke) 3) The corporate income taxes do not exist. The first assumption implies that if ke & kd are constant, increased use of debt by magnifying the shareholders earnings, will result in higher value of the firm via higher value of equity. Consequently, overall or weighted average cost of capital, ko will decrease. The overall cost of capital is measured by Eq- X Noi Ko= ___ =___ V V Thus, with constant annual net operating income (NOI) overall cost of capital of capital would decrease as the value of firm, V increases. Ques6. Write notes on the following. Ans. NET OPERATING INCOME APROACH





According to the net operating income (NOI) approach the market value of the firm is not affected by the capital structure changes. The market value of the firm is found out by capitalizing the net operating income at the over all or the weighted average cost of capital, which is constant. The overall capitalisation rate depends on the business risk of the firm. It is independent of financial mix. If NOI and average cost of capital are independent of financial mix, market value of firm will be a constant are independent of capital structure changes. The critical assumptions of the NOI approach are:

a) The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important.

b) The market uses an overall capitalisation rate, to capitalize the net operating income. Overall cost of capital depends on the business risk. If the business risk is assumed to remain unchanged, overall cost of capital is a constant.

c) The use of less costly debt funds increases the risk to shareholder. This causes the equity capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the increase in the equity-capitalisation rate.

d) The debt capitalisation rate is constant. e) The corporate income taxes do not exist.

Thus, we find that the weighted cost of capital is constant and the cost equity increase as debt is substituted for equity capital. Ques7. Explain the concept of working capital. Discuss the working capital need of a manufacturing firm. Ans. Money required by the company to meet out day today expenses to finance production and stocks to pay wages and other production etc is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more round about and complicated the production to fixed working capital increase correspondingly.





Therefore, working capital management refers to the management of current assets and current liabilities. Working capital, however, represents investment in current assets, such as cash, marketable securities, inventories and bills receivables. Current liabilities mainly

Figure 18.2 The effect of leverage on the cost of capital (NOI approach) EXISTENCE OF OPTMUM CAPITAL STRUCTURE: THE TRADITIONAL VIEW The traditional view, which is also known as an intermediate approach, is a compromise between the net income approach and the net operating approach. According to this view, the value of the firm can be increased or the cost of capital can be reduced by a judicious mix of debt and equity capital. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with leverage. Thus, an optimum capital structure exists, and it occurs when the cost of capital is minimum or the value of the firm is maximum. The cost of capital declines with leverage because debt capital is cheaper than equity capital within reasonable, or acceptable, limit of debt. The statement that debt funds are cheaper than equity funds carries the clear implication that the cost of debt, plus the increased cost of equity, together on a weighted basis, will be less than the cost of equity which existed on equity before debt financing.2 In other words, the weighted average cost of capital will decrease with the use of debt. According to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three-stages.3

ke

ko

kd

Leverage

Cos

t of C

apita

l (P

erce

nt)





First Stage: Increasing Value In the first stage, the rate at which the shareholders capitalise their net income, i.e., the cost of equity, ke, remains constant or rises slightly with debt. But when it increases, it does not increase

1. The traditional capital structure theory has been popularised by Ezra Solomon, op. cit.

2. Barges, Alexander, The Effect of Capital Structure on the Cost of Capital, Prentice-Hall, Inc., 1963, p.11.

3. Solomon, op. cit., p. 94. Fast enough to offset the advantage of low cost debt. During this stage, the cost of debt, Kd, remains constant or rises negligibly since the market view the use of debt as a reasonable policy. As a result, the value of the firm, V, increases or the overall cost of capital, K0 = X/V= Ke (S/V) + kd (D/V), falls with increasing leverage. Under the assumption that Ke remains constant within the acceptable limit of debt, the value of the firm will be: X - KdD kdD X - kdD X (ke-kd)D V=S+D = + = +D= + Ke kd ke ke ke Thus, so long as Ke and Kd are constant, the value of the firm V increases at a constant rate. (Ke-Kd)/Ke. as the amount of debt increases. When equation(9) is solved for X/V, we get [See equation(6): X D = ko=ke-(ke-kd) V V This Implies that, with ke>Kd, the average cost of capital will decline with leverage. Second Stage: Optimum Value Once the firm has reached a certain degree of leverage, increases in leverage have a negligible effect on the value, or the cost of capital of the firm. This is so because the increases in the cost of equity due to the added financial risk offsets





ITS STUDY CENTRE SCF-54 (B’MNT) SECTOR 15

MARKET, FARIDABAD PH 5002194-95

the advantage of low cost debt. Within that range or at the specific point, the value of the firm will be maximum or the cost of capital will be minimum. Third stage: Declining value Beyond the acceptable limit of leverage, the value of the firm decreases with leverage or the cost of the capital increases with leverage. This happens because investors perceive a high degree of financial risk and demand a higher equity-capitalisation rate which offsets the advantage of low-cost debt.

Figure 18.3 The costs of capital behaviour (traditional view) The overall effect of these three stages is to suggest that the cost of capital is a function of leverage. It declines with leverage and after reaching a minimum point or range starts rising. The relation between costs of capital and leverage is graphically shown in Figure 18.3 wherein the overall cost of capital curve, ko is saucer-shaped with a horizontal range. This implies that there is a range of capital structures in which the cost of capital is minimised. ke is assumed to increase slightly in the beginning and then at a faster rate. In Figure 18.4 the cost of capital curve is shown to be U-shaped. Under such a situation there is a precise point at which the cost of capital would be minimum. This precise point defines the optimum capital structure.

Ke Ko

Stage II

Ke Ko Kd

Leverage 0 L L

Cos

t of c

apita

l ( p

er c

ent)





-+

Figure 18.4 The costs of Capital behavior (traditional view-a variation) Many variations of the traditional view exist. As indicated in Figures 18.3 and 18.4, some writers imply the cost of equity function to be horizontal over a certain level and then rising, while others assume the cost of equity function rising slightly in the beginning and then at a faster rate. Whether are cost of equity function is horizontal or rising slightly is not very pertinent from the theoretical point of view, as a number of different cost of equity curves can be consistent with a declining average cost of capital curve. The relevant issue is whether or not the average cost of capital curve declines at all as debt is used. 1 All the supporters of the traditional view agree that the cost of capital declines with debt. ILLUSTRATION 18.3 To illustrate the traditional approach, assume that a firm is expecting a net operating income of Rs 1,50000 on a total investment of Rs 10,00,000 The equity capitalisation rate is 10 per cent, if the firm has no debt; but it would increase to 10.56 per cent when the firm substitutes equity capital by issuing debentures of Rs 3.00000 and, to 12.5 per cent when debentures of Rs 600000 are issued to substitute equity capital. Assume that Rs 300000 debentures can be raised at 6 per cent interest rate, whereas Rs 600000 debentures are raised at a rate of interest of 7 per cent. The market value of the firm, value of shares and the average cost of capital are shown in Table 18.6.

Cos

t of C

apita

l (P

er c

ent)





1. Barges, op. cit., p.12. Table 18.6 MARKET VALUE AND THE COST OF CAPITAL OF THE FIRM (TRADIATIONAL APPROACH) No Debt 6% Rs

3,00,000 Debt

7%Rs 6,00,000

Debt Net operating income, X 1,50,000 1,50,000 1,50,000 Total cost of debt, INT = KdD 0 18,000 42,000 Net income, X- INT 1,50,000 1,32,000 1,08,000 Cost of equity, Ke 0.10 0.1056 0.125 Market value of shares, S= (X-INT)ke

15,00,000 12,50,000 8,64,000

Market value of debt, D 0 3,00,000 6,00,000 Total value of firm, V= S+D 15,00,000 15,50,000 14,64,000 Average cost of capital, Ko = X/V 0.10 0.097 0.103 Criticism of the Traditional View The validity of the traditional position has been questioned on the ground that the market value of the firm depends upon its net operating income and risk attached to it. The form of financing can neither change the net operating income nor the risk attached to it. It simply changes the way in which the income is distributed between equity holder and debt-holders. Therefore, firms with identical net operating income and risk, but differing in their modes of financing, should have same total value. The traditional view it criticised because it implies that totality of risk is distributed among the various classes of securities.1 Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit. They assert that sufficient justification does not exist for such and assumption. They do not accept the contention that moderate amounts of debt in ‘sound’ firms do not really add very much to ‘riskiness’ of the shares. However, the argument of the traditional theorists that an optimum capital





structure exists can be supported on two counts: the tax deductibility of interest charges and market imperfections.

IRRELEVANCE OF CAPITAL STRUCTURE: THE MODIGLIANI-MILLER HYPOTHESIS WITHOUT TAXES

The Modigliani-Miller (M-M) hypothesis is identical with the net operating income approach. (M-M) argue that, in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the capital structure changes. In their 1958 article,2 they provide analytically sound and logically consistent behavioural justification in favour of their hypothesis, and reject any other capital structure theory as incorrect.

1. Durand, op. cit., pp. 229-30. 2. Modigliani, and Miller op. cit., pp. 261-297.

Assumptions The M-M hypotheses can be best explained in terms of their Propositions I and II. It should, however, be noticed that their propositions are based on certain assumptions. These assumptions, as described below, particularly relate to the behaviour of investors and capital market, the actions of the firm and the tax environment.

• Perfect capital markets Securities (share and debt instruments) are traded in the Perfect capital market situation. This specifically means that (a) investors are free to buy or sell securities; (b) they can borrow without restriction at the same terms ad the firms do; and (c) they behave rationally. It is also implied that the transaction cost, i.e., the cost buying d selling securities, do not exist.

• Homogeneous risk classes Firms can be grouped into Homogenous risk classes. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogenous class.

• Risk The risk of investors is defined in terms of the variability of the net operating income (NOI). The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate.1





• No taxes In the original formulation of their hypothesis, M-M assume that no corporate income taxes exist.

• Full payout Firms distribute all net earnings to the shareholders, which means a 100 per cent payout.

Proposition I Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the rate appropriate to that risk class.2 This is their Proposition I and can be expressed as follows: Value of the firm = Market value of equity + Market value of debt Expected net operating income = Expected overall capitalization rate X NOI V=(S+D)= = ko ko Where V= the market value of the firm S= the market value of the firm’s ordinary equity D= the market value of debt X= the expected net operating income on the assets of the firm K0 = the capitalisation rate appropriate to the risk class of the firm.

1. Robichek, A. and S. Myers, Optimal Financing Decisions, Prentice-Hall, 1965, PP. 31-34.

2. Modigliani and Miller op. cit., P. 266.

Proposition I can be stated in an equivalent way in terms of the firm’s average cost of capital which is the ratio of the expected earning to the market value of all its securities. That is:

X X = = ko

(S+D) V





If we define Kd as the expected return on the firm’s debt and Ke as the expected return on the firm’s equity, then expected net operating income is given as follows:

X=KoV=keS+kdD As given in Equation (5), by definition X ko = V

S D Ko = ke + kd S+D S+D

Figure 18.5 The cost of capital under M-M proposition I

Equation (5) expresses Ko as the weighted average of the expected rate of return of equity and debt capital of the firm. Since the cost of capital is defined as the expected net operating income divided by the total market value of the firm, and since M-M conclude that the total market value of the firm is unaffected by the financing mix, it follows that the cost of capital is independent of the capital structure and is equal to the capitalisation rate of a pure-equity stream of its class. The cost of capital function, as hypothesized by M-M through Proposition I,

ko Ke

D/V Leverage

Cos

t of c

apita

l (pe

r cen

t)





is shown in Figure 18.5. It is evident from the figure that the average cost of capital is a constant and is not affected by leverage. Arbitrage Process Why should proposition I hold good? The simple principle of proposition I is that two firms identical in all respects except for their capital structures, cannot command different market value or have different cost of capital. M-M do not accept the NI approach as valid. Their opinion is that if two identical firms, except for the degree of leverage, have different market values, arbitrage (or switching) will take place to enable investors to engage in personal or home-made leverage as against the corporate leverage to restore equilibrium in the market. Consider an example. ILLUSTRATION 18.4 Suppose two firms: unlevered firm U and levered firm L – have identical expected net operating income (x) of Rs 10000. The value of the levered firm (V) is Rs 11000 the value of equity shares (Su)=Vu) is Rs100000. Firm L has borrowed at the expected rate of return (Kd) of 6 per cent. Assume further that you hold 10 per cent shares of the levered firm L. What is your return from your investment in the shares of firm L? Since you own 10 per cent of the shares, you are entitled to 10 per cent of the equity income: Return = 0.10 (X-INT) (where INT= KdDt) = 0.10 (10000-0.06X 50.000) = 0.10 (10000- 3000= Rs 700 and the value of your investment is: investment = 0.10 (1000-50000)= Rs 6000 You can earn same return at less investment through an alternate investment strategy. This you can do by selling your investment in firm L’s Share for Rs 6000, and by borrowing on your personal account an amount equal to your share of firm L’s corporate borrowing at 6 percent rate of interest 010(50000) = Rs5000. You have Rs 11000 with you. You can now buy 10 per cent of the unlevered firm U’s shares. Your investment will be: Investment = 0.10 (1,00,000) Rs= 10,000 And your return will be: Return = 0.10 (10,000) Rs 1,000





However, you have borrowed Rs 5,000 at 6 per cent. Therefore, you will have to pay an interest of Rs 300: Interest =0.06X5,000= Rs 300 Thus your net return is Rs 700 as shown below: Rs Equity return from U 1,000 Less: Interest on personal borrowing 300 Net Return 700 Note that you are also left with cash of Rs 1,000: Rs Sale of firm L’s shares, = 0.1 (60,000) 6,000 Add : Borrowing, 0.1 (50,000) 5,000 Less: Investment in firm U=0.1 (1,00,000) (10,000) Remaining cash 1,000

Due to the advantage of the alternate investment strategy, a number of investors will be induced towards it they will sell their shares in firm L and buy shares and debentures of firm U. this arbitrage will tend to increases the price of firm U’s shares and to decline that of firm L’s shares. It will continue until the equilibrium price for firm U’s and firm L’s shares is reached. The arbitrage would work in the opposite direction if we assume that the value of the unlevered firm U (Vu) is greater than the value of the levered firm L (Vl). Let us assume that Vu=Su= Rs 1,00,000 and Vl=Sl+Dt=Rs 40,000+ Rs 50,000 = Rs 90,000. Further, suppose that you own 10 per cent shares in the unlevered firm U: Your return will be: Return= 0.10 (10,000) = Rs 1,000 And your investment will be: Investment = 0.10 (1,00,000) = Rs 10,000

You can design a better investment strategy. You sell your shares in firm U for Rs 10,000. Now you buy 10 per cent of firm L’s share and debt. Your investment in firm L is Rs 9,000.





Investment= 0.10 (40,000+50,000) =4,000+5,000= Rs 9,000 Since you own 10 per cent of equity and debt of firm L, your return will include both equity income and interest income. Thus your return is Rs 1,000: Return = 0.10 (10,000) = Rs 1,000 You can also calculate your return as follows: Rs Equity income, 0.10 (10,000-3,000) 700 Interest income, 0.06 (5,000) 300 Return 1,000 Note that your alternative investment strategy pays you off the same return at a lesser investment. You are left with Rs 1,000 cash. Rs Sale of firm U’s shares, 0.1(1,00,000) 10,000 Investment in firm L’s share, 0.1 (40,000) (4,000) Investment in firm L’s debt, 0.1 (50,000) (5,000) Remaining cash 1,000

Both strategies give the investor same return, but his alternative investment strategy costs him less since Vt<Vu. In such a situation, marginal investors will sell their shares in the unlevered firm and buy the shares and debentures of the levered firm. As a result of this switching, the market value of the levered firm’s shares will increases and that of the unlevered firm will decline. In the equilibrium Vt=Vu. We can generalize our discussion as follows. 1 In the first instance, let Vt>Vu Both firms earn the same expected net operating income, X. The borrowing and lending Rate is Kd. 1. Modigliani, F and Miller, M.H.,Reply to Heins and Sprenkle, American Economic Review, 59 (Sept 1969), pp.592-95. Assume that an investor hold (alpha) fraction of firm L’s shares. His investment and return will be as follows: Investment Investment







Investment in L’s share )Vt-Dt) (X-kdDt) The investor in our example can design the following alternative investment strategy: Investment Investment Buy fraction of U’s share Vu X Borrow equal to fraction of L’s debt - Dt -kdDt Total (Vu-Dt) (X-kdDt) The investor obtains the same return, (X-Kd D1), in both the cases, but his first investment strategy costs more since V1> Vu. The rational investors at the margin would prefer switching from levered to unlevered firm. The increasing demand for the unlevered firm’s shares will decreases their market price. Ultimately, market values of the two firms will reach equilibrium, and henceforth, arbitrage will not be beneficial. Let us take the opposite case where Vu>Vl. Suppose our investor holds fraction of firm U’s shares. His investment and return will be as follows: Investment Return Investment in U’s shares Vu X The investor can design an alternate investment strategy as follows: Investment Return Buy fraction of L’s shares (Vl-Dt) (X-kdDt) Buy equal to fraction of L’s debt + Dt + kdDt Total Vt X If you can earn the same return with less investment, other can also benefit similarly. Investors will therefore sell shares of firm U and buy shares of firm L. This arbitrage will cause the price of firm U’s shares to decline and that of firm L’s shares to increases. It will continue until the price of the levered firm’s shares equals that of the unlevered firm. Thus, in equilibrium Vl=Vu. On the basis of the arbitrage process, M-M conclude that the market value of a firm (or its cost of capital) is not affected by leverage. Thus, the financing (or capital structure) decision is irrelevant. It does not have any impact on the





maximisation of market price per share. This implies that one capital structure is as much desirable as the other. Proposition II M-M’s Proposition II, which defines the cost of equity, follows from their Proposition I. The cost of equity Formula can be derived from M-M’s definition of the average cost of capital. The expected yield on equity or the cost equity is defined as follows: X-kdD Ke = S Since we know from Equation (4) that X ko = V And Ko and V are constant by definition, the following equation: X=koV=ko(S+D) Substituting Equation (10) into Equation (3), we have Ko(S+D)-kdD KoS+koD-kdD D Ke = = =Ko+(ko-kd) S S S Equation (7) states that, for any firm in a given risk class, the cost of equity, Ke is equal to the constant average cost of capital, Ko, plus a premium for the financial risk, which is equal to debt-equity ration times the spread between the constant average cost of capital and the cost of debt, (Ko-Kd) D/S. the cost of equity, Ke, is a linear function of leverage, measured by the market value C

ost o

f cap

ital

ke ko kd

D/S 0 Leverage

Figure 18.6 Cost of equity under the M-M

Cos

t of C

apita

l







of debt to equity, D/S. Thus, leverage will result not only in more earnings per share to shareholders but also increased cost of equity. The benefit of leverage is exactly taken off by the increased cost of equity, and consequently, the firm’s market value will remain unaffected. It should, however, be noticed that the functional relationship, ke=ko+(ko-kd) D/S, is valid irrespective of any particular valuation theory. For example, M-M assume Ko to be constant, while according to the more popular traditional view Ko is a function of leverage. The crucial part of the M-M thesis is that Ko will not rise even if very excessive use of leverage is made. This conclusion could be valid if the cost of borrowings, Kd. remains constant for any degree of leverage. But in practice Kd increases with leverage beyond a certain acceptable, or reasonable level of debt. However, M-M maintain that even if the cost of debt, Kd, increases Ke will increases at a decreasing rate and may even turn down eventually.1 This is illustrated in Figure 18.6. M-M insist that the arbitrage process will work and that as Kd increases with debt, Ke will become less sensitive to further borrowing. The reason for this is that debt-holders, in the extreme situations, own the firm’s assets and bear some of the firm’s business risk. Since the risk of shareholders is transferred to debt-holders, Ke declines. 1. Modigliani and Miller, “The Cost of Capital….’ Op. cit. Criticism of the M-M Hypothesis The arbitrage process is the behavioural foundation for the M-M thesis. The shortcomings of this thesis lie in the assumption of perfect capital market in which arbitrage is expected to work. Due to the existence of imperfections in the capital market, arbitrage may fail to work and may give rise to discrepancy between the market values of levered and unlevered firms. The arbitrage process may fail to bring equilibrium in the capital market for the following reasons:1 Leading and borrowing rate discrepancy The assumption that firms and individuals can borrow and lend at the same rate of interest does not hold good in practice. Because of the substantial holding of fixed assets, firms have a higher credit standing. As a result, they are able to borrow at lower rates of interest than individuals. If the cost of borrowings to an investor is more than the firm’s borrowing rate, then the equalization process will fall short of completion. In





illustration 18.4, if the cost of debt paid by the firm is less than that paid by the investor, then the value of the levered firm, Vl, must exceed the value of the unlevered firm, VU, for total return to be equal. For example, if the investors can borrow at 9 per cent, his returns after switching will be only Rs 550. Consequently, it does not follow that market opportunities and forces will lead Vl into equality with Vu. Non-substitutability of personal and corporate leverages It is incorrect to assume that “personal (home-made) leverage” is a perfect substitute for “corporate leverage.” The existence of limited liability of firms in contrast with unlimited liability of individuals clearly places individuals and firms on a different footing in the capital markets. If a levered firm goes bankrupt, all investors stand to lose to the extent of the amount of the purchase price of their shares. But, if an investor creates personal leverage, then in the event of the firm’s insolvency, he would lose not only his personal loan. Thus, in illustration 18.4 if the investor keep his investment in the levered firm, his loss in the event of bankruptcy will be Rs 6000. But if he engages in the arbitrage transactions and invests in the unlevered firm, he can lose his principal investment of Rs 5000 and will also be liable to return Rs 5000 borrowed by him on the personal account. Thus, it is more risky to create personal leverage and invest in the unlevered firm than investing directly in the levered firm. Transaction costs The existence of transaction costs also interferes with the working of arbitrage. Because of the costs involved in the buying and selling securities, it would become necessary to invest a greater amount in order to earn the same return. As a result, the levered firm will have a higher market value. Institutional restrictions Institutional restrictions also impede the working of arbitrage. Durand point out that “home-made” leverage is not practically feasible as a number of institutional investors would not be able to substitute personal leverage for corporate leverage, simply because they are not allowed to engage in the “home-made” leverage. 1. The M-M hypotheses have been widely debated and criticised. The basic criticisms of the M-M hypotheses are contained in Durand, op. cit. and Ezra Solomon, Leverage and the Cost of Capital, Journal of Finance, XVIII, (May 1963). Also see Pandey, I.M., Capital Structure and the Cost of Capital, Vikas, reprint 1996. Unit IV





INVENTORY MANAGEMENT Inventories constitutes the most significant part of current assets of large majority of companies in India. On an average, inventories are approximately 60% of current assets in public limited companies in India. Because of the large size of inventories maintained by firms, a considerable amount of funds is required to be committed to them. It is, therefore absolutely imperative to manage inventories efficiently in order to avoid unnecessary investment. A firm nelegecting the management of inventories may fail ultimately. It is possible for a company to reduce its level of inventories to a considerable degree e.g. 10 to 20% without any adverse effect on production and sales, by using simple inventory planning and control techniques. The reduction in ‘Excessive’ inventories carries a favourable impact on a company’s profitability. Nature of Inventories:- Management of inventory constitutes one of the major investments in current assets. The various forms in which a manufacturing concern may carry inventory are: 1) Raw Material: These represents inputs purchased and stored to be converted into finished products in future by making certain manufacturing process of the same. 2) Work in Process: These represent semi-manufactured products which need further processing before they can be treated as finished products. 3) Finished Goods: These represents the finished products ready for sale in market. 4) Stores and Supplies: These represents that part of inventory which does not become a part of final product but are required for production process. They may be in form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc. Normally they form a very major part of total inventory and do not involve significant investment.

MOTIVE/NEEDS OF HOLDING INVENTORY A Company may hold the inventory with the various motives as stated below: 1) Transaction Motive: The company may be required to hold the inventory in order to facilitate the smooth and unintrupped production and sale operations. It may not be possible for the company to procure the raw material whenever





necessary. There may be a time lag between the demand for the material and its supply. Hence it is needed to hold the raw material inventory. Similarly it may not be possible to produce the goods immediately after they are demanded by the customers. Hence it is needed to hold the finished goods inventory. They need to hold work in progress may arise due to production cycle. 2) Precaution Motive: In addition to the requirement to hold the inventory for routine transactions, the company may like hold them to guard against risk of unpredictable changes in demand and supply forces. Eg. The supply of raw material may get delayed due to factors like strike, transport, disruption, short supply, lengthy processes involved in import of raw material etc. hence the company should maintain sufficient level of inventory to take care of such situations. Similarly, the demand for finished goods may suddenly increases (especially in case of seasonal type of products) and if the company is unable to supply them, it may mean gain of competition. Hence, company will like to maintain sufficient supply of finished goods. 3) Speculative Motive: The Company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purpose. This may be with the intention to get advantage in term of quantity discounts connected with bulk purchasing or anticipating price rise.

Objectives of Inventory Management Through the efficient Management of Inventory of the wealth of owners will be maximised. To reduce the requirement of cash in business, inventory turnover should be maximised and management should save itself from loss of production and sales, arising from its being out of stock. On the other hand, management should maximise stock turnover so that investment in inventory could be minimised and on the other hand, it should keep adequate inventory to operate the production & sales activities efficiently. The main objective of inventory management is to maintain inventory at appropriate level so that it is neither excessive nor short of requirement Thus, management is faced with 2 conflicting objectives. (1) To keep inventory at sufficiently high level to perform production and sales activities smoothly. (2) To minimise investment in inventory at minimum level to maximise profitability. Both in adequate & excessive quantities of inventory are undesirable for business. These mutually conflicting objectives of inventory management can be





explained is from of costs associated with inventory and profits accruing from it low quantum of inventory reduces costs and high level of inventory saves business from being out of stock & helps in running production & sales activities smoothly. The objectives of inventory management can be explained in detail as under:- (i) To ensure that the supply of raw material & finished goods will remain continuous so that production process is not halted and demands of customers are duly met. (ii) To minimise carrying cost of inventory. (iii) To keep investment in inventory at optimem level. (iv) To reduce the losses of theft, obsolescence & wastage etc. (v) To make arrangement for sale of slow moving items. (vi) To minimise inventory ordering costs.

Techniques of Inventory Management (i) A.B.C. Analysis A.B.C. analysis is a selective technique of controlling different items of inventory. In actual practice, thousands of items are included in business as inventories. But all these items are not equally important. According to this technique, only those items of inventory are paid more attention which are significant for business. According to this technique, all items are classified into 3 categories A.B. and C. In ‘A’ category those items are taken which are very precious and their quantity or number is small. (ii) In ‘B’ category those items are reserved which are less costly than the items of category ‘A’ but their number is greater. (iii) In category ‘C’ all those items are included which are low priced but their number is highest. The rate of use of items of category ‘A’ is the highest and that of category ‘C’ is the lowest. In a manufacturing organisation, the items of inventory can be classified as under:-





Example:- Class Number of items in terms

of their % % as per their value

A 15 70 B 30 20 C 55 10 100 100 Thus, the number of items of category ‘A’ are 15% but their value is 70% of total inventory. Therefore, inventory management can be made more effective by concentrating control on this category. Effort are made to minimise investment items of this category. The % of number of items in category ‘B’ is 30 but their value is 20%. Therefore this category will be paid less attention. The items in category ‘C’ is 55% but their value is just 10% of total. Therefore, management need not spend much time for control of this class of inventory because very little investment is made in them. These items are purchased in bulk quantity once in 2-3 years. The management must be aware that theses items may be less important in terms of value but their non-availabetety can break down the production process. Therefore, these item should available in time A.B.C. analysis can be presented by following diagram also. Advantages of ABC Analysis (1) A Close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption & due to this, costs associated with inventories maybe reduced.

Y X % of Units

% o

f Cos

ts

0 1

0 2

0 3

0 4

0 5

0 6

0 7

0 8

0 9

0 1

00

10 20 30 40 50 60 70 80 90 100





(2) The investment in inventory can be regulated in proper manner & optimum utilisation of available funds can be assured. (3) A strict control on inventory items in this manner help in maintaining a high inventory turnover rates. 2) FIXATION OF INVENTORY LEVELS: Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. However, the following propositions should be remembered. (i) Only the fixation of inventory levels does not facilitates the inventory control. These has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time. (ii) The various levels fixed are not fixed on a permanent basis and are subject to revision regularly. The various levels which can be fixed are as below. 1) Maximum level: It indicates the level above which the actual stock should not exceed. If it exceeds, it may involved unnecessary blocking of funds in inventory while fixing this level, following factors are considered. i) Maximum usage. ii) Lead time. iii) Storage facilities available, cost of storage and insurance etc. iv) Prices for material v) Availability of funds.





vi) Nature of material eg If a certain type of material is subject to government regulation in respect of import of goods etc maximum level may be fixed at a higher level. vii) Economic order Quantity. 2) Minimum Level: It indicates the level below which the actual stock not reduce, If it reduces, it may involve the risk of non-availability of material whenever it is required. While fixing this level, following factors are considered. i) Lead time. ii) Rate of consemption 3). Re-order level It indicates that level of material stock at which it is necessary to take the steps for the procurement of further lots of material. This is the level falling in between the two existences of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received. 4). DANGER LEVEL: This is the level fixed below minimum level. If the stock reaches this level, it indicates the need to take urgent action in respect of getting the supply. At this stage, the company may not be able to make the purchases in the systematic manner but may have to make rush purchases which may involve higher purchase cost. CALCULATION OF VARIOUS LEVELS: The various levels can be decided by using the following mathematical expressions. 1). Re-Order level:- Maximum lead time X Maximum usage. 2). Maximum level:- Re-order level + Re order Quantity- (Minimum Usage X Maximum lead time)





3). Minimum level:- Re-order level- (Normal usage + Normal lead time) 4). Average level:- Minimum level + Maximum level 2 5). Danger level:- Normal Usage X Lead time for emergency Purchases. 3). INVENTORY TURNOVER: Inventory turnover indicates the ratio of materials consumed to the average inventory held. It is calculated as below: Value of Material Consumed _______________________ Average inventory held Where value of material consumed can be calculated as: Opening stock + purchases- closing stock. Average inventory held can be calculated as: Opening stock + closing stock __________________________ 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed. It can be done by dividing 365 days (a year) by inventory turnover ratio. 4. EOQ:- Economic order Quantity as per notes include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year. What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. If the firm has business which deals





with public utility services, obviously the requirement will be low. It is primarily because the amount becomes available as soon as services are sold and also the services arranged by the firm and immediately sold, without much difficulty and complication. On the other hand trading concerns need heavy amounts because these require funds for carrying goods traded. Similarly many industrial units will also need heavy amounts for carrying on their business. Many manufacturing concerns will also need sufficiently heavy amounts, the of course depends on the nature of commodities which are being manufactured.

MANUFACTURING FIRM We now come to manufacturing firm. If it is complex and complicate, it will be another determinant. In this complex process obviously more capital will be needed and goods will be produced after considerable delays. Longer it take to produce a good, more will be its cost and more working capital will become unavoidable. When the companies are engaged in the production of heavy machinery and equipment, a way out is found out by demanding some advance money from the party or parties which plea orders or which usually take away the goods. Ques. 8 Define EOQ. How is it computed ? Give an example. Ans. Economic order quantity refers to the size of the order which gives maximum economy is purchasing any item of raw materials or finished product. It is fixed mainly after talking into account the following costs: I. INVENTORY CARRYING COST It is the cost of keeping items in stock. It includes interest on investment. Obsolescence losses, store- keeping cost, insurance premium, etc. the larger the volume of inventory, the higher will be the inventory carrying cost and vice versa. II ORDERING COST It is the cost of placing an order and securing the supplies. It various from time to time depending upon the number or orders placed and the number of times ordered. The more frequently the order are placed and fewer the quantities purchased an each order, the greater will be the ordering cost and vice versa. The economic ordering quantity can be determined by any of the following two methods. 1) FORMULA METHOD





In this case the EOQ can be determined as per the following for formula: E= Economic ordering quantity. U= Quantity purchase in a year. P= Cost of placing an order. S= Annual cost of storage of one unit. For Example:- A refrigeration manufacture, purchase 1600 units of a certain component from 13. His annual usage is 1600 units. The order placing cost is Rs 100 and the cost of carrying one unit for a year is Rs 8.

Calculate the economic ordering qty by formula method: E = Sqrt. (2u*p)/s = Sqrt. (2*1.600*100)/8 = Sqrt. (40,000)=200 units

EOQ model is based on the following assumptions:

I. The firm knows with certainly the annual usage or demand of the particular item of inventories.

II. The rate at which the firm uses the inventories or makes sales is constant through out a year.

III. The order the replenishment of inventory are placed exactly when inventories reach the zero level.

The above assumption may also be called as limitation of EOQ modes. There is every likelihood of a discrepancy between actual and estimated demand for a particular items of inventory. Similarly, the assumptions as to constant usage or sale of inventories and instantaneous replenishment of inventories are also of doubtful validity. On account of these reasons, EOQ model may sometimes give wrong estimate about economic order quantity. 2. TABULAR METHOD This method is to be used in those circumstances where the inventory carrying cost per units is not constant. This will be clear with the following.: Calculating the Economic Ordering Quantity using Tabular Method on the basis of data given.





Annual Requirement

Orders per year

Units per order

Order placing costs

Avg. stock in units (50% of order placed)

Carrying costs

Total amount cost

1600 1 1600 100 800 6400 6500 2 800 200 400 3200 3400 3 533 300 267 2136 2436 4 400 400 200 1600 2000 5 320 500 160 1280 1780 6 267 600 134 1072 1672 7 229 700 115 920 1620 8 200 800 100 800 1600 9 178 900 89 712 1612 10 160 1000 80 640 1640 The above table shows that total cost in the minimum when each is of 200 units. Therefore, economics ordering quantity is 200 units only. As graphic presentation of the economic ordering quantity on the basis of figures given in the above table will be as follows: Total cost on inventory management Inventory carrying costs. Ordering cost [ EOQ =2000 units]

_____________

_____________

_ _ _ _ _ _ _ _ _





Cost in thousand (Rs) 0 1 2 3 4 5 6 7 8 9 10 (5) Bill of Materials: In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purpose whenever it is required. This aim can be achieved by preparing what is normally called as “Bill of Materials”. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department. The form in which the bill of material is usually prepared is as below:

BILL OF MATERIALS No. Date of Issue Production/Job Order No Department authorized S. No Description

of Material Code No

Qty. For Department Use Only

Remarks

Material Requisition

No

Date Quantity Demanded





The function of bill of materials are as below:

(1) Bill of materials gives an indication about the orders to be executed to all the persons concerned.

(2) Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not available with the stores.

(3) Bill of material may serve as a base for the Production Department for placing the material requisition slips.

(4) Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as base for quoting the price for the job or production order.

(6) Perpetual Inventory System: As discussed earlier, in order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts.

(1) Maintenance of Bin Cards and Stores Ledger in order to know about eh stock in quantity and value at any point of time.

(2) Continuous verification of physical stock to ensure that the physical balance and the book balance tallies.

The continuous stock taking may be advantageous from the following angles:

(1) Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at the year end. Further, it is not necessary to close down the factory for Annual stock taking.

(2) The figures of stock can be readily available for the purpose of periodic Profit and Loss Account.

(3) Discrepancies can be located and adjusted in time. (4) Fixation of various levels and bin cards enables the action to be taken for

the placing the order for acquisition of material.





(5) A systematic maintenance of perpetual inventory system enables to locate slow and non-moving items and to take remedial action for the same.

(6) Stock details are available correctly for getting the insurance of stock.

ILLUSTRATIVE PROBLEMS

(1) A company uses annually 50,000 units of an item each costing Rs. 1.20 Each order costs Rs. 45 and inventory carrying cost 15% of the annual average inventory value.

(a) Find EOQ (b) If the company operates 250 days a year, the procurement time is 10

days, and safety stock is 500 units. Find reorder level, maximum, minimum and average inventory.

Unit II

Investment decisions The investment decisions of a firm generally known as capital budgeting or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of year. The long term assets are those which affect the firm’s operations beyond the one year period. The firm’s investment decision would generally include expansion, acquisition, modernisation and replacement of long term assets. Sale of a division or business (Investment) is also analysed as an investment decision. Activities such as changes in the methods of sales distribution or undertaking an advertisement compaign or a research and development programme have long-term implication’s for the firm’s expenditure and benefits and therefore, they may also be evaluated as investment decisions. Features:- 1) The exchange of current funds for future lengths. 2) The funds are invested in long term assets. 3) The future benefits will occur to the firm over a series of year.





Importance of Investment Decisions Investment decision require special attention because of the following reasons: 1) They influence the firm’s growth in the long turn. 2) They affect the risk of the firm. 3) They involve commitment of large amount of funds. 4) They are irreversible or reversible at substantial loss. 5) They are among the most difficult decisions to make. 1) GROWTH: A firm’s decision to invest in long term assets has a decisive influence on rate and direction of its growth. A wrong decision can prove disastrous for continued survival of firm, unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On other hand, inadequate investment in assets would make it difficult for the firm to complete successfully and maintain its market share. 2) Risk: A long-term commitment of funds may also change risk complexity of the firm. If the adoption of an investment increases overage gain but causes frequent fluctuations in its earnings the firm will become more risky. 3) Funding: Investment decisions generally involve large amount of funds which make it imperative for firm to plan its investment programmes very carefully and make an advance arrangement for procuring finance internally or externally. 4) Irreversibility: It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. 5) Complexity:





Investment decisions are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate future cash flow of an investment. The uncertainty in cash flow is caused by economic, political, social and technological forces. Techniques of Capital Budgeting: it may be grouped in the following two categories:- (A) Discounted cash flow (DCF) Criteria.

(1) Net present value (NPV) (2) Internal Rate of Return (IRR) (3) Profitability Index (PI) (4) Discounted Payback Period.

(B) Non-discounted Cash flow Criteria:

(1) Pay back period (PB) (2) Accounting rate of return (ARR)

(A) Discounted Cash Flow (DCP) Criteria – These techniques are considered good because they take into account time value of money. (1) Net Present Value (NPV) This method take into account time value of money. In this method present value of cash flows is calculated for which cash flows are discounted. The rate of interest is called cost of capital and is equal to minimum rate of return which must accrue from the project. Later, present value of cash out flows is calculated in same manner and subtracted from present value of cash inflows. This difference is called Net Present value or NPV. In case investment is made only in beginning of the project, it present value is equal to the amount invested in the project. Taking this assumption, NPV can be calculated as under: NPV = CF1 CF2 Cfn + + - - - C (1+k)1 (1+k)2 (1+k)n n Cft = ∑ -C





t=1 (1+k)t Where Cf1, Cf2 represent cash inflows K = Cost of Capital C = Cost of investment proposal n = Expected life of Proposal If the project has a salvage value also, it should be added in cash inflows of last year. Similarly, if some working capital is also needed, it will be added to initial cost of project and to cash flows of last year. Acceptance Rule:- 1) Accept if NPV >O (i.e. NPV is Positive) 2) Reject if NPV <O (i.e. NPV is Negative) 3) May accept if NPV= O Advantage: 1) It takes into account time value of money. 2) It considers cash inflows form project throughout its life. 3) In this method variable discount rates can be used for the projects with longer life period. 4) This method is more closely related to firm’s objective of maximising wealth of shareholders. 5) True measure of profitability. Disadvantages: (1) Difficult to use, calculate & understand. (2) In calculating NPV, discount rate is most significant because with different discount rates NPV will be different. Thus comparable profitability of projects will change with the change in discount rate. To determine required rate of return which is called cost of capital, is a difficult task. Different authors have their different opinions regarding its calculation.





(3) When the initial cost of 2 projects is different, this method is not very useful because we will accept or project whose NPV is higher and such a project may have more initial cost as compared to other. This method evaluates absolute profitability rather than relative profitability. (4) When life of 2 projects is dissimilar, this method does not give satisfactory results. Normally, project with less life time is preferred. But as per this method, NPV of the project with longer life may be more, and thus finds will be blocked for a longer period, in this project. In such cases, NPV method may not present actual worth of alternate projects. 3) PROFITABILITY INDEX It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1). It is the ratio of value of future cash benefits at required rate or return to the initial cash outflow of the investment. PI method should be adopted when the initial costs of projects are different. NPV method is considered good when the initial cost of different projects is the same. Thus NPV is an absolute measure of evaluating projects and PI is an absolute measures. Pl can be calculated as under:- Present Value of Cash Inflows PI _________________________ Present Value of Cash outflows Acceptance rule

• Accept if Pl>1.0 • Reject if Pl<1.0 • Project may be accepted if Pl= 1.0

MERITS

• Considers all cash flows. • This method considers all benefits during the life time of the project. • This method takes into account the time value of money. • Pl method is considered better to NPV in case when the initial costs of

projects are different for eg. The NPV of two project is equal ie, Rs 5000. The initial cost of project is Rs 40,000 and that of project B Rs 20,000. Project should be selected on the basis of profitability index, whereas under NPV method both the projects will be considered equally profitable.





• Generally consistent with the wealth maximisation principle. Disadvantages/ Demerits 1). It is difficult to understand and implement this method. 2). The calculations in this method are complex as compared to traditional methods. 3). Requires estimates of the cash flows which is a tedious task. 4). At times fails to indicate correct choice between mutually exclusive projects. 4). Discounted Pay Back Period: This is an improvement over the pay back period method in the sense that it considers time value of money. Thus discounted pay book period indicates that period with which the discounted cash inflows equal to the discounted cash outflows involved in a project. Pay Back Method: Under this method the pay back period of each project/ investment proposal is calculated. The investment proposal, which has the least pay back period is considered profitable. Actual pay back period is compared with the standard one. If actual pay back period is less than the standard, the project will be accepted and in case, actual payback period is more than the standard pay back period, the project will be rejected. Thus, the project with the least payback period is considered profitable. “Pay Back Period is the number of year required for the original investment to be recouped. For eg, if the investment required for a project is Rs 20,000 and it is likely to generate cash flow of Rs 10,000 for 5 years, its payback period will be 2 years. It means that investment will be recovered in first 2 year of the project. There are two methods of calculating payback period. First method is used when cash flows remains the same during the life time of the project. In such a case payback (PB) is calculated as under:- INVESTMENT CO PB = _______________________ =___ CONSTANT ANNUAL CASH FLOW C





For eg, if the investment for a machinery is Rs 50,000 and it will generate Rs 10,000 such year for 10 years, then its Pay Back period will be:- Rs 50000 PB = _________ = 5 Years Rs 10000 For the pay back period of 5 years, it can be observed that the investment of Rs 50,000 will be recovered by the business in 5 years. ACCEPTANCE RULE

• Accept if PB < standard pay back. • Accept if PB > standard pay back.

MERITS

1. Easy to understand and compute. 2. This method follows short terms view point, as a result, the obsolescence

are minimum. 3. Emphasis liquidility, therefore useful for the companies which faces the

problem of liquidity. Such companies will invest their funds in such projects in which investment can be recovered in minimum time.

4. Used to find out internal Rate of Return. 5. Suitable for those organisations which emphasise on short-term

investments rather than long terms development. 6. Uses cash flow information. 7. Easy and crude way to cope with risk.

Demerits

1. Ignores the value of money. 2. Ignores the cash flows occurring after the pay back period. Thus does not

take into account the whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows of Rs 50,000 during the last 5 years have been taken into account.

3. No objective way to determine the standard payback. 4. This method also does not take into account the time value of money. The

time value of money is the interest on investment. The payback period of two projects may be the same but a project may get more CFAT in the





initial years and less in the later years. In such a case the cash flows in the initial years can fetch additional income of interest. Such a project may become more profitable than the others. But this method ignores this fact.

5. This method does not take into account the total life time of the project. 6. No relation with the wealth maximisation principle. 7. not a measure of profitability.

II. Average Rate of Return Method: This method is also called Accounting Rate of Return Method. This method is based on accounting information rather than cash flows. There are various ways of calculating Average Rate of Return. It can be calculated as:- Average annual Profit after Tax ARR = ___________________________X100 Average Investment Average Annual Profit = Total of after tax profit of all the year ___________________________ No. Of years Average Investment = Original Investment + Salvage Value ________________________________ 2

or Original Investment – Salvage Value ________________________________ + Salvage Value

2 If working Capital is also required in the initial year of the project, the average investment will be= Net working Capital + Salvage value + ½ (initial cost of Machine- Salvage Value). In another method instead of average investment original cost is used.





In this method, to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Thus, the project is given more significant on which the average rate of return is the highest. Acceptance Rule

• Accept if ARR > minimum rate. • Accept if ARR < minimum rate.

Merits 1). Easy to understand. Necessary informations to calculate average rate of return are available easy. 2). This method takes into account all the profits during the life time of the project, whereas pay back period ignores the profits accruing after the pay back period 3). Give more weightage to future receipts. 4). Easy to understand and calculate. 5). Uses accounting data with which executives are familiar. Demerits 1). Ignore the time value of money. 2). Does not use cash flow. 3). No objective way to determine the minimum acceptable rate of return. 4). This method does not account for the profits arising on sale of profit on old machinery on replacement. 5). ARR method does not consider the size of investment for each project. It may be time that the competing ARR of two projects may be the same but they may require different average investments. It becomes difficult for the management to decide which project should be implemented. Unit IV

MANAGEMENT OF RECEIVABLE “Receivables are asset accounts representing amounts owned to a firm as a result of sale of goods or services in ordinary course of business.” Receivables are also turned as trade receivables, accounts receivables, customer receivables, sundry debtors, bills receivable etc. Management of





receivable is also called management of trade credit. The receivable arising from credit sales contain risk element. Purpose of Receivables There a 3 purposes of investing or maintaining Receivables. (1) Growth in Sales:- In comparison to cash sales, firm can make high sales by selling on credit, because many customers do not want to pay cash. Some of the customers may have deficit of cash. Therefore, if any firm does not sell on credit, it sales may go down. (2) Increased Profits:- Due to credit sale of goods and services, the total sales of business can increases. As a result of it, it profits also start increasing. (3) Meeting Competition:- Various firm sell goods on credit to their customer only because their competitors are doing so. If a firm does not follow credit policy of it competitors, its total sales will decrease because its customers will be attracted towards other firms. Objectives of Receivable Management From creation of receivables the firm gets a few advantages & it has to bear bad debts, administrative expenses, financing costs etc. In the management of receivables financial manager should follow such policy through which cash resources of the firm can be fully utilised. Management of receivables is a process under which decisions to maximise returns on the investment blocked in them are taken. Thus, the main objectives of management receivable is to maximise the returns on investment in receivables & to minimise risk of bad debts etc. Because investment in receivables affects liquidity and profitability, it is, therefore, significant to maintain proper level of receivables. In other words, the basic objectives of receivables management is to maximise the profits. Efficient credit management helps to increase the sales of the firm. Thus, following are the main objectives of receivables management:- (1) To optimise the amount of sales.





(2) To minimise cost of credit. (3) To optimise investment in receivables.

Therefore, the main objective of receivable management is to establish a balance between profitability and risk (cost). A business can afford to invest in its receivables unless the marginal costs and marginal profits are the same. Although the level of receivables is affected by various external factors like standards of industry, economic conditions, seasonal factors, rate of competition etc, management can control its receivables. Though credit policies, credit terms, credit standards and collection procedures.

Aspects/Areas/Variables of RM

Formulation of Credit Analysis Collection Polices Evaluation of Credit Policies Credit Policies - Trade References - Bank References Turnover of Aging - Financials statement Accounts schedule Credit Credit Standards- Credit Bureau Report Receivable of Terms - Past Experience Receivable a) Credit period b) Cash Discount c) Cash Discount Period (A) Formulation of Credit Policies:-







Credit Policy means such factors which affect the amount of investment in receivable and about which management has to take decisions for example credit period, cash discount period etc. Following are the main constituents of credit policy- (1) Credit Terms:- are these terms on the basis of which credit sales are made to customers. These are also called terms of repayment of receivable. These are 3 main constituents of credit terms. They are: (a) Credit Period:- It is the period for which goods are sold on credit to customers i.e. the period after which payment is to be made by customers. For example, if customers are required to pay before the end of 30 days from date of sale, it will be written as ‘Net 30’. Credit period normally depends on the standard of the industry. By raising credit period, not only the sales and profits of firm rise but its costs also rise. Similarly, by reducing the credit period sales & profits decline on one hand & cost of fund & bad debt go down on the other. Therefore, on optimum credit policy should be determined by establishing balance in costs and profits of different credit periods. (b) Cash Discount:- A Firm gives cash discount to encourage its customers to pay quickly. In terms of cash discount, we include rate of cash discount and period for cash discount. The customers who do not to avail of cash discount, they have to make payment before expiry of general credit period. Due to availability of cash discount average collection period is reduced. As a result, the amount locked up in receivables declines. Cash discount is a loss to the firm. Therefore, decision to allow cash discount or to change its rate should be undertaken on the basis analysis of its costs and benefits. (c ) Cash Discount Period:- is the period during which cash discount is available. The period of cash discount affects average collection period. Thus, the terms of credit collectively include credit period, cash discount and period of cash discount. For example, if terms of credit are expressed as ‘2/10, Net 30’ , it means that if the payment is made with in 10 days, 2% cash





discount will be paid. If this cash discount is not avaited of, the payment has to be made with in 30 days of date of sale. (2) Credit Standards:- The term ‘Credit standard’s is basic yardstick of making credit sales to the customers. On the basis of credit standard it is determined to whom goods are to be sold or not to be sold. The credit standards followed by a firm affect sales, profits, investment in receivable & costs. If a firm follow loose credit standards, its sales and receivables will be more as standards, its sales and receivables will be more as compared, to firm which uses tight credit standards. (B) Credit Analysis:- is made to evaluate ability of the customers before making credit sales. A firm should determine procedure to evaluate applications for credit. On the basis of credit analysis only, a firm should decide to whom it will sell on credit & for how much amount. To sell on credit, all customers should not be treated a like. Each customer should be examined properly before selling goods on credit to him. 1) Trade Refrences:- Firm can ask its customers to mention such names/firms with which they are dealing at present. This is an important source of credit information after receiving trade references, firm should get desired informations from them. Sometimes, customer provides names of wrong persons, therefore, before believing the informations received, the honesty and sincerity of traders should be examined. 2) Bank References:- The bank of the customers can also provide important credit information’s about the customer. Such information’s are obtained by the firm with the help of its bank. Sometimes, firm ask customers to direct his bank to provide necessary information’s to it. The information’s like average bank balance of customer, loan given to customer, experience with customer etc can be obtained from bank of customer. Normally, bank does not give clear answer to firm’s question Therefore the firms should collect information’s from other sources. 3) Financial Statements:- This is one of easiest way to obtain information’s about credit worthiness of prospective customers. If prospective customer is a public limited company,





there may not be any difficulty in getting financial statements, in form of profit & loss Account & balance sheet. However, getting financial statements may be difficult in case of Private Limited companies of partnership firms. Past Experience:- This can be considered to be most reliable source of getting information about credit-worthiness of customer who is dealing with company presently. If there is the question of extending further credit to existing customer, the company should inevitable consider pas experience while dealing with that customer. (c ) Collection Policies:- are needed because all customers do not pay in time. Some customers pay at slow rate and some do not make payment at all. The objective of collection policy is to fasten the collection of debt. If the collection from debtors is delayed, additional funds have to be procured for smooth operation of selling and production activities. Delay in realisation from debtors also increases possibility of bad debts. Thus, the main objectives of realisation policy is to reduce the ratio of bad debt & reduce average collection period. The collection policy means the steps which are taken to realise the debts from debtors for their default in non payment with in the stipulated time. Proper coordination in sales and accounting department should be established to determine clear collection policy. Another aspect of collection policy is the methods employed to realise the over dues. After the end of credit period, firm should undertake necessary steps to make collection from debtors. Initially the efforts should be polite but with the passage of time they can be made stringent. Among these methods following are included:-

(1) Reminder letters (2) Telephone (3) Telegram (4) Extension of Payment Period (5) Legal Action

Before taking any action, difficulties of customers should be examined.

Therefore, following points must be considered for determining collection procedures:-





(1) Collection procedure must be clear. (2) Before Starting action for collection, the nature of the customers and their

business connections should be considered. (3) The time gap between due date and action for realisation of debts should

be determined separately for different classes of customers like regular customers, seasonal customers etc.

(4) So far as possible, legal action should be avoided. (5) The expenses incurred on collection should not exceed the amount of

collection of debt. (6) While estimating collection cost, past experience should be considered.

(D) Evaluation of Credit Policies/ Monitering Receivable:- The collection policy followed by firm should be optimum. It should neither be too liberal nor too strict. Proper adjustment in credit policies should be made according to changing ciramstances. To observe whether credit policy followed by firm is suitable or not, following methods can be used. (1) Turnover of Accounts Receivable:- This ratio is calculated by dividing annual credit sales by average accounts of receivables. The objective of this ratio is to measure liquidity. Credit Sales during the Year Turnover of Accounts Receivable =________________________ Average Accounts Receivable. Months or Days in a year Average collection Period = _____________________ Turnover of Accounts Receivable 2) Aging Schedule of Receivable:-







In this schedule, receivables are classified on basis of their age. The main objective of preparing this schedule is to find out how much old are the receivable. It is prepared in form of a statement. With the help of this schedule management can find out such debtors & can adopt appropriate collection method for them whose average credit period is higher and which are older. Thus management can reduce possibility of bad debts. A specimen of this schedule is given as under:-

Aging schedule of Accounts Receivables Period (No of Days)

No of Accounts

Amt (Rs) No as % Total no.

Amt as % of total

0-20 100 30000 23.8 16.2 21-40 200 80000 41.6 43.2 41-60 40 20000 9.5 10.8 61-80 50 40000 11.9 21.6 81-100 20 10000 4.7 5.4 Over 100 10 5000 2.5 2.8 420 185000 100.00 100.00

Management Of Cash

Management of cash is one of most important areas of overall working capital management. This is due to the fact that cash is the most liquid type of current assets. As such, it is the responsibility of finance function to see that various functional areas of business have sufficient cash whenever they require the same. At the same time, it has also to be ensured that funds are not blocked in form of idle cash, because it will effect interest cost & opportunity cost. As such, management of cash has to find a mean between these 2 extremes of shortage of cash as well as idle cash. Motives of holding Cash/ Need:- 1) Transactive Motive:- Business needs cash for various payments in ordinary course of its operation which includes payment for purchase of material, wages, dividend, taxes etc. Similary business gets cash from its selling activities & other investment. But there is no coordination between inflow and outflow of cash. When expected cash receipt is short of required payment, cash is needed by firm so that liabilities could be paid, if cash receipts match with cash payments business does not need cash for transactional purpose.





2) Precautionary Motive:- Firms need cash to meet some contingencies. For example.

(1) Strikes, floods, failure of important customers. (2) Slow rate of cash collection from debtors. (3) Rejection of orders by customers due to their dissatisfaction. (4) Rise in cost of raw material etc.

3) Speculative Motive:- It means to make use of profitable opportunities by firm. Sometimes, firm wants to make use of such profitable opportunities which are outside operation of business. For this purpose, firm retains some cash. Some of these opportunities are:-

(1) Opportunity to purchase raw material at low price by payment of cash immediately.

(2) Opportunity to purchase securities at falling prices. (3) Purchasing raw material at a time when its prices are lowest.

(4) Compensation Motive:- Bank provide number of services to its customers like clearance by cheque, credit information about other customers, transfer of funds etc. for certain services banks charge commission but same of services are provided by them free of cost for which they require indirect compensation. For this purpose they wish their customer to maintain minimum cash balance. 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. Following are main advantages of adequate cash-

(1) To prevent firm from being insolvent. (2) The relation of firm with bank does not deteriorate. (3) Contingencies can be met easily. (4) It helps firm to maintain good relation’s with suppliers.

(2) To minimise Cash Balance:-





The second objective of cash management is to minimise 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 maintain. Managing Cash Flows:- The main objective of managing cash flows is to accelerate collection of cash and delay disbursement of cash without damaging credit worthiness. After preparing cash budget, management should try that there should not be any significant difference in actual & budgeted cash flows. Accelerating Cash Collections:- The customers should be encouraged to make early payment by giving cash discount to fill time gap between sale of goods and its payment by cheque. There are 2 methods of reducing these time gaps:- (1) Concentration Banking:- It is a system of collecting cash from customers of large sized firms which have large number of branches. Some of these branches are selected for collection of cash from debtors which are called collection centres. Firm opens its account in local banks of these collection centre. On receiving cheque, centre sends them to local branch of bank and then they are transferred to Head office daily for disbursements. Thus, this method is profitable technique of realising debts at the earliest because it reduces time gap between sending of cheque by customer and their receipts by firm. (2) Lock box System:- Under concentration banking, cheques or drafts received by collection centres are deposited in local banks & therefore, sometime is wasted before cheques or drafts are sent for collection. Under the lock box system, this time gap can be reduced. Under this system, firm takes on rent a lock box from post office at important collection centres.





Customers are instructed to send their cheques/drafts in lock-box. Firm authorises local banks to withdraw these cheques/drafts from lock box and credit the same to firm’s account. Bank operates this lock-box several times a day. Local banks are also instructed to transfer funds exceeding a particular level to Head office. This system is considered better to concentration banking because in this system, time involving in receiving cheque, their accounting & deposit of these cheque in banks is saved. But under this system, firm has to bear additional expenses of post office & bank. Slowing Disbursements:- The main objective of disbursement management is to slow down the payments without farming goodwill & credit worthiness of firm. Following methods can be used for slowing disbursements.:- 1) Avoidance of Early Payments:- Under this management, firm should make payment on due date only, neither early nor afterwards. Firm is allowed some time to make payment. But firm should not bear loss of cash discount. 2) Centralised Disbursements:- Under this system, all payments should be made from the central account by Head Office. This system will help in delaying payments and it will increase time gap in payment before they reach creditors. If payment is made by local branch, it will not take much time to reach to creditors by post. In this system, firm will have to maintain lesser total cash as against deentralised disbursement. Where each branch will have to maintain some cash. In this method, greater time will be involved in the presentation & collection of cheques. Control over payments will also become easier. 3). Float- Float is the amount which is trapped in cheques but which are yet to be collected. It means that although cheque has been issued but actual cash will be required later when it will be actually presented for payment.





For Example:- if the payment of wages and salaries is made by cheque on Ist of every month. It is not necessary that all cheques would be presented on Ist day. In actual practice, some cheques will be presented on Ist day, some on 2nd & some on 3rd. Thus firm need not deposit extra amount in bank on very Ist day. 4) Accruals:- Wages & other expenses can be paid after the date of actual services rendered to them. Determining Optimum cash Balance:- If available cash is more than operating requirements of firm, additional cash should be invested in short-terms securities. Optimum cash balance is that level of cash at which transaction cost & opportunity cost are minimum. If firm maintains more cash than optimum level, opportunity cost increases and transaction decreases and vice versa. Investing Surplus Cash:- If nature of surplus cash is permanent, it can be invested in long term assets. While investing cash in securities, their safety, maturity and marketability should be considered. a) Safety:- Cash should be invested in those securities, the prices of which do not change substantially and there is no risk in repayment of its principal & interest. b) Maturity:- more changes take place in long term securities. c) Marketability:- of securities means easiness in converting them into cash. Therefore, the surplus cash should be invested in such securities which can be converted into cash with out much loss. Unit-II

Risk analysis Risk exists because of inability of decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainity since the future events on which they depend are uncertain. An investment is not risky if, we can





specify a unique sequence of cash flows for it. But the whole trouble is that cash flows cannot be forecast accurately, & alternative sequence of cash flows can occur depending on future events. Thus, risk arises in investment evaluation because we cannot anticipate occurrence of possible future events with certainity & consequently, cannot make any connect prediction about cash flow sequence. Techniques to handle Risk

1) Pay back 2) Risk-adjusted discount rate. 3) Certainty equivalent.

2) Risk-adjusted Discount Rate:- To allow a risk, businessman required a premium over and above an alternative which was risk free. Accordingly, more uncertain the returns in future, the greater the risk & greater premium required. Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting analysis through discount rate. That is, if time preference for money is to be recognised by discounting estimated future cash flows, at same risk-free rate, to their present value, than, to allow for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate. Such a composite discount rate, called risk-adjusted discount rate, will allow for both time preference & risk preference & will be a sum of risk-free rate & risk-premium rate reflecting the investors attitude towards risk. The risk adjusted discount rate method can be expressed as follows: n NPV = ∑ NCFt t=0 (1+k)t Where K= Risk-adjusted rate. That is, Risk-adjusted discount rate= Risk free Rate+ Risk Premium K= kf+kr





Under CAPM risk- premium is difference between market rate of return & risk free rate multiplied by beta of the project. The risk adjusted discount rate accounts for risk by varying discount rate depending on degree of risk of investment projects. A higher rate will be used for riskier projects & a lower rate for less risky projects. The net present value will decrease with increasing k, indicating that riskier a project is perceived, the less likely it will be accepted. In contrast to net present value method, if firm uses IRR method, then to allow for risk of an investment project, the IRR for project should be compared with risk-adjusted minimum required rate of return. If IRR is higher than this adjusted rate, the project would be accepted, otherwise it should be rejected. Evaluation:- Advantages:- 1) Simple to understood. 2) Has a great deal of intuitive appeal for risk averse businessman. 3) It incorporates an attitude towards uncertainity. Disadvantages:- 1) There is no easy way of deriving a risk-adjusted discount rate. 2) It does not make any risk adjustment is numerator for cash flows that are for cast over future years. 3) It is based on assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks, they are willing to pay a premium to take risks. Accordingly, composite discount rate would be reduced, not increased, as the level of risk increases.

• It is based on the assumption that investors are risk averse. Though it is generally true, there exists a category or risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risk. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.1

Certainty Equivalent Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if





an investor, according to his ‘best estimate,’ expects a cash flow of Rs 60,000 next year, he will apply an intuitive correction factor and may work with Rs 40,000 to be on safe side. There is a certainty-equivalent cash flow. In formal way, the certainty equivalent approach may be expressed as: n tNCFt NPV = ∑ t=0 (1+kf)t Where, NCFt= the forecasts of net cash flow without risk-adjustment t = the risk-adjustment factor or the certainty equivalent coefficient kf = risk-free rate assumed to be constant for all periods.

The certainty- equivalent coefficient, t assumes a value between 0 and 1, and varies inversely with risk. A lower t will be used if greater risk is perceived and a higher t will be used if lower risk is anticipated. The coefficients are subjectively or objectively established by the decision maker. These coefficients reflect the decision-maker’s confidence in obtaining a particular cash flow in period t. For example, a cash flow of Rs 20,000 may be estimated in the next year, but if the investor feels that only 80 per cent of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. That is, he considers only Rs 16000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is: NCFt* Certain net cash flow t = = NCFt Risky net cash flow For example, if one expected a risky cash flow of Rs 80,000 in period t and considers a certain cash flow of Rs 60,000 equally desirable, then t will be 0.75=60,000/80,000. ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000, Rs 3,000, Rs 2,000 and Rs 1,000 in year 1 through 4. Assume that the associated t factors are estimated to be: o = 1.00, 1=0.90, 2=0.70, 3=0.50





and 4=0.30, and the risk free discount rate is 10 per cent. The net present value will be: 0.90(4,000) 0.70(3,000) 0.50(2,000) 0.30(1,000) NPV = 1.0(-6,000) + + + + = Rs 37 (1+0.10) (1+0.10)2 (1+0.10)3 (1+010)4 The project would be rejected as it has a negative net present value. If the internal rate of return method is used, we will calculate that rate of discount which equates the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash outflows. The ratio so found will be compared with the minimum required risk-free rate. Project will be accepted if the internal rate is higher than, the minimum rate; otherwise it will be unacceptable. Evaluation of Certainty Equivalent The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to ‘best estimate.’ Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments. Risk-adjusted Discount Rate VS. Certainty-Equivalent The certainty-equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty equivalent approach is theoretically a superior technique over the risk-adjusted discount approach because it can measure risk more accurately.1 The risk-adjusted discount rate approach will yield the same result as the certainty-equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods. Thus,





t NCFt NCFt = (1+kf)t (1+k)t To solve for l t NCF(1+k)t = NCFt (1+kf)t NCFt(1+kf)t (1+kf)t t = = NCFt(1+k)t (1+k)t For period t+1, Equation (6) will becomes (1+kf)t+1 t+1 = (1+k)t+1 Earlier, we have stated that the values of 1 will vary between 0 and 1. Thus, if Kf and k are constant for all future periods, then K must be larger than Kf to satisfy the condition that t varies. 1. Robichek and Myers, op. cit., pp. 82-86. Unit IV 16

Management Of Working Capital Working capital management is an important component of overall financial management. Management of working capital like long-term financial decisions affects the risk and profitability of business. In business two types of assets are used.

(1) Fixed Assets (2) Current Assets Fixed Assets include land, building, plant and machinery, furniture and

fittings etc. fixed assets are used in the business for a long period and they are not purchased for the purpose of selling them to earn profit.

Current Assets, on the other hand, are used for day to day operation of business. For the efficient and effective use of fixed assets, there should be adequate working capital in the business. Current assets include cash, bank





stock debtors, bills receivable, marketable securities etc. the capital employed in these assets is called working capital. In any business, there should be proper balance between fixed capital and working capital.

The problem relating to management of working capital is different from that of management of fixed assets. Fixed assets are purchased for long term use in business and the return on them is received during their lifetime. On the other hand, current assets get converted into cash in short term. One more significant characteristic of the current assets is that, if the amount of current assets is more in a business, it will increases the liquidity but profitability will reduce. On the other hand, if current assets are relatively lesser, profitability will improve but liquidity will be adversely affected. Therefore, the main objective of working capital management is to determine optimum amount of investment in current assets so that balance in profitability and liquidity of the business could be ascertained.

Definition of Working Capital

There is difference of opinion among different authors about the definition of working capital. Considering the objectives and scope of working capital, it can be defined in two ways: (i) Gross Concept (ii) Net Concept (i) Gross Concept:- According to the gross concept, working capital means total of all the current assets of a business. It is also called gross working capital.

(ii) Net Concept:- According to the net concept of working capital, net working capital means the excess of current assets over current liabilities. If current assets are equal to current liabilities then according to this concept working capital will be zero and in case current liabilities are more than current assets, the working capital will be called negative working capital.

Gross Working Capital= Total Current Assets

Net Working Capital= Current Assets-Current Liabilities





Current assets are those assets which are converted into cash within one accounting period, for example, stock, debtors, bills receivables, prepaid expenses, cash and bank balance. Similarly, current liabilities are those liabilities which have to be paid within an accounting year, for example, creditors bills payables, short term loans etc. Net working capital can also be defined in another manner. Net working capital is the part of current assets which has been financed from long term funds. It is, therefore also called circulating capital. Gross concept and net concept of working capital have their own significance. When individual current assets are to be managed, gross concept of working capital is used. Net concept of working capital emphasizes on how much current assets have been financed out of long term funds. Under this concept the relationship between current assets and current liabilities is established or their liquidity is determined. The difference between gross working capital and net working capital can be understood with the help of following illustration. ILLUSTRATION I. From the following balance sheet, you are required to calculate the amount of Gross Working Capital and Net Working Capital:-

Balance Sheet Rs Rs Share Capital 10,00,000 Land and Building 10,00,000 Reserves 1,00,000 Plant and Machinery 2,90,000 Debentures 4,00,000 Cash and Bank Balance 10,000 Short-term Loan 50,000 Marketable Securities 90,000 Trade Creditors 40,000 Trade Debtors 1,00,000 Bills Payable 10,000 Bills Receivable 40,000 Inventory 70,000 16,00,000 16,00,000 Solution : Gross Working capital= Cash and Bank Balance+ Marketable Securities+ Trade Debtors+ Bills Receivable+ Inventory = Rs. 10,000+Rs90,000+Rs1,00,000+Rs40,000+Rs70,000 = Rs. 3,10,000







Net Working Capital= Current Assets- Current Liabilities = Rs10,000 + Rs 90,000 + 1,00,000 + Rs 40,000 + Rs70,000- Rs50,000 – Rs 40,000 – Rs 10,000 = Rs 3,10,000- rs 1,00,000 = Rs 2,10,000 Need For Working Capital For the efficient operation of the business, working capital is required along with the fixed capital. Working capital is needed for the purchase of raw material and for the payment of various day to day expenses. There will be hardly any business which does not require working capital. The need for working capital is different businesses. Financial management aims at maximising the wealth of shareholders. To achieve this objective, it is necessary to earn adequate profits. The profit depends largely on sales but sales do not result in cash immediately. To increase sales goods are to be sold on credit, the collection of which takes place after time terms. Thus, there exists a gap between the sale of goods and realisation of cash. During this period expenses are to be incurred to continue business operations. For this purpose, working capital is required. The need for working capital can be explained with the help of operating cycle or cash cycle. Operating cycle means that time period which is required to convert raw material into cash. In a manufacturing enterprise raw material is purchased with cash, then raw material is converted into work-in progress, which in turn gets converted into finished goods; both receivable through sales and lastly cash is received from debtors and bills receivable. In the operating cycle, following events are included:

(1) Conversation of cash into raw material. (2) Conversation of raw material into work-in-progress. (3) Conversation of work in progress into finished goods. (4) Conversation of finished goods into Debtors and Bills Receivable. (5) Conversation of Debtors and Bills receivable through sales into cash.

Debtors and Bills Receivable

Cash

Raw Materials

Finished Goods

Work-in-Progress





Operating Cycle The greater the period of operating cycle, more will be the requirement of working capital. Business enterprises engaged in manufacturing work have larger duration of operating cycle as compared to those engaged in trading business because in such enterprises cash is directly converted into finished goods. Because no business is able to match its cash inflows and cash outflows, therefore, the business needs to maintain some cash to pay its current liabilities in time. Similarly, to maintain supply of goods to meet the demand in the market, the stock of finished goods has to be kept. For the smooth running of manufacturing work stock of raw material has to be maintained. Firm has to sell on credit due to competition. Thus, business needs adequate working capital. Permanent And Variable Working Capital In business current assets are required because of the operating cycle. But the need for working capital does not end with the completion of operating cycle. Operating cycle goes on continuously and therefore, in order to understand the need for working capital, it becomes essential to distinguish between permanent or regular and variable or seasonal or temporary working capital. (a) Permanent Working Capital:- The requirements for current assets do not remain stable throughout the year and it fluctuates from time to time. A certain minimum amount of raw material, work in progress and finished goods and cash must be maintained regularly in the business so that day to day operation of the business could continue without any obstacles. This minimum





requirement of current assets is called permanent or regular working capital. The arrangement of permanent working capital should be made from long term sources only, for example share capital, debentures, long term loans etc. (b) Variable Working Capital:- In certain months of the year the level of business activities is higher than normal and therefore, additional working capital may be required along with the permanent working capital. It is known as variable or temporary working capital. This part of the working capital is required due to changes in demand and supply of goods on account of change in seasons etc. for example, in boom period, stock is to be kept to fulfill demand and the amount of debtors increases due to more sales. Similarly, in depression, the amount of stock and debtors declines. Thus, extra working capital required due to changes in demand and production is called variable working capital. In order to run the business smoothly both types of working capital is required. Variable working capital is required for a short time. Therefore, it should be financed from the short term sources only so that later on it can be refunded when it is not required.

Fig. 1. Permanent and Temporary Working Capital From Fig.1 it is clear that the need for regular working capital remains the same for whole the year, whereas variable working capital needs are sometimes high and sometimes low. In a growing concern the need for working capital goes on rising because in the level of business activities. It is presented in Fig. 2)

Y TEMPARARY WORKING CAPITAL PERMANENT WORKING CAPITAL X TIME

Y TEMPARARY WORKING CAPITAL

PERMANENT TEMPARARY CAPITAL X

A

mou

nt o

f wor

king

cap

ital (

RS

.)

OU

NT

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WO

RK

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CA

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.)





Fig. 2. Permanent and Temporary Working Capital Factors Affecting Working Capital Business should prepare its financial plan in such a way that it has neither surplus nor inadequate working capital. The needs for every business are different but generally the following factors must be considered while determining the requirement of working capital. (1) Nature of Business:- Nature of business affects the working capital requirements of the business. Railways, transport, electricity, water and other public utilities require relatively lower working capital because the demand for their services is regular and fixed. They also get immediate payment. They need not keep much stock. On the other hand, the trading institutions require more working capital because they have to keep adequate stock, cash and debtors. In financial institutions and banks, the need for working capital is more than permanent capital. (2) Growth and Expansion:- the large sized businesses require more permanent and variable working capital in comparison to small business. If a company is growing, its working capital requirements will also go on increasing. Thus, the growing concerns require more working capital as compared to the stable industries. (3) Production Cycle:- Production cycle means the time period between the purchase of raw material and converting it into finished product. The requirements of working capital in a business depends upon the production cycle. It the period of production cycle is longer, more working capital will be required. If the production cycle is small, the requirements of working capital will also be small. Therefore, business should choose such an alternate method of





production which takes lowest time. Before selecting specific production process, it should be seen that it is completed in pre-determined time. (4) Business Fluctuations:- Business has to pass through the stages of boom and depression. These fluctuations affect the requirement of working capital. During the boom period the business grows rapidly. Management has to invest more in stock and debtors. This requires additional working capital. on the other hand, during depression, sale of business decreases. As a result the quantum of stock and debtors also reduces. It decreases the need for working capital. (5) Production Policy:- The determination of working capital needs depends upon the production policy of the business. The demand for certain products is seasonal i.e, such product are purchased in certain months of a year. For such industries two type of production policy can be followed. Firstly they can produce the goods in the months of demand or secondly, they produce for the whole year. If the second alternative is followed, it would mean that till the time of demand finishes, product will have to be kept in stock. It would require additional working capital. (6) Credit Policy:- Credit policy affects the working capital requirements in two ways:- (i) Terms of credit allowed by customers to the firm. (ii) Terms of credit available to the firm. If the firm sells goods on credit to its customers, it would require more working capital. If the firm follows tight credit policy, the requirement for working capital will decrease. Similarly, if the firm purchases raw material on credit, lesser working capital would be required. Thus, a liberal credit policy towards purchase will reduce the amount of working capital requirement against a tight credit policy. (7) Availability of Raw Material:- Availability of raw material on the continuous basis affects the requirement of working capital. There are certain types of raw materials which are not available regularly. In such a situation firm requires greater working capital to meet the requirements of production. Some raw materials are available in particular season only for example wool, cotton oil seeds, etc. They have to be kept in stock for the whole year for which additional working capital is needed. (8) Availability of Bank Credit:- If the firm is in a position to get financial help easily from the bank at the time of its need, it keep a low level of working





capital but if such facility is not available, firm will have to keep greater working capital. (9) Turnover of Inventories:- The greater the turnover of inventories i.e., finished product. Work-in-progress, raw material, lesser will be the requirement of working capital. If turnover is lower, more working capital is needed. (10) Magnitude of Profit:- Magnitude of profit is different for different businesses. Nature of product, control on the market and ability of managers etc. determine the quantum of profit. If the profit margin is high, it will help to arrange funds internally which will also increases the working capital. (11) Level of Taxes:- Whole of the cash profit is not available for working capital. Taxes and dividends are to be paid out of profits. Taxes are a statutory liability but it can be planned. Taxes are to be paid within a reasonable time. If tax liability is high, more working capital will be needed. (12) Dividend Policy:- Dividend policy also affects working capital needs. When dividend is paid in cash it has unfavourable effect on working capital. If the management does not pay dividend and the profits are retained, it increases working capital. Dividend as bonus shares does not affect the working capital. How much dividend is to be paid in cash and how much profits to be retained in business, it all depends upon number of factors including liquidity position of business, past dividend policy, need of capital for business. (13) Depreciation Policy:- It also affects the working capital. Depreciation does not result in outflow of cash. Therefore , it affects working capital directly. It affects tax liability and dividend. High depreciation means lesser profit and accordingly lesser taxes. Amount of dividend will also be lower. In all, there will be lesser outflow of cash. (14) Price Level Changes:- Price level changes also affect working capital needs. If the prices of different goods increase, to maintain same level of production, more working capital is needed. Debtors may be due to tight credit policy, which would impair sales further.

Minimum Cost Total Cost

Cost of Liquidity

Cost of Illiquidity

Cost





Thus, the low level of current assets involves costs which increases as this level falls. In determining the optimum level of current assets, the firm should balance the profitability solvency tangle by minimizing total cost-cost of liquidity and cost of illiquidity. This is illustrated in Figure 22.5. It is indicated in the figure that with the level of current assets the cost of liquidity increases while the cost of illiquidity decreases and vice versa. The firm should maintain its current assets at that level where the sum of these two costs is minimized. The minimum cost point indicates the optimum level of current assets in Figure 22.5

Figure 22.5 Cost trade-off ESTIMATING WORKING CAPITAL NEEDS The most appropriate method of calculating the working capital needs of a firm is the concept of operating cycle. However, a number of other methods may be used to determine working capital needs in practice. We shall illustrate here three approaches which have been successfully applied in practice: Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous year. This method is essentially based on the operating cycle concept. Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment. To illustrate the above methods of estimating working capital requirement and their impact on of return we shall take two hypothetical firms (as given in Table 22.6). The calculations are based on the following assumptions regarding each of the three methods:





Method 1. Inventory: one Month’s supply of each of raw material, semi finished goods and finished material. Debtors: one month’s sales. Operating cash: one month’s total cost. Method 2: 25-35% of annual sales. Method 3: 10-20% of fixed capital investment. The following calculations based on data of firm A are made to show how three methods work: Method 1: Let us first compute inventory requirements. Raw material: one month’s supply: Rs 2,48,000+12= Rs 20,667 Semi-finished material: one month’s supply (based on raw material plus one half of normal conversion cost): Rs 20,667+ (Rs 1,71,200 + Rs 1,60,000+ Rs 57,600) ½ ÷12 = Rs 20,667+16,200= Rs 36,867 Table 22.6 DATA FOR TWO FIRMS Firm A (Rs) Firm B (Rs) Material Cost, Raw Material consumed 2,48,000 2,48,000 Less: By product 68,800 68,800 Net material cost 1,79,200 1,79,200 Manufacturing cost, Labour 1,71,200 1,71,200 Maintenance 1,60,000 1,60,000 Power and fuel 57,600 57,600 Factory overheads 2,40,000 2,40,000 Depreciation (DEP) 1,60,000 3,20,000 Total product cost 7,88,800 9,48,800 Total product cost 9,68,000 11,28,000 Annual sales 14,48,000 14,48,000 PBIT 4,80,000 3,20,000 Investment (INVST) 16,00,000 32,00,000 Period 1 year 1 year Plant life 10 year 10 year PBDIT 6,40,000 6,40,000





ROI [{PBIT/INVST-DEP)] 33.3% 11.1%

Finished material: one month’s supply:

Rs 9,68,000 ÷ 12= Rs 80,666 The total inventory needs are: Rs 20,667+ Rs 36,867 + Rs 80,666= Rs 138,200 After determining the inventory requirements, projection for debtors and operating cash should be made. Debtors: one month’s sales: Rs14,48,000÷12= Rs 1,20,667 Operating Cash: one month’s total Cost: Rs 9,68,000÷ 12= Rs 80,667 Thus the total working capital required is: Rs 1,38,200+ Rs 1,20,667+ Td 80,666= Rs 3,39,533 Method 2: The average ratio is 30 per cent. Therefore, 30% of annual sales (Rs 14,48,000 is 4,34,400. Method 3. 15% (the average rate) of fixed investment (Rs 16,00,000) is Rs 2,40,000. The first method gives details of the working capital items. This approach is subject to markets are seasonal. As per the first method the working capital requirement is Rs 3,39,533. if this figure is in calculating the rate of return, it is lowered from 33.3% to 27%. On the other hand, the return of firm B drops from 11.1% to 9.9%. the estimated working capital for firm B as per the method is Rs 3,66,200. Rates of return are calculated as follows:





Unit –III Dividend Models

A WALTER’S MODEL This model was propounded by Prof. James E. Walter who argues that the choice of dividend policies almost always affect the value of the firm. He shows the importance of relationship between the firm’s rate of return ® and its cost of capital (K) in determining the dividend policy that will maximise the wealth of shareholders. Assumptions:- 1) Internal financing:- The firm finances all investment through retained earnings, that is debt or new equity is not issued. 2) Constant return and cost of capital:- The firm’s rate of return (r ) and its cost of capital (k) are constant. 3) 100% payout or retention:- All earning are either distributed as dividends or reinvested internally immediately. 4) Constant EPS and DIV:- Beginning earnings and dividends never change. The value of the earnings per share, (EPS) and dividend per share (DIV) may be changed in the model to determine results, but any given values of EPS or DIV are assumed to remain constant forever in determining a given value. 5) Infinite time:- The firm has a very long or infinite life. Walter’s formula to determine the market price per share is as follows:- DIV r (EPS-DIV)/k P = + K K





Where P= market price per share. DIV = Dividend price per share. EPS = Earning price per share. R= firm’s rate of return (average). K= firm’s cost of capital or capitalisation rate. Equation (1) reveals that the market price per share is the sum of present value of 2 sources of income (i) Present value of infinite stream of constant dividends, (DIV/k) and (ii) Present value of infinite stream of capital gain r (EPS-DIV)/k k When the firm retains a perpetual sum of (EPS-DIV) at rate of return ®,its present value will be: R (EPS-DIV)/R This quantity can be known as a capital gain which occurs when earnings are retained within the firm. If this retained earnings occur every year, the present value of an infinite number of capital gains, r (EPS-DIV)/k will be equal to : [r(EPS-DIV)] /k. Thus, the value of a share is the present value of all dividends plus the present value of all capital gain as show in eg (1) which can be rewritten as follows: P= DIV+(r/K) (EPS-DIV) ____________________ K To show the effect of dividend or retention policy on the market value of share, we shall use Eq (2) E.g The effect of different dividend policies on the value of shares respectively for the growth firm, normal firm and declining firm is constructed through given table.





Dividend Policy and the value of share (Walter’s Model) Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k) Basic Data r= 0.15 k=0.10 EPS = Rs 10

T= 0.10 K= 0.10

EPS = Rs 10

r= 0.08 k = 0.10

EPS = Rs 10 Payout Ratio 10% DIV R 50 P= [0+(0.15/0.10)(10-0)] 0.10 = Rs = 150

DIV = Rs 0 P = 100

DIV =Rs 50 P= 80

Payout Ratio 40% DIV = Rs 4 P=[4+0.15/0.10)(10-4) 0.10 =Rs 130

DIV=Rs 4

P= Rs= 100

DIV=Rs54 P= Rs 88

Payout Ratio 80% DIV = Rs 8 P = 110

DIV = Rs 8 P = 100

DIV = Rs 8 P = 96

Payout Ratio 100% DIV = Rs 10 P = Rs 100

DIV= Rs 10 P = Rs 100

DIV = Rs 10 P = Rs 100

The above table shows that dividend policy depends on the relationship between the firm’s rate of return ® and its cost of capital (k). Walter’s view on the optimum dividend pay out ratio can be summarised as follows.





Growth firm: Internal Rate More than Opportunity Cost of Capital (r>k) Growth firms are those firms which expand rapidly because of ample investment opportunities yielding returns higher than the opportunity cost of capital. These firms are able to reinvest earning at a rate ® which is higher than the rate expected by shareholders (k). They will maximise value per share if they follow a policy of retaining all earnings for internal investment. It can be seen from table above that the market value per share for growth firm is maximum (i.e. Rs150) when it retain 100% earnings & minimum (Rs100) if distributes all earnings. Thus, the optimum payout ratio for a growth firm is zero. The market value per share P, increases as payout ratio decline when r>k. Normal firms: Internal Rate equal opportunity cost of Capital (r=k) Most of the firms do not have unlimited surplus-generating investment opportunities, yielding returns higher than opportunity cost of capital. After exhausting super profitable opportunities, these firms earns on their investments rate of return equal to cost of capital (r=K). for normal firms with r=K, the dividend policy has not effect on market value per share in Walter’s Model. From above table it is shown that market value per share for normal firm is same (i.e. Rs 100) for different dividend-payout ratio. Thus, there is no unique optimum pay out ratio for normal firm. One dividend policy is as good as the other. The market value per share as not affected by payout ratio when r=k. Declining firms: Internal Rate less than Opportunity Cost of Capital (r<k). Some firms do not have any profitable investment opportunities to invest earnings. The market value per share of declining firm with R<k will be maximum when it does not retain earnings at all from above table it is observed that declinings firm’s payout ratio is 100% (i.e. o retained earnings) the market value per share is Rs 100 & it is Rs 80 when payout ratio is zero. Thus, optimum payout ratio for declining firm is 100%. The market value per share, P, increases as payout ratio increases when r<k. Thus,

• Retain all earnings when r>k. • Distribute all earnings when r<k. • Dividend (or retention) policy has no effect when r=k.

Criticism:-





(1) No External Financing:- Walter’s model of share valuation mixes dividend policy with investment policy of firm. The model assumes that the investment opportunities of the firm are financed by retained earnings only & no external financing debt or equity is used for the purpose. When such a situation exists, either the firm’s investment or its dividend policy or both will be sub-optimum. (2) Constant rate of Return, This model is based on the assumption that r is constant. In fact, r decreases as more and more investment is made. This reflects the assumption that the most profitable investment are made first & then poorer investment is made. The firm should stop at a point where r=k. (3) Constant opportunity Cost of Capital, k A firm’s cost of capital or discount rate, k, does not remain constant, it changes directly with the firm’s risk. Thus the present value of firm’s income moves inversely with cost of capital. By assuming that the discount rate, k, is constant, Walter’s model abstracts from the effect of risk on the value of firm. Constant Opportunity Cost of Capital, k A firm’s cost of capital or discount rate, k, does not remain constant; it changes directly with the firm’s risk. Thus the present value of the firm’s income moves inversely with the cost of capital. By assuming that the discount rate, k, is constant, Walter’s model abstracts from the effect of risk on the value of the firm. • DIVIDEND RELEVANCE: GORDON’S MODEL One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron Gordon.1 Gordon’s model is based on the following assumptions:2

o All-equity firm The firm is an all-equity firm, and it has no debt. o No external financing No external financing is available. Consequently

retained earnings would be used to finance any expansion. Thus, just as Walter’s model Gordon’s model too confounds dividend and investment policies.

o Constant return The internal rate to return, r, of the firm is constant. This ignores the diminishing marginal efficiency of investment as represented in Figure 20.1





o Constant cost of capital The appropriate discount rate K for the firm remains constant. Thus, Gordon’s model also ignores the effect of a change in the firm’s risk-class and its effect on K.

o Perpetual earnings The firm and its stream of earnings are perpetual. o No taxes Corporate taxes do not exist. o Constant retention The retention ratio, b, once decided upon, is

constant. Thud, the growth rate, g=br, is constant forever. o Cost of capital greater than growth rate The discount rate is greater

than growth rate, K>br=g. If this condition is not fulfilled, we cannot get a meaningful value for the share.

According to Gordon’s dividend-capitalisation model, the market value of a share is equal to the present value of an infinite stream of dividends to be received by the shareholders as explained earlier in Chapter 8. Thus: DIV1 DIV2 DIV DIVt Po = + + … =∑ (1+k) (1+k)2 (1+k) t=1 (1+k)t However, the dividend per share is expected to grow when earnings are retained. The dividend per share is equal to the payout ratio, (1-b), times earnings, i.e., DIVt = (1-b) EPS, where b is the fraction of retained earnings. The retained earnings are assumed to be reinvested within the all-equity firm at a rate of return of r. This allows earnings to grow at the rate of g= br per period. When we incorporate growth in earnings and dividend, resulting from the retained earnings, in the dividend-capitalisation model, the present value of a share is determined by the following formula: DIV(1+g) DIV(1+g)2

DIV(1+g)3 DIV(1+g) Po = + + +….+ (1+k) (1+k)2 (1+k)3 (1+k)t 1. Gordon, Myron J., The Investment, Financing and Valuation of Corporation.

Richard D. Irwin, 1962. 2. Francis, op. cit., p. 352.

DIV (1+g)t = ∑

t=1 (1+k)t





When Equation (4) is solved it becomes: DIV1

Po = K-g Substituting EPS1 (1-b) for DIV, and br for g. Equation (5) can be rewritten as EPS1 (1-b) Po = k-br Equation(6) explicitly shows the relationship of expected earnings, EPS1, dividend policy, b, internal profitability, r, and the all-equity firm’s cost of capital, k, in the determination of the value of the share. Equation (6) is particularly useful for studying the effects of dividend policy (as represented by b) on the value of the share. Let us consider the case of a normal firm where the internal rate of return of the firm equals its cost of capital, i.,e., r=k. Under such a situation, Equation (6) maybe expressed as follows: EPSl (1-b) rA(1-B) Po = = (since EPS =rA,A total assets per share) K-br k-br If r=k, then EPSl(1-b) rA(1-b) EPS1 rA Po = = = = =A K(1-b) k(1-b) k r Equation (8) shows that regardless of the firm’s earnings, EPS1, or riskiness (which determines K), the firm’s value is not affected by dividend policy and is equal to the book value of assets per share. That is, when r=k, dividend policy is irrelevant since b, which represents the firm’s dividend policy, completely cancels out of equation (8). Interpreted in economic sense, this finding implies that, under competitive conditions, the opportunity cost of capital, k, must be equal to the rate of return generally available to investors in comparable shares. This means that any funds distributed as dividends may be invested in the market at the rate equal to the firm’s internal rate of return. Consequently, shareholders can neither





lose nor gain by any change in the company’s dividend policy, and the market value of their shares must remain unchanged.1 Considering the case of the declining firm where r<k, Equation (8) indicates that, if the retention ratio, b, is zero or payout ratio, (1-b), is 100 per cent the value of the share is equal to: rA Po = (if b=0) k If r<k then r/k<1 and from Equation (9) it follows that Po is smaller than the firm’s investment per share in assets. A. It can be shown that if the value of b increases, the value of the share continuously falls. 2 These result may be interpreted as follows:

1. Dobrovolsky, Sergie P., The Economics of Corporation Finance, McGraw Hill, 1971, p.55.

2. ibid., p. 56. It the internal rate of return is smaller than k, which is equal to the rate available in the market, profit retention clearly becomes undersirable from the shareholders’ standpoint. Each additional rupee (sic) retained reduces the amount of funds that shareholders could invest at a higher rate elsewhere and thus further depress the value of the company’s share. Under such conditions, the company should adopt a policy of contraction and disinvestment, which would allow the owner to transfer not only the net profit but also paid in capital (or a part of it) to some other, more remunerative enterprise.1

Finally, let us consider the case of a growth firm where r>k. The value of a share will increase as the retention ratio, b increases under the condition of r>k. however, it is not clear as to what the value of b should be to maximise the value of the share, P0. For example, if b=k/r, Equation (6) reveals that denominator, k-br=0, thus making P0 infinitely large, and if b=1,k- br becomes negative, thus making P0 negative. These absurd result are obtained because of the assumption that r and k are constant, which underlie the model. Thus, to get the meaningful value of the share, according to Equation (6), the value of b should be less than k/r. Gordon’s model is illustrated in Illustration 20.2.





ILLUSTRATION 20.2 Let us consider the data in Table 20.2. The implications of dividend policy, according to Gordon’s model, are shown respectively for the growth, the normal and the declining firms. Table 20.3 DIVIDEND POLICY AND THE VALUE OF THE FIRM (GORDON’S MODEL)

Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k) Basic Data r= 0.15 k=0.10 EPS1 = Rs 10

T= 0.10 K= 0.10

EPS1 = Rs 10

r= 0.08 k = 0.10

EPS1 = Rs 10 Payout Ratio, (1-b) =, Retention Ratio, B = 60% g=br=0.6X0.15=0.09 10(1-0.6) P = 0.10-0.09 4 = Rs 400 0.01

g=br=0.6X0.10=0.06 10(1-0.6) P = 0.10-0.06 4 = Rs 100 0.04

g=br=0.6X0.08=0.048 10(1-0.6) P= 0.010-0.048 4 = Rs 77 0.052

Payout Ratio = (1-b) = 60% Retention Ratio, b = 40% g=br=0.4X0.15=0.06 10(1-0.4) p= 0.10-0.06 6 = Rs 150 0.04

g=br=0.4X0.10=0.04 10(1-0.4) P = 0.10-0.04 6 = Rs 100 0.06

g=br=0.4X0.08=0.032 10(1-0.4) P= 0.10-0.032 6 = Rs 88 0.068

Payout Ratio = (1=b) = 90% , Retention Ratio, b =10% g=br=0.10X0.15= 0.015 10(1-0.1) P= 0.10-0.015 9 = Rs 106 0.085

g=br= 0.10X0.10= 0.01 10(1-0.1) P = 0.10-0.01 9 = Rs 100 0.09

g=br=0.10X0.08=0.008

10(1-0.1) P = 0.10-0.008 9 = Rs 98 0.092

It is revealed that under Gordon’s model:





• The market value of the share, P0, increases with the retention ratio, b, for firms with growth opportunities, i.e. when r>k.

• The market value of the share, P0, increases with the payout ratio, (1-b), for declining firms with r<k.

• The market value of the share is not affected by dividend policy when r=k.

Gordon’s model’s conclusions about dividend policy are similar to that of Walter’s model. This similarity is due to the similarities of assumptions which underlie both the models. Thus the Gordon model suffers from the same limitations as the Walter model.

• DIVIDENDS AND UNCERTAINTY: THE BIRD-IN-THE HAND ARGUMENT According to Gordon’s model, dividend policy is irrelevant where r=k, when all other assumptions are held valid. But when the simplifying assumptions are modified to conform more closely with reality, Gordon concludes that dividend policy does affect the value of a share even when r=k. This view is based on the assumption that under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. Investors, behaving rationally, are risk-averse and, therefore, have a preference for near dividends to future dividends. The logic underlying the dividend effect on the share value can be described as the bird-in-the-hand argument. The bird-in-the hand argument was put forward, first of all by Kirshman in the following words: Of two stocks with identical earnings record, and prospects but the one paying a larger dividend that the other, the former will undoubtedly command a higher price merely because stockholders prefer present to future values. Myopic vision plays a part in the price-making process. Stockholders often act upon the principle that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower rate.1

1. Krishman, Johan, E., Principles of Investment. McGraw Hill, 1933, p. 737; cf. in Mao J.C.T., Quantitative Analysis of Financial Decision, Macmillan, 1969. Where Pb is the price of the share when the retention rate b is positive i.e., b>0. The value of Pb calculated in this way can be determined by discounting this dividend stream at the uniform rate, k. Iz the weighted average of Kt:1 DIV0(1+g) DIV0(1+g)2 DIV0((1+g)t Po = + +……..+





(1+kt) (1+kl)2 (1+kl)t DIVl (1-b) EPSl = = kl – g kl - br Assuming that the firm’s rate of return equals the discount rate, will Pb be higher or lower than P0? Gordon’s View, as explained above, it that the increase in earnings retention will result in a lower value of share. To emphasise, he reached this conclusion through two assumptions regarding investor’s behaviour: (i) investors are risk averters and (ii) they consider distant dividends as less certain than near dividends. On the basis of these assumptions, Gordon concludes that the rate at which an investor discounts his dividend stream from a given firm increases with the futurity of this dividend stream. If investors discount distant dividend at a higher rate than near dividends, increasing the retention ratio has the effect of raising the average discount rate, K, or equivalently lowering share prices. Thus, incorporating uncertainty into his model, Gordon concludes that dividend policy affects the value of the share. His reformulation of the model justifies the behaviour of investors who value a rupee of dividend income more than a rupee of capital gains income. These investors prefer dividend above capital gains because dividends are easier to predict, are less uncertain and less risky, and are therefore, discounted with a lower discount rate.2 However all do not agree with this view. • DIVIDEND IRRELEVANCE: MODIGLIANI AND MILLER’S HYPOTHESIS According to Modigliani and Miller (M-M) under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. 3 They argue that the value of the firm depends on the firm’s earnings which result from its investment policy. Thus, when investment decision of the firm is given, dividend decision the split of earnings between dividends and retained earnings is of no significance in determining the value of the firm. A firm, operating in perfect capital market conditions, may face one of the following three situations regarding the payment of dividends:

• The firm has sufficient cash to pay dividends. • The firm does not have sufficient cash to pay dividends, and therefore, it

issues new shares to finance the payment of dividends. • The firm does not pay dividends, but a shareholder needs cash.





1. Mao, James C.T., Quantitative Analysis of Financial Decision, Macmillan.

1969, p. 482. 2. Francis, op. cit., p.354. 3. Merton H. Miller and France Modigliani, Dividend Policy, Growth and

Valuation of the Shares, Journal of business XXIV (October 1961), pp. 411-433.

In the first situation, when the firm pays dividends, shareholders get cash in

their hand, but the firm’s assets reduce (its cash balance declines). What shareholders gain in the form of cash dividends, they lose in the form of their claims on the (reduced) assets. Thus, there is a transfer of wealth from shareholder’s one pocket to their another pocket. There is no net gain or loss. Since it is a fair transaction under perfect capital market conditions, the value of the firm will remain unaffected. In the second situation, when the firm issues new shares to finance the payment of dividends, two transactions take place. First, the existing shareholders get cash in the form of dividends, but they suffer an equal amount of capital loss since the value of their claim on assets reduces. Thus, the wealth of shareholders does not change. second, the new shareholders part with their cash to the company in exchange for new shares at a fair price per share. The fair price per share is share price before the payment of dividends less dividend per share to the existing shareholders. The existing shareholders transfer a part of their claim(in the form of new shares) to the new shareholders in exchange for cash. There is no net gain or loss. Both transactions are fair, and thus, the value of the firm will remain unaltered after these transactions. In the third situation, if the firm does not pay any dividend a shareholder can create a “home-made dividend” by selling a part of his/her shares at the market (fair) price in the capital market for obtaining cash. The shareholder will have less number of shares. He or she has exchanged a part of his claim on the firm to a new shareholder for cash. The net effect is the same as in the case of the second situation. The transaction is a fair transaction is a fair transaction, and no one loses or gains. the value of the firm remains the same, before or after these transactions. consider the example in illustration 20.3. ILLUSTRATION 20.3 The Himgir Manufacturing Company Limited currently has 2 crore outstanding shares selling at a market price of Rs 100 per share. The firm has no borrowing. It has internal funds available to make a capital expenditure (capex) of Rs 30 crores. The capex is expected to yield a positive net present value of Rs 20 crore. The firm also wants to pay a dividend per share of Rs 15. Given the firm’s capex plan and its policy of zero borrowing, the firm will have to





issue new shares to finance payment of dividends to its shareholders. How will the firm’s value be affected (i) if it does not pay any dividend; (ii) if it pays dividend per share Rs 15? The firm’s current value is: 2X100= Rs200 crore. After the capex, the value will increases to:200+20= Rs220 crore. If the firm does not pay dividends, the value per share will be: 220/2 = Rs 110. If the firm pays a dividend of Rs 15 per share, it will entirely utilize its internal funds (15X2=Rs 30 crores), and it will have to raise Rs 30 crore by issuing new shares to undertake capex. The value of a share after paying dividend will be: 110-15= Rs 95. Thus, the existing shareholders get cash of Rs 15 per share in the form of dividends, but incur a capital loss of Rs 15 in the form of reduce share value. They neither gain nor lose. The firm will have to issue: 30 crores/95= 31,57,895 (about 31.6 lakh) share to raise Rs 30 crore. The firm now has 2.316 crore shares at Rs 95 each share. Thus, the value of the firm remains as: 2.316X95 = Rs 220 Crore. The crux of the M-M dividend hypothesis, as explained above, is that shareholders do not necessarily depend on dividends for obtaining cash. In the absence of taxes, flotation costs and difficulties in selling shares, they can bet cash by devising “home-made dividend” without any dilution in their wealth. Therefore, firms paying high dividends (i.e. high-payout firms) need not command higher prices for their shares. A formal explanation of the M-M hypothesis is given in the following pages. M-M’s hypothesis of irrelevance is based on the following assumptions:1

• Perfect capital markets The firm operates in perfect capital markets where investors behave rationally, information is freely available to all and transactions and flotation costs do not exist. Perfect capital markets also imply that no investor is large enough to affect the market price of a share.

• No taxes Taxes do not exist,: or there are no differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains.

• Investment policy given The firm has a fixed investment policy. • No risk Risk of uncertainty foes not exist. That is, investors are able to

forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r=k=kt for all t.

Under the M-M assumptions, r will be equal to the discount rate, k and

identical for all shares. As a result, the price of each share must adjust so that the rate of return, which is composed of the rate of dividends and capital gains,





on every share will be equal to the discount rate and be identical for all shares. Thus, the rate of return for a share held for one year may be calculated as follows:

Dividends + Capital gains (or loss) r = Share price (13) DIV1 + (P1 –Po) r = Po

Where P0 is the market or purchase price per share at time 0, P1 is the market price per share at time 1 and DIV1 is dividend per share at time 1. As hypothesized by M-M, r should be equal for all shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase the high return yielding share. This process will tend to reduce the price of the low-return shares and increase the prices of the high-return shares. This switching or arbitrage will continue until the differentials in rates of return are eliminated. The discount rate will also be equal for all firms under the M-M assumptions since there are no risk differences. From M-M’s fundamental principle of valuation described by Equation (13), we can derive their valuation model model as follows:

DIV1 + (P1 –Po) r = Po

DIV1+P1 DIV1+P1 Po = = (1+r) (1+k) (14) Since r=K in the assumed world of certainty and perfect markets. Multiplying both sides of equation (14) by the number of shares outstanding. n, we obtain the total value of the firm if no new financing exists: nDIV1+P1) V = nPo = (1+k) (15)





If the firm sells m number of new share at time 1 at a price of P1, the value of the firm at time 0 will be: n(DIV1+ P1) + mPl - mPl nPo = (1+k) (16) M-M’ s valuation Equation (16) allows for the issue of new shares, unlike Walter’s and Gordon’s models. Consequently, a firm can pay dividends and raise funds to undertake the optimum investment policy (as explained in figure 20.1). Thus, dividend and investment policies are not confounded in the M-M model, like Walter’s and Gordon’s models. As such, M-M’s model yields more general conclusions. The investment programmes of a firm, in a given period of time, can be financed either by retained earnings or the issue of new shares or both thus, the amount of new shares issued will be: mP1=I1-(X1-nDIV1)=I1-X1+nDIV1 (17)

where I1 represents the total amount of investment during first period and

X1 is the total net profit of the firm during first period. By substituting Equation (17) into Equation (16), M-M showed that the value of the firm is unaffected by its dividend policy, thus, nDIV1 + Pl) + mPl - mPl nPo = (1+k) nDIVl + (n+m) Pl – (Il – Xl + nDIVl)

= (1+k) (n+m) Pl – Il + Xl = (1+k) (18) A firm which pays dividends will have to raise funds externally to finance it investment plans. M-M’s argument, that dividend policy does not affect the wealth of the shareholders, implies that when the firm pays dividends, its advantage is offset by external financing. This means that the terminal value of





the share (say, price of the share at first period if the holding period is one year) declines when dividends are paid. Thus, the wealth of the shareholders dividends plus terminal price-remains unchanged. As a result, the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends. Thus, the shareholders are indifferent between payment of dividends and retention of earnings. ILLUSTRATION 20.4 The Vikas Engineering Ltd. Co., currently has 1,00,000 outstanding shares selling at Rs 100 each. The firm has net profits of Rs 10,00,000 and wants to make new investments of Rs 20,00,000 during the period the firm is also thinking of declaring a dividend of Rs 5 per share at the end of the current fiscal year. The firm’s opportunity cost of capital is 10 per cent. What will be the price of the share at the end of the year if (i) a dividend is not declared, (ii) a dividend is declared, (iii) How many new shares must be issued? The price of the share at the end of the current fiscal year is determined as follows: DIVl + Pl Po = (1+k) The value of P when dividend is not paid is: Pl = Rs100(1.10)-0=Rs110 When dividend is paid it is: Pl = Rs 100(1.10)-Rs 5 = Rs 105 In can be observed that whether dividend is paid or not the wealth of shareholders remains the same. When the dividend is not paid the shareholder will get Rs 110 by way of the price per share at the end of the current fiscal year. On the other hand, when dividend is paid, the shareholder will realise Rs 105 by way of the price per share at the end of the current fiscal year plus Rs as dividend. The number of new shares to be issued by the company to finance its investments is determined as follows: mPl = I – (X-nDIVl) 105m = 20,00,000 – (10,00,000-5,00,000) 105m = 15,00,000 m = 15,00,000/ 105= 14,285 shares





RELEVANCE, OF DIVIDEND POLICY:MARKET IMPERFECTIONS

M-M hypothesis of dividend irrelevance is based on simplifying assumptions as discussed in the preceding section. Under these assumptions, the conclusion derived by them is logically consistent and intuitively appealing. But the assumptions underlying M-M’s hypothesis may not always be found valid in practice. For example. We may not find capital markets to be perfect in reality; there may exist issue costs; dividends may be taxed differently than capital gains; investors may encounter difficulties in selling their shares. Because of the unrealistic nature of the assumptions, M-M’s hypothesis is alleged to lack practical relevance. This suggests that internal financing and external financing are not equivalent. Dividend policy of the firm may affect the perception of shareholders and, therefore, they may not remain indifferent between dividends and capital gains. The following are the situations where the M-M hypothesis may go wrong. Tax Differential: Low Payout Clientele M-M’s assumption that taxes do not exist is far from reality. Investors have to pay taxes on dividends and capital gains. But different tax rates are applicable to dividends and capital gains. Dividends are generally treated as the ordinary income, while capital gains are specially treated for tax

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