Financial Management` 1 Question : What do you mean by financial management ? Answer : Meaning of Financial Management : Financial management deals with procurement of funds and their effective utilisation in the business.. The primary task of a Chartered Accountant is to deal with funds, 'Management of Funds' is an important aspect of financial management in a business undertaking or any other institution like hospital, art society, and so on. The term 'Financial Management' has been defined differently by different authofrs. According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital funds." Phillippatus has given a more elaborate definition of the term, as , "Financial Management, is concerned with the managerial decisions that results in the acquisition and financing of short and long term credits for the firm." Thus, it deals with the situations that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives. The most acceptable definition of financial management is that given by S.C.Kuchhal as, "Financial management deals with procurement of funds and their effective utilisation in the business." Thus, there are 2 basic aspects of financial management : 1) Procurement of funds : As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager must consider while procuring funds. The funds should be procured at minimum cost, at a balanced risk and control factors. Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of new equity shares may dilute the control of the existing shareholders. Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes profits. Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer monitoring of 'end use' of resources mobilized through capital markets. Such restrictions are essential for the safety of funds provided by institutions and investors. There are other financial instruments used for raising finance e.g. commercial paper, deep discount bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in lack of flexibility. In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilization is to be undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR's) and Global Depository Receipts (GDR's). The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes : - Identification of sources of finance - Determination of finance mix - Raising of funds - Division of profits between dividends and retention of profits i.e. internal fund generation. 2) Effective use of such funds : The finance manager is also responsible for effective utilisation of funds. He must point out situations where funds are kept idle or are used improperly. All funds are procured at a certain cost Chapter : Introduction
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Financial Management`
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Quest ion : What do you mean by f inancia l management ?
Answer : Meaning of Financial Management :
Financial management deals with procurement of funds and their effective utilisation in the business..
The pr imary task of a Charte red Accountant i s to dea l wi th funds, 'Management o f Funds ' i s
an important aspect o f f inancia l management in a business under taking or any o ther ins t i tut ion l ike
hospi ta l , ar t soc iety, and so on. The term 'F inancia l Management ' has been def ined di fferently by
di fferent authofrs.
According to Solomon "Financial Management is concerned wi th the e ff icient use of an
important economic resource, namely cap ital funds." Phi l l ippa tus has given a more e laborate
def ini t ion of the term, as , "Financial Mana gement, i s concerned wi th the manageria l decis ions that
result s in the acquis i t ion and financing of short and long term credi t s fo r the firm." Thus, i t deals
wi th the si tua tions tha t require select ion of speci fic prob lem of size and gro wth of an enterpr ise. The
analys is o f these decisions i s based on the expected inf lows and out flo ws of funds and the ir e ffect on
manager ia l object ives.
The most accep tab le def ini t ion of f inancia l management i s that given by S.C.Kuchhal
as, "Financial management deals w i th procurement o f funds and the i r effect ive ut i l isat ion in the
business." Thus, there a re 2 basic aspects o f f inancia l management :
1) Procurement of funds : As funds can be obtained from di fferent sources thus, the ir procurement i s a lways c onsidered
as a complex problem by business concerns. These funds procured from d i fferent sources have
di fferent charac ter is t ics in terms of r i sk, cos t and control that a manager must consider whi le
procuring funds. The funds should be procured at minimum cost , a t a balanced r i sk and cont rol
factors.
Funds ra ised by issue of equity shares a re the best fro m r isk po int o f view for the company,
as i t has no repayment l iabi l i ty except on winding up of the company, but from cost point o f view, i t
is most expensive, as dividend expectat ions o f shareholders are higher than prevai l ing interest rates
and dividends are appropriat ion of prof i t s and not al lo wed as expense under the income tax ac t . The
issue of new equity shares may di lute the contro l o f the exis t ing shareholders.
Debentures are compara tively cheaper s ince the interes t i s pa id out o f p rofi ts before tax. But,
they entai l a high degree of r isk s ince they have to be repa id as per the terms of agreement; a lso, the
interes t payment has to be made whether or not the company makes prof i t s .
Funds can a lso be procured from banks and financial inst i tut ions, they provide funds subject
to cer ta in res tr ict ive covenants. These covenants res tr ict f reedom of the borrower to raise loans fro m
other sources. The reform process i s also moving in direct ion of a c loser monitor ing of 'end use ' o f
resources mobil ized through cap ita l markets . Such restr ic t ions are essential for the safety o f funds
provided by ins t i tut ions and investors. There are other f inancia l instruments used for rais ing f inance
e .g . commercial paper , deep discount bonds, etc . The finance manager has to balance the ava ilabil i ty
of funds and the rest r ic t ive provis ions t ied wi th such funds result ing in lack of f lexib il i ty.
In the globali sed co mpet i t ive scenario , i t is no t enough to depend on ava ilable ways of
f inance but resource mobil iza t ion i s to be under taken through innovat ive ways or financial p roducts
that may meet the needs o f investors. Mult iple op tion conver t ib le bonds can be sighted as an
example, funds can be raised indigenously as also fro m abroad. Foreign Direc t Investment (FDI) and
Fore ign Inst i tut iona l Investors (FI I) are two major sources o f f inance from abroad along wi th
Amer ican Depository Receip ts (A DR's) and Global Deposi tory Receipts (GDR's) . The mechanism of
procuring funds i s to be modified in the l ight of requirements o f fore ign investors. Procurement o f
funds inter al ia inc ludes :
- Ident i ficat ion of sources o f finance
- Determinat ion of f inanc e mix
- Raising of funds
- Division of p rofi ts between d ividends and retent ion of p rofi ts i .e . in terna l fund genera tion.
2) Effect ive use of such funds : The f inance manager i s also responsible for e ffect ive ut i l i sa t ion of funds . He must po int out
si tua tions where funds are kep t idle or are used improperly. All funds are p rocured at a cer ta in cost
Chapter : Introduction
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and after entai l ing a cer tain amount o f r i sk. I f the funds are no t ut i l ised in the manner so tha t they
genera te an income higher than cost o f procurement , there i s no meaning in running the business. I t is
an important considerat ion in dividend dec isions also, thus, i t i s cruc ia l to employ funds properly and
prof i tab ly. The funds a re to be employed in the manner so tha t the company can produce a t i t s
optimum level wi thout endangering i t s financia l solvency. Thus, f inancia l implicat ions o f each
decision to invest in fixed asse ts are to be properly ana lysed. For this, the f inance manager must
possess sound knowledge of techniques o f capita l budgeting and mus t keep in view the need of
adequate working capi ta l and ensure that whi le f irms enjoy an op timum leve l o f working cap ita l they
do no t keep too much funds blocked in inventor ies, book debts, cash, etc .
F ixed assets a re to f inanced fro m medium or lon g term funds, and not short term funds, as f ixed
asse ts cannot be so ld in shor t term i .e . wi thin a year , a l so a large amount o f funds would be blocked
in s tock in hand as the company cannot immedia tely sel l i ts finished goods.
Quest ion : Explain the scop e of f inancia l management ?
Answer : Scope of f inancial management : A sound f inancial management is essent ia l in a l l type of f inancia l organisat ions - whether
prof i t or iented or no t , where funds are invo lved and a lso in a central ly p lanned e conomy as also in a
capi tal i st set -up . Firms, as per the commercia l his tory, have not l iquidated because thei r technology
was obso lete or their products had no or lo w demand or due to any o ther factor , but due to lack of
f inancia l management. Even in boom per iod, when a co mpany makes high profi t s , there i s danger o f
l iquidat ion, due to bad f inancia l management. The main cause of l iquidat ion of such companies i s
over - trad ing or over -expanding without an adequate f inancia l base .
Financial management op timises the output f rom the given input o f funds and at tempts to use
the funds in a most productive manner . In a country l ike India, where resources are scarce and
demand on funds are many, the need for proper f inancia l management i s enormous. I f proper
techniques a re used most o f the enterpr ises can reduce the ir capi ta l employed and improve return on
investment. Thus , as men and machine are properly managed, f inances are also to be well managed.
In newly sta r ted companies, i t i s impor tant to hav e sound financial management, as i t ensures
their survival , o ften such companies ignores financia l management a t their own peri l . Even a s imple
act , l ike deposit ing the cheques on the day of the ir receip t i s not per formed. Such organisa t ions pay
heavy inte res t charges on borro wed funds, but a re tardy in real is ing the ir own deb tors. This i s due to
the fac t they lack real isat ion of the concept o f t ime value of money, i t is not appreciated tha t each
va lue of rupee has to be made use o f and that i t has a direct cost o f ut i l i sa t ion. I t must be real i sed
that keeping rupee idle even for a day, resul ts into losses . A non -profi t organisat ion may not be keen
to make profi t , t rad it ionally, but i t does need to cut down i t s cos t and use the funds at i t s disposa l to
their opt imum capaci ty . A sound sense of f inancia l management has to be cul t iva ted among our
bureaucra ts, administrators, engineers, educat ionis ts and public a t large . Unless this i s done, co lossa l
wastage of the capi ta l resources cannot be arrested.
Quest ion : What are the object ives of f inancia l management ?
Answer : Object ives of f inancial management : Eff ic ient f inancia l management requires exis tence of some objectives or goals because
judgment as to whether or not a financial decision i s e f f ic ient i s to be made in l ight o f some
objective . The two main objectives o f financial management are :
1) Profit Maximisat ion : I t is t rad it ional ly being argued, tha t the objec tive o f a company is to earn prof i t , hence the object ive
of f inancia l management i s prof i t maximisat ion. Thus, each a l ternat ive , i s to be seen by the f inance
manager from the view point o f prof i t maximisat ion. But , i t cannot be the only objec tive of a
company, i t i s a t best a l imi ted object ive else a number o f prob lems would ar ise. Some of them are :
a) The term profi t i s vague and does no t c lar i fy what exact ly i t means. I t conveys d i fferent meaning
to di fferent people.
b) Profi t maximisat ion has to be at tempted wi th a real isat ion of r i sks involved . There i s direc t
rela t ion bet ween r isk and profi t ; h igher the r isk, higher i s the prof i t . For maximising profi t , r i sk is
al together ignored, implying tha t f inance manager accep ts highly r isky proposals a lso. Pract ical ly,
r isk i s a very important factor to be balanced wi th profi t objec tive .
c) Profi t maximisat ion is an objec tive not taking into account the t ime pattern o f returns.
E.g. Proposa l X gives re turns higher than that by proposa l Y but , the t ime per iod i s say, 10 years and
7 years respect ively. Thus, the overal l prof i t is onl y considered no t the t ime per iod, nor the f low of
prof i t .
d) Prof i t maximisat ion as an object ive i s too narrow, i t fai l s to take into account the soc ial
considera t ions and obl iga tions to var ious interes ts o f workers , consumers, socie ty, as well as ethica l
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t rade prac tices. Ignor ing these fac tors, a company cannot survive for long. Prof i t maximisa tion at the
cost o f soc ial and moral obliga tions i s a shor t sighted pol icy.
2) Wealth maximisat ion : The companies having profi t maximisa tion as i t s object ive, may adopt po lic ies yielding
exorb itant profi ts in the shor t run which are unheal thy for the growth, survival and overal l interests
of the business. A company may not under take planned and prescr ibed shut -downs of the p lant for
maintenance, and so on for maximis ing profi ts in the shor t run. Thus , the objec tive of a f irm should
be to maximise i t s va lue or weal th.
Accord ing to Van Horne, "Value of a firm is represented by the market pr ice of the
company's common stock. . . . . . . the marke t pr ice of a firm's stock represents the foca l judgment of al l
market par t icipants as to what the value of the par t icular f irm is. I t takes into account present as a lso
prospective future earnings per share, the t iming and r i sk o f these earning, the d ivide nd pol icy of the
f irm and many other fac tors having a bear ing on the market pr ice o f s tock. The market pr ice serves as
a per formance index or report card of the firm's progress . I t ind ica tes how wel l management i s doing
on behal f o f stockholders." Share pr ices in the share market , a t a given point o f t ime, are the resul t o f
a mixture o f many fac tors, as genera l economic outlook, par t icular outlook of the co mpanies under
considera t ion, technica l fac tors and even mass psychology, but , taken on a long term bas is, they
ref lect the value , which var ious par t ies, put on the company.
Normally this va lue i s a funct ion, o f :
- the l ikely rate o f earnings per share o f the company; and
- the capi ta l i sa t ion rate .
The l ikely ra te of earnings per share (EPS) depends upon the assessment as to the profi tably
a company is go ing to operate in the future or what i t i s l ikely to earn aga inst each of i t s ordinary
shares.
The cap ital isat ion ra te re f lec ts the l iking of the investors o f a company. I f a comp any earns a
high rate o f earnings per share through i ts r i sky operat ions or r isky f inancing pa ttern, the investors
wi l l not look upon i t s share wi th favour . To tha t extent , the market va lue of the shares o f such a
company wi l l be lo w. An easy way to de term ine the cap ital i sat ion ra te is to s tar t wi th fixed deposit
in teres t rate o f banks , investor would want a higher re turn i f he invests in shares, as the r i sk
increases . How much higher return is expected, depends on the r i sks involved in the par t icular share
which in turn depends on company po licies, pas t records, type of business and confidence commanded
by the management. Thus, cap ita l i sa t ion ra te i s the cumula tive result o f the assessment o f the var ious
shareholders regard ing the r i sk and o ther quali tat ive fac tors o f a company. I f a co mpany invests i t s
funds in r i sky ventures, the investors wi l l put in thei r money i f they ge t higher re turn as compared to
that f rom a low r i sk share.
The market va lue of a share i s thus, a function of earnings per share and capital i sat ion rate .
Since the profi t maximisat ion cr i ter ia cannot be applied in real wor ld si tua tions because of i ts
technica l l imi tat ion the f inance manager o f a company has to ensure tha t his dec is ions a re such tha t
the market va lue of the shares o f the company is maximum in the long run. This impl ies tha t the
f inancia l policy has to be such tha t i t opt imises the EPS, keeping in view the r i sk and other factors.
Thus, wealth maximisa t ion i s a be tter object ive for a commercial under taking as com pared to return
and r i sk.
There i s a growing emphasis on socia l and other obl igat ions of an enterpr ise. I t cannot be
denied tha t in the case of under takings, especia l ly those in the publ ic sector , the question of weal th
maximisat ion i s to be se en in context o f soc ia l and o ther ob ligat ions o f the enterpr ise .
I t must be unders tood that financial dec is ion making i s re lated to the objec tives of the
business. The finance manager has to ensure tha t there i s a posit ive impact o f each f inanc ia l decision
on the fur therance of the business objec tives . One of the main object ive of an under taking may be to
"progress ive ly bui ld up the capabil i ty to under take the des ign and development o f a ircraft engines,
he licopters, e tc ." A finance manager in su ch cases wi l l a l loca te funds in a way that this object ive i s
achieved a l though such an al loca tion may no t necessar i ly maximise weal th .
Quest ion : What are the funct ions of a Finance Manager ?
Answer : Functions of a Finance Manager : The twin aspects, procurement and effect ive ut i l i sat ion of funds are cruc ial tasks faced by a
f inance manager . The f inancial manager is requi red to look into the f inancial implicat ions o f any
decision in the f irm. Thus al l decisions involve management o f funds under the purview of the
f inance manager . A large number o f dec is ions involve substantial or mater ia l changes in value of
funds procured or employed . The finance manager , has to manage funds in such a way so as to make
their opt imum ut i l isat ion and to ensu re the ir procurement in a way tha t the r isk , cos t and cont rol are
properly balanced under a given s i tuat ion. He may not , be concerned wi th the decis ions , that do no t
affec t the basic financia l management and s truc ture .
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The nature o f job of a n accountant and finance manager i s di ffe rent , an accountant 's job is
pr imar i ly to record the business transactions, prepare financial sta tements sho wing resul t s of the
organisat ion for a given per iod and i t s financia l condi t ion a t a given point o f t ime. H e i s to record
var ious happenings in monetary terms to ensure tha t assets, l iabi l i t ies, incomes and expenses are
properly grouped, c lass i fied and d isclosed in the f inancia l s tatements . Accountant i s not concerned
wi th management o f funds that is a spec ial i sed task and in modern t imes a complex one. The finance
manager or control ler has a task entirely d i fferent from that o f an accountant , he i s to manage funds .
Some of the impor tant decisions as regards f inance are as fo l lo ws :
1) Estimating the requireme nts of funds : A business requires funds for long term purposes i .e .
investment in fixed assets and so on. A careful est imate o f such funds i s required to be made. An
assessment has to be made regard ing requirements o f working cap ita l involving, es t imat io n of amount
of funds blocked in cur rent assets and tha t l ikely to be genera ted for short per iods through current
l iab il i t ies. Forecast ing the requirements o f funds is done by use o f techniques o f budgetary cont rol
and long range planning. Estimates o f requ irements o f funds can be made only i f a l l the physical
act ivi t ies o f the organisat ion are fo recas ted. They can be trans la ted into monetary terms.
2) Decis ion regarding capital structure : Once the requirements o f funds i s es t imated , a decision
regarding var ious sources from where the funds would be ra ised i s to be taken. A proper mix of the
var ious sources i s to be worked out , each source of funds involves di ffe rent i ssues for considerat ion.
The finance manager has to carefully look into the exis t ing c api ta l s tructure and see how the var ious
proposa ls o f ra ising funds wi l l a ffec t i t . He i s to mainta in a proper ba lance between long and shor t
term funds and to ensure that suff ic ient long -te rm funds are raised in order to finance fixed assets
and o ther long-term investments and to provide for permanent needs o f working cap ita l . In the
overal l volume of long -term funds, he i s to ma inta in a proper ba lance between own and loan funds
and to see tha t the overal l cap ita l i sa t ion of the company is such, that the co mpany is ab le to p rocure
funds at minimum cost and is ab le to tolera te shocks of lean per iods . All these decisions are kno wn
as ' f inancing dec is ions ' .
3) Investment dec ision : Funds procured from d i fferent sources have to be invested in var ious kinds
of asse ts. Long term funds are used in a projec t for f ixed and a lso current assets. The investment o f
funds in a project is to be made af ter careful assessment o f var ious projects through capital
budgeting. A par t o f long term funds i s a lso to be kept for f in ancing working capi tal requirements.
Asse t management pol ic ies are to be laid do wn regarding var ious i tems of current asse ts, inventory
policy i s to be de termined by the production and finance manager , while keeping in mind the
requirement o f production an d future pr ice es t imates o f raw mater ials and avai lab il i ty o f funds .
4) Dividend decision : The finance manager is concerned wi th the decis ion to pay or declare
dividend. He i s to assis t the top management in decid ing as to what amount o f dividend should be
paid to the shareholders and what amount be retained by the company, i t involves a large number of
considera t ions. Economica lly speaking, the amount to be retained or be paid to the shareholders
should depend on whether the company or shareholders can make a more profi tab le use o f resources,
a l so considerat ions l ike trend of earnings, the t rend of share market pr ices , requi rement o f funds for
future gro wth, cash f low si tua tion, tax posit ion of share holders, and so on to be kept in mind.
The pr incipal funct ion of a finance manager re lates to decisions regard ing procurement,
investment and dividends.
5) Supply of funds to a l l parts of the organisation or cash management : The finance manager has
to ensure that al l sec t ions i .e . branches , factor ies, unit s or depar tments o f the organisat ion are
suppl ied wi th adequate funds. Sec tions having excess funds contr ibute to the centra l pool for use in
other sect ions that needs funds. An adequate supply of cash at a l l points o f t ime is absolute ly
essentia l for the smooth flo w of business operat ions. Even i f one of the many branches is short of
funds, the whole business may be in danger , thus, cash management and cash d isbursement polic ies
are impor tant wi th a view to supplying adequate funds at a l l t imes and points in an organisa t ion. I t
should ensure that there is no excess ive cash.
6) Evaluating f inancia l performance : Management contro l sys tems are usual ly based on financia l
analys is, e .g. ROI (return on investment) sys tem of d ivisional contro l . A finance manager has to
constant ly review the f inancial per formance of var ious unit s o f the organisat ion. Analys is of the
f inancia l per formance he lps the management for assess ing ho w the funds are ut i l i sed in var ious
divisions and what can be done to imp rove i t .
7) Financial negot iat ions : Finance manager 's major t ime is ut i l i sed in carrying out negotiat ions
wi th financial inst i tut ions, banks and publ ic depositors. He has to furnish a lot o f informat ion to
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these ins t i tut ions and persons in order to ensu re tha t ra ising of funds is wi thin the statutes .
Negot ia t ions for outside f inancing of ten requires spec ia l i sed skil ls .
8) Keeping in touch with stock exchange quotations and behavior of share prices : I t involves
analys is o f major t rends in the s tock mar ket and judging the ir impact on share pr ices o f the
company's shares .
Quest ion : What are the various methods and tools used for f inancia l management ?
Answer : Finance manager uses var ious too ls to discharge his functions as regards financia l
management. In the area o f f inancing there are var ious methods to procure funds from long as also
short term sources. The f inance manager has to decide an op timum cap ital structure tha t can
contr ibute to the maximisat ion of shareholder 's wealth. Financial leverage or t rading on equity is an
important method by which a f inance manager may increase the return to common shareholders.
For eva luat ion of cap ita l proposals, the f inance manager uses capital budgeting techniques
as payback, internal ra te of re turn, ne t present va lue, prof i tab il i ty index, average rate o f return. In
the a rea o f current assets management, he uses methods to check eff icient ut i l isat ion of current
resources a t the enterpr ise 's disposal . An enterpr ise can increase i t s prof i tab il i t y wi thout a ffec t ing i t s
l iquid ity by an efficient management of working cap ital . For ins tance, in the area o f working capital
management, cash management may be central ised or de -central ised; cent ral i sed method i s considered
a bet ter too l o f managing the e nterpr ise 's l iquid resources. In the area o f dividend decis ions , a fi rm is
faced wi th the prob lem of dec larat ion or postponing dec larat ion of d ividend, a problem of interna l
f inancing.
For evaluat ion of an enterpr ise 's per formance, there ar e var ious methods, as rat io ana lys is.
This technique i s used by a l l concerned persons. Different rat ios serving di fferent object ives. An
investor uses var ious rat ios to eva lua te the prof i tabi l i ty o f investment in a par t icular company. They
enable the inve stor , to judge the prof i tab il i ty, solvency, l iquid ity and growth aspec ts o f the firm. A
short - term credi tor i s more inte rested in the l iquid ity aspect o f the firm, and i t i s poss ible by a study
of l iquid ity rat ios - current rat io , quick ra t ios , e tc . The ma in concern of a f inance manager is to
provide adequate funds from best poss ible source, at the r ight t ime and a t minimum cost and to
ensure tha t the funds so acquired are put to best possib le use . Funds f low and cash f low s ta tements
and projected financia l statements help a lo t in this regard.
Quest ion : Discuss the role of a f inance manager ?
Answer : In the modern enterpr ise , a finance manager occupies a key posit ion, he be ing one of the
dynamic member o f corporate manager ial team. His role , i s becom ing more and more pervasive and
signi ficant in so lving complex managerial problems. Tradi t ional ly, the role o f a f inance manager was
confined to rais ing funds from a number o f sources, but due to recent develop ments in the socio -
economic and po li t ical scenario throughout the wor ld, he i s placed in a cent ral posi t ion in the
organisat ion. He i s responsib le fo r shaping the for tunes o f the enterpr ise and i s invo lved in the most
vi ta l decision of a l loca tion of cap ital l ike mergers, acquisi t ions, e tc . A finance m anager , as other
members o f the corpora te team cannot be averse to the fas t developments, around him and has to take
note o f the changes in o rder to take re levant steps in view of the dynamic changes in c ircumstances .
E.g. in troduction of Euro - as a single currency of Europe is an interna tional leve l change, having
impact on the corporate f inancia l plans and pol icies world -wide.
Domest ic developments as emergence of f inancia l services sec tors and SEBI as a watch dog
for investor pro tection an d regula t ing body of capita l markets i s contr ibuting to the importance of the
f inance manager 's job. Banks and f inancia l ins t i tut ions were the major sources o f f inance, monopoly
was the s tate o f a ffa ir s of Indian business, shareholders sat is fact ion was no t the pro moter 's concern
as most o f the co mpanies, were close ly held . Due to the opening of economy, compet i t ion increased ,
se l ler 's market i s being conver ted into buyer 's market . Development of interne t has brought new
chal lenges before the managers. India n concerns no longer have to compete only nat ional ly, i t i s
facing internat ional competi t ion. Thus a new era i s ushered during the recent years, in financia l
management, special ly, wi th the develop ment o f f inancia l too ls, techniques, ins truments and
produc ts. Also due to increasing emphasis on public sec tor under takings to be sel f -suppor t ing and
their dependence on capital market for fund requirements and the increas ing signi f icance of
l iberal isat ion, global i sat ion and deregulat ion.
Quest ion : Draw a typi cal organisat ion chart highl ighting the f inance funct ion of a co mpany ?
Answer : The f inance function i s the same in al l enterpr ises , de ta i l s may di ffer , but major features
are universa l in na ture. The f inance funct ion occupies a s igni f icant posi t ion in a n organisat ion and i s
not the responsibi l i ty o f a sole execut ive. The impor tant aspects o f finance manager a re to carr ied on
by top management i .e . managing d irec tor , chairman, board of directors. The board of directors takes
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decisions involving financia l considerat ions, the f inancia l control ler i s bas ica l ly meant for ass is t ing
the top management and has an important role of contr ibut ing to good decis ion making on i ssues
involving al l funct ional areas of business. He i s to br ing out f inancia l implica t ions o f al l dec is ions
and make them understood. He may be ca lled as the financial cont rol ler , v ice -president ( finance) ,
chief accountant , t reasurer , or by any other des ignation, but has the pr imary responsibi l i ty o f
per forming f inance functions. He i s to dischar ge the responsib il i ty keeping in view the overal l
out look of the o rganisa t ion.
BOARD OF DIRECTORS
PRESIDENT
V.P.(Product ion) V.P.(Finance) V.P.(Sales)
Treasurer Control ler
Cred it
Mgmt.
Cash
Mgmt.
Banking
rela t ions
Portfo l io
Mgmt.
Corpora te
General &
Cost
Accounting
Taxes Interna l
Audi t
Budgeting
Organisation chart o f f inance function The Chief f inance executive works direct ly under the President o r Managing Director o f the company.
Besides routine work, he keeps the Board informed about al l phases o f business ac t ivi ty, inc lus ive of
economic, social and po li t ical developments a ffect ing the business behaviour and fro m t ime to t ime
furnishes informat ion about the financial s tatus o f the co mpany . His functions are : ( i ) Treasury
functions and ( i i) Control functions.
Relat ionship Between f inancial management and other areas of management : There i s close
rela t ionship be tween the areas o f financial and other management l ike product ion, sa les, mar keting,
personnel , e tc . Al l act ivi t ies direc t ly or indi rec tly involve acquis i t ion and use o f funds.
Determinat ion of production, p rocurement and market ing stra tegies are the impor tant prerogat ives o f
the respect ive depar tment heads, but for implement ing, the ir dec isions funds a re required . Like,
replacement o f fixed assets for improving production capaci ty requi res funds. Simi lar ly, the purchase
and sales promotion pol icies are laid down by the purchase and market ing d ivis ions respect ive ly, but
again procurement o f raw mater ials , adver t i sing and o ther sa les promotion require funds. Same is
for , recruitment and promotion of s ta ff by the personnel department would requi re funds for payment
of sa lar ies, wages and other benefi ts . I t may, many t imes, be d i fficu lt to demarca te where one
function ends and other star t s . Although, finance funct ion has a signi f icant impact on the other
functions, i t need no t l imi t or obstruc t the general functions o f the business. A firm fac ing f inancia l
di fficult ies, may give weight age to f inancia l considera t ions and devise i ts own product ion and
market ing strategies to suit the s i tua tion. Whi le a f irm having surplus f inance, would have
compara tively lower r igidity as regards the f inancia l considerat ions vis -a -vis other functions of the
management.
Pervasive Nature of Finance Funct ion : Finance i s the l i fe blood of of an organisat ion, i t i s the
common thread b inding al l o rganisa t ional funct ions. This inter face can be explained as be low :
* Production - Finance : Production function requires a large investment. Productive use o f
resources ensures a cos t advantage for the f irm. Opt imum investment in inventor ies improves p rof i t
margins. Many parameters o f product ion have an impact on cost and can poss ibly be cont rolled
through interna l management, thus enhancing prof i t s . Important production decisions l ike make or
buy can be taken only a f ter the f inancia l implica t ions are considered.
* Market ing - F inance : Various aspects o f market ing management have f inancia l implica t ions,
decisions to hold inventor ies on large scale to provide off the shel f service to customers increases
inventory ho lding cost and a t the same t ime may increase sales, simi lar wi th extension of credit
faci l i ty to customers. Market ing s tra tegies to increase sale in m ost cases, have add it iona l costs that
are to be weighted careful ly agains t incrementa l revenue before taking decision.
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* Personnel - Finance : In the globali sed competi t ive scenario , business organisa t ions are moving to
a f la t ter organisa t ional structure . Investments in human resource developments are also increasing.
Restructur ing of remunerat ion structure, vo luntary ret irement schemes, sweat equi ty, e tc . have
become major financial decisions in the human resource management.
Quest ion : What is the rele vance of t ime va lue of money in f inancia l dec ision making ?
Answer : A finance manager is required to make dec isions on investment, f inancing and d ividend in
view of the company's objectives. The dec is ions as purchase of asse ts or p rocurement o f funds i .e .
the investment/ f inancing decisions a ffect the cash f low in di fferent t ime per iods. Cash out f lows
would be at one point o f t ime and inf low a t some o ther point of t ime, hence, they are not comparable
due to the change in rupee va lue of money. They can b e made comparable by introducing the interest
factor . In the theory of f inance, the interest factor is one of the c rucial and exclus ive concept , kno wn
as the t ime va lue of money.
Time va lue of money means that worth of a rupee received today i s d i fferent from the same
rece ived in future. The preference for money now as compared to future i s known as t ime preference
of money. The concept i s app licable to both individuals and business houses.
Reasons of t ime preference of money :
1) Risk : There is uncer ta inty about the receip t o f money in future.
2) Preference for present consumption : Most o f the persons and companies have a preference for present consumption may be due to urgency
of need.
3) Investment opportunit ies : Most of the persons and companies have preference for present money because of avai lab il i t ies of
opportuni t ies o f investment for earning add it ional cash flo ws.
Importance of t ime va lue of money : The concept o f t ime va lue of money helps in ar r iving at the co mparab le valu e of the di fferent rupee
amount a r i sing at d i fferent points o f t ime into equivalent values o f a par t icular po int o f t ime, p resent
or future. The cash f lows ar i s ing at di fferent points o f t ime can be made comparab le by us ing any one
of the fo l lo wing :
- by compounding the present money to a future date i .e . by find ing out the value of present money.
- by discounting the future money to present da te i .e . by f inding out the present va lue(PV) of future
money.
Notes on:- Finance Function
The finance function is most important for all business enterprises. It remains a focus of all activities. It starts with the
setting up of an enterprise. It is concerned with raising of funds, deciding the cheapest source of finance, utilization of
funds raised, making provision for refund when money is not required in the business, deciding the most profitable
investment, managing the funds raised and paying returns to the providers of funds in proportion to the risks undertaken
by them. Therefore, it aims at acquiring sufficient funds, utilizing them properly, increasing the profitability of the
organization and maximizing the value of the organization and ultimately the shareholder‟s wealth.
Notes on:- Inter-relationship between Investment, Financing and Dividend Decisions
The finance functions are divided into three major decisions, viz., investment, financing and dividend decisions.
It is correct to say that these decisions are inter-related because the underlying objective of these three decisions is the
same, i.e. maximisation of shareholders‟ wealth. Since investment, financing and dividend decisions are all interrelated,
one has to consider the joint impact of these decisions on the market price of the company‟s shares and these decisions
should also be solved jointly. The decision to invest in a new project needs the finance for the investment. The financing
decision, in turn, is influenced by and influences dividend decision because retained earnings used in internal financing
deprive shareholders of their dividends. An efficient financial management can ensure optimal joint decisions. This is
possible by evaluating each decision in relation to its effect on the shareholders‟ wealth.
The above three decisions are briefly examined below in the light of their inter -relationship and to see how they
can help in maximising the shareholders‟ wealth i.e. market price of the company‟s shares.
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Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be accepted
which is expected to yield at least so much return as is adequate to meet its cost of financing. This have an influence on
the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the total volume of
long-term funds, he has to ensure a proper mix of loan funds and owner‟s funds. The optimum financing mix will
increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of
dividends and what portion should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders‟ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to
be taken jointly keeping in view their joint effect on the shareholders‟ wealth.
INTRODUCTION
Decisions relating to working capital and short term financing are referred to as Working Capital Management. These involve
managing the relationship between a firm.s short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both
maturing short-term debt and upcoming operational expenses.
MEANING AND CONCEPT OF WORKING CAPITAL
There are two concepts of working capital - gross and net. Gross working capital refers to the firm.s investment in current
assets. Current assets are those assets which can be converted into cash within an accounting year. Net working capital refers
to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are
expected to mature for payment within an accounting year.
Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash
(i) Rs. 100 per debentures redeemable at par 20 year maturity, 8% coupon rate, 4% flotation costs, sale price Rs. 100.
(ii) Rs. 100 per Preference share redeemable at par; 15 – year maturity. 10% dividend rate, 5% flotation costs, sale price Rs. 100.
(iii) Equity shares: Rs. 2 per share flotation costs, sale price Rs. 22.
(iv) In addition, the dividend expected on the equity share at the end of the year Rs. 2 per share; the anticipated growth rate in
dividends is 5% and the company has the practice of paying all its earning in the form of dividends. The corporate tax rate is 50%.
Que. 33: - The capital structure of Swan & Co. comprising of 12% debentures, 9% preference shares and equity shares of Rs. 100 each is in
the proportion of 3: 2: 5.
The company is contemplating to introduce further capital to meet the expansion needs by seeking 14% term loan from financial
institutions. As a result of this proposal, the proportions of debentures, preference shares and equity would get reduced by 1/10,
1/15, and 1/6 respectively.
In the light of above proposal, calculate the impact on weighted average cost of capital assuming 50% tax rate, expected dividend
of Rs. 9 per share at the end of the year current market price of equity shares of Rs. 110 and growth rate of dividends 5%. No
change in dividend, dividend growth rate and market price of share is expected after availing the proposed term loan.
Que. 34: - P Ltd. presently pays a dividend of Re. 1.00 per share and has a share price of Rs. 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm‟s expected or required return
on equity using a dividend – discount model approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5
years and 10% per year thereafter. Now what is the firm‟s expected, or required, return on equity?
Que. 35: -(a) Three companies A, B & C are in the same type of business and hence have similar operating risks. However, the capital
structure of each of them is different and the following are the details:
A B C
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Equity Share Capital Rs. 4,00,000 2,50,000 5,00,000
(Face value Rs. 10 per share)
Market value per share Rs. 15 20 12
Dividend per share Rs. 2.70 4 2.88
Debentures Rs Nil 1,00,000 2,50,000
(Face value per debenture Rs. 100)
Market value per debenture . ----- 125 80
Interest rate ----- 10% 8%
Assume that the current levels of dividends are generally expected to continue indefinitely and the income – tax rate at
50%. You are required to compute the weighted average cost of capital of each company.
(b) ZED Limited is presently financed entirely by equity shares. The current market value is Rs. 6,00,000. A dividend
Rs. 1,20,000 has just been paid. This level of dividends is expected to be paid indefinitely. The company is thinking of investing in
a new project involving a outlay of Rs. 5,00,000 now and is expected to generate net cash receipts of Rs. 1,05,000 per annum
indefinitely. The project would be financed by issuing Rs. 5,00,000 debentures at the market interest rate of 18%. Ignoring tax
consideration:
a. Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.6%.
b. Prove that weighted average cost of capital is not affected by gearing.
Que. 36: - John inherited the following securities on his uncle‟s death:
Nos. Annual Maturity
Types of Security Coupon % Years % Yield
Bond A (Rs. 1,000) 10 9 3 12
Bond B (Rs. 1,000) 10 10 5 12
Preference shares C (Rs. 100) 100 11 --- 13
Preference shares D (Rs. 100) 100 12 --- 13
The yield to preference shares is higher than coupon rate because they are likely to be recalled at a premium. Compute the current
value of John‟s portfolio of investments.
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Important Questions
Que 1 :- X Ltd. Provides you the following information:
1. Funds required : Rs. 10,00,000
2. Financial Plans :
Financial Plan I : 50% Equity Shares of Rs. 10 each, Current Market Price Rs. 20, 50%,
10% Debentures of Rs. 100 each.
Financial Plan II : 40% Equity Shares of Rs. 10 each, Premium in Market 100%, 40%,
10% Debentures of Rs. 100 each, 20%, 15% Preference Shares of Rs. 100 each.
3. Tax Rate : 40%
4. Annual Transfer to : 20% of the Face Value of Debentures.
Debenture Redemption Reserve
Required: Calculate the Indifference Point under uncommitted EPS Approach.
Que 2:- Prepare the Income Statement and Balance-Sheet from the following data:
Price Earning ratio
Market Price per equity share
No. of Equity shares of Rs. 10 each
No. of 12% Pref. Shares of Rs. 100 each
Degree of Financial Leverage
Degree of Operating Leverage
Income-Tax rate
Variable Cost as % of Sales Revenue
Rate of Interest on debt
3 times
Rs. 18
10,000
1,000
2-1
2-1
40%
60%
10%
Practical Questions:- Que. 1: - A firm requires total capital funds of Rs. 25 lacs and has two options; All equity; and half equity and half 15% debt. The equity
shares can be currently issued at Rs. 100 per share. The expected EBIT of the company is Rs. 2,50,000 with tax rate at 40%. Find
out the EPS under both the financial mix.
Que. 2: - The balance sheet of Delta Corporation shows a capital structure as follows:
Rs.
Current liabilities 0
Bonds (6% interest) 1,00,000
Common stock 9,00,000
Total Claims Rs. 1,000,000
Its rate of return before interest and taxes on its assets of Rs. 1 million is 20%. The value of each share (whether market or book
value) is Rs. 30. The firm is in the 50% tax bracket. Calculate its earnings per share.
Que. 3: - Paramount Produces Ltd. wants to raise Rs. 100 lakhs for a diversification project. Current estimate of earnings before interest and
taxes (EBIT) from the new projects is Rs. 22 lakhs per annum. Cost of debt will be 15% for amounts up to and including Rs. 40
lakhs, 16% for additional amounts up to and including Rs. 50 lakhs and 18% for additional amounts above Rs. 50 lakhs. The
equity (face value Rs. 10) of the company have a current market value of Rs. 40. This is expected to fall to Rs. 32 if debts
exceeding Rs. 50 lakhs are raised.
The following options are under consideration of the company.
Option Equity Debt
I 50% 50%
II 60% 40%
III 40% 60%
Determine the earning per share (E.P.S.) for each option and state which option the company should exercise. Tax rate applicable
to the company is 50%.
Que. 4: - A Ltd. has agreed to buy the net assets of B Ltd. for Rs. 18,00,000. In order to finance the purchase the directing of A Ltd. are
considering the following proposals:
(i) To issue Rs. 18,00,000 5% 20 years sinking fund debentures.
(ii) To issue Rs. 18,00,000 5 ½% cumulative preference shares.
(iii) To issue 60,000 equity shares at a premium of Rs. 10
Chapter : EBIT-EBT Analysis
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Summarised balance sheets as on 31st December, 1990 and profits and loss accounts for the year ended for each company are as
follows:
Balance sheet as on 31st December, 1990
Liabilities A Ltd. B Ltd.
(Rs.) (Rs.)
Equity shares issued:
25,000 shares fully paid 5,00,000 -----
50,000 shares fully paid ------- 2,00,000
Profit and loss account
Balance and general reserve 19,00,000 2,00,000
5% debentures 10,00,000 ----
Current liabilities 16,00,000 4,00,000
50,00,000 8,00,000
Assets A Ltd. B Ltd.
(Rs.) (Rs.)
Fixed assets 20,00,000 4,00,000
Current assets 30,00,000 4,00,000
50,00,000 8,00,000
Profit and loss accounts for the year ended 31st December, 1990
A Ltd. B Ltd.
(Rs.) (Rs.)
Sales 28,00,000 60,00,000
Profit before the items given below 15,10,000 2,80,000
Depreciation 2,60,000 50,000
Interest to debentures 50,000 --
Income –tax 6,00,000 1,15,000
9,16,000 1,65,000
Net Profit 6,00,000 1,15,000
Dividends 1,25,000 50,000
Balance transferred to P & L appropriation a/c 4,75,000 65,000
You are required to:
(a) calculate the consolidated net profit per equity share outstanding which would result under each of the above three proposals
assuming the profits before debenture interest and income tax of the combined operation will remain constant;
(b) calculate the additional net annual cash outlay during the next year under each of the above three proposals assuming the rate
of dividend on equity shares will be same as in 1990; and
(c) discuss the advantages and disadvantages of each of the above three proposals.
Que. 5: - A Company‟s capital structure consists of the following: Rs. (in lakhs)
Equity Shares of Rs. 100 each 20
Retained earnings 10
9% Preference shares 12
7% Debentures shares 8
Total 50
The company‟s earnings before interest and tax (EBIT) is at the rate of 12% on its capital employed which is likely to remain
unchanged after expansion. The expansion involves additional finances of Rs. 25 lakhs for which following alternatives are
available to it:
(i) Issue of 20,000 equity shares at a premium of Rs. 25 per share.
(ii) Issue of 10% preference shares.
(iii) Issue of 8% debentures.
It is estimated that P/E ratio in the case of equity shares. Preference shares and debentures financing would be 21.4, 17 and 15.7
respectively. Which of these alternatives of financing would you recommend and why? The income tax rate is 50%.
Que. 6: - A company needs Rs. 12,00,000 for the installation of a new factory which would yield an annual EBIT of Rs. 2,00,000. The
company has the objective of maximizing the earnings per share. It is considering the possibility of issuing equity shares plus
raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to
drop to Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000. Cost of borrowings are indicated as under:
Upto Rs. 2,50,000 ------ 10% p.a.
Between Rs. 2,50,001 and Rs. 6,25,000 ------- 14% p.a.
Between Rs. 6,25,001 and Rs. 10,00,000 ------- 16% p.a.
Assuming the tax rate to be 50%, Work out the EPS.
Que. 7: - A company earns a profit of Rs. 3,00,000 p.a. after meeting its interest liability of Rs. 1,20,000 on 12% debentures. The tax rate is
50%. The number of Equity shares of Rs. 10 each are 80,000 and the retained earnings amount to Rs. 12,00,000. The company
proposes to take up an expansion scheme for which a sum of Rs. 4,00,000 is required. It is anticipated that after expansion, the
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company will be able to achieve the same return on investment as at present. The funds required for expansion can be raised either
through debt at the rate of 12% or by issuing Equity shares at par.
Required:
(i) Compute the Earning per share (EPS), if:
- the additional funds were raised as debt
- the additional funds were raised by issue of equity shares
(ii) Advise the company as to which source of finance is preferable.
Que. 8: - The following figures of Krish Ltd. are presented to you: (Rs.)
Earnings before interest and tax
Less: Debentures interest @ 8% 80,000
Long term loan interest @ 11% 2,20,000
Less: Income Tax
Earnings after tax
23,00,000
3,00,000
20,00,000
10,00,000
10,00,000
No. of equity shares of Rs. 10 each 5,00,000
E.P.S. Rs. 2
Market price of share Rs. 20
P/E Ratio 10
The company has undistributed reserves and surplus of Rs. 20 lakhs. It is in need of Rs. 30 lakhs to payoff debentures
and modernize its plants. It seeks your advice on the following alternative modes of raising finance.
Alternative 1 –Raising entire amount as term loan from banks @ 12%
Alternative 2 –Raising part of the funds by issue of 1,00,000 shares of Rs. 20 each and the rest by term loan at 12%.
The company expects to improve its rate of return by 2% as a result of modernization, but P/E ratio is likely to go, down
to 8 if the entire amount is raised as term loan.
(i) Advice the company on the financial plan to be selected.
(ii) If it is assumed that there will be no change in the P/E ratio if either of the two alternatives are adopted, would
your advice still hold good?
Que. 9: - Bhaskar Manufactures Ltd. has equity share capital of Rs. 5,00,000 (face value Rs. 100). To meet the expenditure of an expansion
programme, the company wishes to raise Rs. 3,00,000 and is having following four alternative sources to raise the funds:
Plan A: To have full money from the equity shares.
Plan B: To have Rs. 1 lakh from equity and Rs. 2 lakhs from borrowing from the financial institutions @ 10% per annum.
Plan C: Full money from borrowing @ 10% per annum
Plan D: Rs. 1 lakh in equity and Rs. 2 lakhs from preference shares @ 8% per annum dividend.
The company is having present earnings of Rs. 1,50,000. The corporate tax is 50%. Suggest a suitable plan of the above
four plans to raise the required funds.
Que. 10: -American Express Ltd. is setting up a project with a capital outlay of Rs. 60,00,000. It has the following two alternatives in
financing the project cost.
Alternatives : 100% Equity finance
Alternative : Debt –Equity ratio 2: 1
The rate of interest payable on the debt is 18% p.a. the corporate rate of tax is 40%. Calculate the indifference point between two
alternative methods of financing.
Que. 11: -PCB Corporation has plans for expansion which calls for 50% increase in assets. The alternatives before the corporation are issued
of equity shares or debt at 14%. Its balance sheet and profit and loss accounts are as given below:
Balance sheet as at 31st December, 1989
Liabilities Rs. in lakhs Assets Rs. in lakhs
12% debentures 25 Total assets 200
Ordinary shares
10 lakh shares of
Rs. 10 each 100
General reserve 75 -----
200 200
Profit and Loss Account for the year ending 31st March, 2001 (Rs. in lakhs)
Sales 750
Total cost excluding interest 675
EBIT 75
Interest on Debentures 3
EBT 72
Taxes 36
EAT 36
Earnings per share = Rs. 36,00,000 = Rs. 3.60
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10,00,000
PIE ratio = 5 times
Market price = Rs. 18 If the Corporation finances the expansion with debt, the incremental financing charges will be at 14% and P/E ratio is expected to
be at 4 times. If the expansion is through equity, the P/E ratio will remain at 5 times. The company expects that its new issues will
be subscribed to at a premium of 25%. The company expects that its new will be subscribed to at a premium of 25%. With the
above information determine the following:
(i) IF EBIT is 10% of sales, calculate EPS at sales levels of Rs. 4 crores, Rs. 8 crores and Rs. 10 crores.
(ii) After expansion determine at what level of EBIT, EPS would remain the same, whether new funds are raised
by equity or debt.
(iii) Using P/E ratios, calculate the market value per share at each sales level for both debt and equity financing.
Que. 12: - ABC Corporation plans to expand assets by 50%; to finance the expansion, it is choosing between a straight 12% debt issue and
equity shares. Its balance sheet and profit and loss account are shown below:
ABC CORPORATION
Balance Sheet as on 31st December, 1996
Liabilities Rs. Assets Rs.
11% Debentures 40,00,000 Total assets 2,00,00,000
Equity share capital
(10,00,000 shares of Rs.
10 each) 1,00,00,000
Retained earnings 60,00,000
2,00,00,000 2,00,00,000
ABC CORPORATION
Profit & Loss Account for the year ended 31st December, 1996
Rs.
Sales 6,00,00,000
Total costs (excluding interest) 5,40,00,000
Net income before interest and taxes (EBIT) 60,00,000
Interest on debentures @ 11% 4,40,000
Income before taxes 55,60,000
Taxes @ 50% 27,80,000
Profit after tax 27,80,000
Earnings per share Rs. 27,80,000/10,00,000 2.78
Price/earnings ratio 7.5 times
Market price (7.5 x Rs. 2.78) Rs. 20.85
If ABC Corporation finance Rs. 1 crore expansion with debt, the rate of the incremental debt will be 12% and the price/earnings
ratio of the equity shares will be 5 times. If the expansion is financed by equity, the new shares can be sold at Rs. 12 per share and
the price/earnings ratio will remain at 7.5 times.
(d) Assuming that net income before interest and taxes (EBIT) is 10% of sales, calculate earnings per share at sales level of Rs. 4
crores and Rs. 10 crores when financing is with (i) equity shares and (ii) debt.
(e) At what level of earnings before interest and taxes (EBIT), after the new capital is acquired, would earnings per share (EPS)
be the same when new funds are raised by issuing equity shares of raising debt?
(f) Using the P/E ratio, calculate the market value per share for each sales level for the debt and the equity financing.
Que. 13: - ABC Co. has a total capital of Rs. 2,50,000, and it normally earns Rs. 50,000 (before interest and taxes). The financial manager of
the firm wants to take a decision regarding the capital structure. After a study of the capital market, he gathers the following data:
Amount of Debt Interest Rate Equity Capitalization Rate
Rs. % (at given level of debt) %
0 --- 10.00
50,000 8.0 10.50
1,00,000 8.0 11.00
1,50,000 9.0 11.60
2,00,000 9.5 12.30
You are required (i) to determine the weighted average cost of capital and optimum capital structure by traditional approach, (ii)
Determine equity capitalization rate if Modigliani Miller approach is followed.
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Financial Management
Capital Structure
Practical Questions:-
Que. 1- The following is the B/S as at 31st March, 1998 of S. Co. Ltd. : Share Capital: Rs. Rs.
10,000 equity shares of Rs. 100 each fully paid up 10,00,000
25,000 11% Cum. Preference shares of Rs. 10 each
Fully paid up 2,50,000 12,50,000
Reserve & surplus 25,00,000
Secured Loans 20,00,000
Unsecured loans 12,00,000
Trade creditors 18,00,000
Outstanding expenses 7,50,000
95,00,000
Represented by Fixed assets 55,00,000
Current assets 37,00,000
Advances and deposits 3,00,000 95,00,000
The Co. plans to manufacture a new product in line with its current production, the capital cost of which is estimated to be Rs. 25
lakhs. The company desires to finance the new project to the extent of Rs. 16 lakhs by issue of equity shares at a premium of Rs. 100
per share and the balance to be raised from internal sources. Additional information‟s made available to you are.
(a) Rate of dividends declared in the past five years i.e. year ended 31st March, 1998. 31st March, 1997, 31st March, 1996, 31st
March, 1995 and 31st March, 1994 were 24%, 24%, 20%, 20% and 18% respectively.
(b) Normal earning capacity (net of tax) of the business is 10%
(c) Turnover in the last three years was Rs. 80 lakhs (31st March, 1998), Rs. 60 lakhs (31st March, 1997) and Rs. 50 lakhs (31st
March, 1996).
(d) Anticipated additional sales from the new project Rs. 30 lakhs annually.
(e) Net profit before tax from the existing business which was 10% in the last three years is expected to increase to 12% on
account of new product sales.
(f) Income tax rate es 35%
(g) The trend of market price of the equity share of the company quoted on the Stock Exchange was:
Year High Low
1997-98 Rs. 300 Rs. 190
1996-97 Rs. 250 Rs. 180
1995-96 Rs. 240 Rs. 180
You are required to examine whether the company‟s proposal is justified. Do you have any suggestions to offer in this regard ?
All workings must form part of your answer.
Que. 2- The following figures are made available to you:
Rs. Net profits for the year 18,00,000
Less: Interest on secured debentures at 15% p.a.
(debentures were issued 3 months after the commencement of the year) 1,12,500
16,87,500
Less: Income –tax at 35% and dividend distribution tax 8,43,750
Profit after tax 8,43,750
Number of equity shares (Rs. 10 each) 1,00,000
Market quotation of equity share Rs. 109.70
The company has accumulated revenue reserves of Rs. 12 lakhs. The company is examining a project calling for an
investment obligation of Rs. 10 lakhs: this investment is expected to earn the same rate of return as funds already employed.
You are informed that a debt equity ratio (Debt dividend by debt plus equity) higher than 60% will cause the price earning
ratio to come down by 25% and the interest rate on additional borrowals will cost company 300 basic points more than on their
current borrowal on secured debentures. You are required to advise the company on the probable price of the equity share, if
debentures. You are required to advise the company on the probable price of the equity share, if
(a) the additional investment were to be raised by way of loans; or
(b) the additional investment were to be raised by way of equity.
Que. 3- AB Ltd. provides you with following figures:
Rs.
Profit 3,00,000
Less: Interest on Debentures @ 12% 60,000
2,40,000
Income tax @ 50% 1,20,000
1,20,000
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Number of Equity Shares (Rs. 10 each) 40,000
E.P.S (Earning per share) 3
Ruling price in market 30
P/E ratio (Price/EPS) 10
The company has undistributed reserves of Rs. 6,00,000. The company needs Rs., 2,00,000 for expansion. This amount
will earn at the same rate as funds already employed. You are informed that a debt equity ratio (Debt/Debt + Equity) higher than 35%
will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14%.
You are required to ascertain the probable price of the share: (i) if the additional funds are raised as debt: and (ii) if the
amount is raised by issuing equity shares.
Que. 4- A company’s capital structure consists of the following:
Equity Shares of Rs. 100 each Rs. 20,00,000
Retained earnings Rs. 10,00,000
9% Preference shares Rs. 12,00,000
7% Debentures Rs 8,00,000
Total Rs. 50,00,000
Its capital employed which is likely to remain unchanged after expansion. The expansion involves additional finances of
Rs. 25 lakhs for which following alternatives are available to it:
(i) Issue of 20,000 equity shares at a premium of Rs. 25 per share.
(ii) Issue of 10% preference shares.
(ii) Issue of 8% debentures.
It is estimated that P/E ratio in the case of equity shares, preference shares and debentures financing would be 21.4, 17 and
15.7 respectively. Which of these alternatives of financing would you recommend and why? The income-tax rate is 50%.
Que. 5- The Halda Manufacturing Company Ltd. has to make a choice between debt issue and equity issue for financing its expansion
programme. The existing position of the company is given below:-
Rs. Debt 5% 40,000
Equity share capital (Rs. 10 per share) 1,00,000
Reserves and surplus 60,000
Total capital 2,00,000
Sales 6,00,000
Less: Total cost 5,38,000
Income before interest and taxes 62,000
Less: Interest 2,000
Income before taxes 60,000
Less: Income –tax @ 50% 30,000
Income after taxes 30,000
The expansion programme would require Rs. 1,00,000. If this is financed through debt, the rate of new debt will be 7 per
cent and the price earning ratio will be 6 times. If the expansion programme is financed through equity, new shares can be sold to net
Rs. 25 per share and the price –earning ratio will be 7 times. The expansion will generate additional sales of Rs. 3,00,000, with a
return of 10 per cent on sales before interest and taxes.
If the company is to produce a policy of maximizing the market value of its shares, which form of financing should it
choose? Assume 50% company tax rate.
Que. 6- Diamond Tools Ltd. has developed a financial plan for the next three years based on following estimates:
(Rs. Lakhs)
Year 1 Year 2 Year 3
Sales 600 720 900
Fixed assets 480 570 660
The following assumptions have been made for the purpose of planning:
Gross profit 30%
Return on sales (net of taxes) 10%
Dividend pay-out ratio 50%
Ratios based on year end figures:
Cash and debtors to sales 4 times
Inventory (cost of goods sold) 3 times
Required current ratio 2:1
Required ratio of long-term debt to equity 1:2
At the beginning of Year 1 the firm expects to have equity of Rs. 360 lakhs and long –term debt of Rs. 180 lakhs.
Determine how much additional equity capital the firm will have to raise each year based on above ratios and assumptions.
Assume that the company is not seeking separate finance from bank for additional working capital needs.
Que. 7: - A company has to raise Rs. 2,00,000 to finance an expansion program. It has two options; either to borrow or the issue sufficient
number of ordinary shares at current market price of Rs. 30 per share. Based on date for previous accounting year given below and
additional data provided you are required to evaluate the options.
Data for previous accounting year Rs. lakh
Profit 3.00
Less: 12% Interest on debt 0.60
2.40
Less: 50% Tax 1.20
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1.20
Company‟s present share capital consists of 40,000 ordinary shares of Rs. 10 each. It has undistributed reserves of Rs. 6,00,000.
It is known that debt –equity ratio higher than 40% will pull down P/E ratio to 8 and pre –tax cost of additional borrowings will be
14%.
Que. 8: - A company requires Rs. 25,00,000 for a new plant, which is expected to yield earnings before interest and taxes Rs. 5,00,000. The
company seeks your advice on three financing alternatives under consideration. The company‟s objective is to maximize earnings
per share.
The following particulars regarding the alternatives are available:
Alternative A: Raise Rs. 2,50,000 by debt and the rest by issue of fresh equity
Alternative B: Raise Rs. 10,00,000 by debt and the rest by issue of fresh equity
Alternative C: Raise Rs. 15,00,000 by debt ad the rest by issue of fresh equity
Funds can be borrowed at 10% p.a. upto Rs. 2,50,000, at 15% p.a. beyond Rs. 2,50,000 upto Rs. 10,00,000 and at 20% p.a. beyond
Rs. 10,00,000. The company‟s shares are currently selling at Rs. 150 but are expected to decline to Rs. 125 in case borrowed fund
exceeds Rs. 10,00,000. The tax rate is 50%.
Que. 9: - XYZ Co. has a capital structure of 30% debt and 70% of equity. The company is considering various investment proposals costing
less than Rs. 30 lakhs
The company does not want to disturb its present capital structure. The cost of raising the debt and equity are as follows:
Project Cost Cost of Debt Cost of Equity
Upto Rs. 5 lakhs
Above Rs. 5 lakhs and upto Rs. 20 lakhs
Above Rs. 20 lakhs and upto Rs. 40 lakhs
Above Rs. 40 lakhs and upto Rs. 1 crore
9%
10%
11%
12%
13%
14%
15%
15.5%
Assuming the tax rate is 50%, compute the cost of capital of two projects ABC & XYZ whose fund requirements are Rs. 5 lakhs &
21 lakhs respectively and if a project is expected to yield after tax return of 11%, determine under what conditions it would be
acceptable.
Que. 10: - For varying levels of debt –equity mix, the estimates of the cost of debt and equity capital (after tax) are given below:
Debt as % of total Cost of debt Cost of equity
Capital employed
0 7.0 15.0
10 7.0 15.0
20 7.0 16.0
30 8.0 17.0
40 9.0 18.0
50 10.0 21.0
60 11.0 24.0
You are required to decide on the optimal debt –equity mix for the company by calculating the composite cost of capital.
Que. 11: - XYZ Ltd. intends to set up a project with capital cost of Rs. 50,00,000. It is considering the three alternative proposals of
financing.
Alternative 1 = 100% Equity financing
Alternative 2 = Debt Equity 1: 1
Alternative 3 = Debt Equity 3: 1
The estimated annual net inflow is @ 24% i.e. Rs. 12,00,000 on the project. The rate of interest on debt is 15%. Calculate the
weighted average cost of capital for three different alternatives and analyze the capital structure decision.
Que. 12: - ABC Ltd. with EBIT of Rs. 3,00,000 is evaluating a number of possible capitals below which of the capital structure will you
recommend, and why?
Capital structure Debt (Rs.) Kd % Ke %
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
Que. 13: - X Ltd. and Y Ltd. are identical expect that the former uses debt while the later does no. Thus levered firm has issued 10%
Debentures of Rs. 9,00,000. Both the firms earn EBIT of 20% on total assets of Rs. 15,00,000. Assuming tax rate of 50% and
capitalization rate of 15% for an all equity firm.
(i) Compute the value of the two firms using NI approach.
(ii) Compute the value of the two firms NOI approach.
(iii) Calculate the overall cost of capital, Ko, for both the firms using NOI approach.
Que. 14: -From the following selected data, determine the value of the firms, P and Q belonging homogeneous risk class under (a) the net
income (NI) approach, and (b) The net operating income approach.
Firm P Firm Q
Rs. Rs.
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EBIT 2,75,000 2,25,000
Interest at 15% 75,000
Equity capitalization rate, Ke 20%
Corporate tax rate 50%
Which of the two firms has an optimal capital structure under the (i) NI approach, and (ii) NOI approach?
Que. 15: - Summer Ltd. and Winter Ltd. are identical in all respects including risk factors expect for debt/equity mix. Summer Ltd. having
issued 12% debentures of Rs. 30 lakhs, while Winter Ltd. issued only equity capital. Both the companies earn 24% before interest
and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for
an all –equity company. Compute the value of Summer Ltd. and Winter Ltd. using (i) Net Income approach and (ii) Net operating
income approach.
Que. 16: -Cost of equity of an unlevered business is 20%. The cost of debt funds is 10%. Assume different degree of leverage and that net
operating Income approach holds. Hence, compute cost of levered equity (KLE) for each degree of leverage.
Que. 17: -The following data relate to two Companies X and Y
Company X Company Y
Number of ordinary shares 90,000 1,50,000
Market price per share (Rs.) 1.20 1.00
6% Debentures (Rs.) 60,000 -----
Profit before interest (Rs.) 18,000 18,000
Explain how under Modigliani & Miller approach, an investor holding 10% of shares in Company X will be better off in switching
his holding to Company Y. Also show the way equilibrium is restored.
Que. 18: -A company expects to sell 20,000 units of product X at unit selling price Rs. 50. The variable cost of production per unit is Rs. 30.
The annual fixed cost is Rs. 1,50,000. Alternately, the company may sale 20,000 units of product Y at unit selling price Rs. 50. In
this case, the unit variable production cost and annual fixed cost are Rs. 25 and Rs. 2,50,000 respectively. Tax rate is 40%.
Both of the products require same initial investment Rs. 7,50,000. The following two capital structures are under consideration.
Sources of Funds Plan 1 Plan 2
Rs. lakh Rs. lakh
10% Preference Capital 1.50 2.00
Ordinary Share Capital (Rs. 100) 5.00 2.50
15% loan 1.00 3.00
Total Funds 7.50 7.50
Required:
(a) Operating break –even points for products X and Y
(b) Financial break –even points for products X and Y for both of the capital structures
(c) Overall break –even point for products X and Y for both of the capital structure
(d) EBIT –EPS indifference points for two proposed capital structures.
(e) Draw EBIT –EPS indifference chart
(f) % Change in EBIT for 10% change in sales for products X and Y
(g) % Change in EPS for 10% change in sales for products X and Y for both of the capital structures
(h) Return on equity capital employed for products X and Y for both of the capital structures
(i) Return on long –term capital employed for products X and Y for both of the capital structures
(j) Comment on risk and return of the products
Que. 19: - Tow companies, X and Y belong to the equivalent risk group. The two companies are identical in every respect that company Y is
levered, while X is unlevered. The outstanding amount of debt of the levered company is Rs. 6,00,000 in 10% debenture. The
other information for the two companies is as follows:
X (Rs.) Y (Rs.)
Net operating income (EBIT)
- Interest
Earning to equity holders
Equity capitalization rate ke
Market value of equity
Market value of debt
Total value of firm, V,
Overall capitalization rate ke = EBIT/V
Debt equity ratio
1,50,000
---
1,50,000
0.15
10,00,000
----
10,00,000
15.0%
0
1.50.000
60,000
90,000
0.20
4,50,000
6,00,000
10,50,000
14.3%
1.33%
An investor owns 5% equity shares of company Y. Show the process and the amount by which he could reduce his outlay through
use of the arbitrage process, is there any limit to the process?
Que. 20: - Firm A and B are similar except that A is unlevered, while B has Rs. 2,00,000 of 5 percent debenture outstanding. Assume that
the tax rate is 40 percent; NOI is Rs. 40,000 and the cost of equity is 10%. (i) Calculate the value of the firm, if the MM
assumptions are met. (ii) If the value of the firm B is Rs. 3,60,000 then do these values equilibrium values. It not, how will
equilibrium be set? Explain,
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Que. 21: - A firm has a bond outstanding Rs. 300 lakh. The bond has 12 years of life remaining until maturity, and has a 12.5% coupon and
is callable at Rs. 1,050 per bond; it had flotation costs of Rs. 4.2 lakh, which are being amortized at Rs. 30,000 annually. The
floatation costs for a new issue will be Rs. 9 lakh and the current interest rte will be 10%. The after tax cost of the debt is 6%.
Should the firm refund the outstanding debt?
Show detailed workings. Consider Corporate Income –tax rate at 50%.
Que. 22: - X Ltd. and Y Ltd. are identical except for leverage. They earn same operating profit Rs. 4 lakh before tax. Y Ltd. has Rs. 8 lakh
in 10% debt while company X is entirely financed by equity. Assuming a tax rate of 40% and capitalization rate of 16% for an all
– equity company, compute the value of business and overall cost of capital by
(i) Net Income Approach and (ii) Net Operating Income Approach
Que. 23: - A Ltd. expects to earn Rs. 5 lakh annually before interests and taxes. The company is financed entirely by equity funds and cost
of unlevered equity is 15%. Tax rate is 40%. The company wishes to buy back Rs. 10 lakh of its equity and to replace the same by
10% debt. Determine income available to equity and debt –holders of the business before and after buy –back and hence explain
how the value of the company will change after buy –back.
Question : Explain the meaning of capita l budget ing ?
Answer : The term cap ita l budget ing means p lanning for capi tal assets. Capi tal budgeting decision
means the dec is ion as to whether or no t to invest in long -te rm projec ts such as set t ing up of a factory
or insta l l ing a machinery or creat ing add it ional capac it ies to manufac ture a par t which a t present may
be purchased from outs ide and so on. I t inc ludes the f inancia l analysis o f the var ious p roposa ls
regarding capi ta l expenditure to eva lua te their impact on the financial condit ion of the company for
the purpo se to choose the bes t out o f the var ious a l ternat ives. The finance manager has var ious too ls
and techniques by means of which he assis ts the management in taking a proper cap ita l budgeting
decision. Capi ta l budget ing dec is ion i s thus , eva luat ion of expend iture decisions that involve current
out lays but are l ike ly to produce benefi t s over a per iod of t ime longer than one year . The benefi t tha t
ar i ses from cap ital budgeting dec ision may be ei ther in the form of increased revenues or reduced
costs . Such dec is ion requi res evaluat ion of the proposed projec t to forecas t l ikely or expected return
from the project and determine whether return from the projec t is adequate. Also as business is a par t
of soc ie ty, i t i s i t s moral responsib il i ty to undertake only those projec ts tha t are social ly desi rable.
Capital budget ing dec ision is an important , cruc ial and cr i t ical business decision due to :
1) Substantia l expenditure : capi tal budget ing dec is ion involves the investment o f substant ia l amount o f funds and i s thus i t i s
necessary for a firm to make such decis ion af ter a thoughtful considerat ion, so as to resul t in
prof i tab le use o f scarce resources. Hasty and incorrect decisions would not only result in huge losses
but would a lso account for fai lure o f the f irm.
2) long t ime period : capi tal budget ing dec ision has i t s e ffect over a long per iod of t ime, they affec t the future benefi t s
and also the f irm and inf luence the ra te and direct ion of growth of the f i rm.
3) Irreversibi l ity : most o f such decisions are ir reversib le , once taken, the fi rm may not been in a posi t ion to reverse i t s
impact . This may be due to the reason, that i t i s d i ff icult to find a buyer for second -hand capital
i tems.
4) Co mplex decision : capi tal investment decision involves an asses sment o f future events, which in fac t are d i fficul t to
predic t , fur ther , i t i s d i fficult to es t imate in quanti ta t ive terms al l benefi ts or costs rela t ing to a
par t icular investment decision.
Quest ion: discuss the various types o f capita l investment dec isions?
Answer : There are var ious ways to class i fy cap ita l budgeting dec is ions, genera l ly they are
c lassi f ied as :
1) On the basis o f the f irm's existence :
Chapter : Capital Budgeting
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cap ital budget ing decisions are taken by both newly incorporated and exis t in g firms. New
f irms may require to take dec is ion in respec t of selec t ion of p lant to be ins ta l led, whi le exis t ing
f irms may require to take dec ision to meet the requirements o f new envi ronment or to face cha llenges
of competi t ion. These decisions may be cl ass i fied into :
i ) Replacement and modernisat ion dec isions : rep lacement and modernisat ion dec is ions a ims to
improve opera t ing eff ic iency and reduce costs. Usual ly, p lants require replacement due to they been
economical ly dead i . e . no more econo mic l i fe le f t or on they becoming technologica lly outda ted. The
former decis ion i s o f replacement and la t ter one of modernisa t ion , however , both these decisions are
cost reduction dec isions .
i i ) Expansion decision : exis t ing successful firms may experience grow th in demand of the p roduct
and may exper ience shortage or delay in de livery due to inadequate production fac i l i t ies and thus,
would consider proposals to add capac ity to exis t ing product l ines.
i i i ) Diversif icat ion dec is ions : these decisions require e valuat ion proposa ls to divers i fy into new
product l ines, new markets, e tc . to reduce r i sk o f fai lure by dea ling in d i fferent products or operat ing
in severa l markets. expansion and diversi f ica t ion decis ions are revenue expansion decisions.
2) On the basis o f decis ion s ituat ion :
i ) Mutually exclusive dec isions : decisions a re said to be mutua lly exclusive when two or more
al terna tive proposals a re such tha t accep tance of one would exclude the accep tance of the o ther .
i i ) Accept-Reject dec is ions : the accep t -ejec t decisions occurs when proposa ls are independent and
do no t compete wi th each o ther . The f irm may accept or rejec t a proposal on the bas is o f a min imum
return on the required investment. Al l those proposa ls which have a higher return than c er ta in desired
rate o f re turn are accep ted and res t rejec ted.
i i i ) Cont igent dec is ions : contigent decis ions are dependable proposa ls , investment in one requires investment in ano ther .
Quest ion: What are the various projects evaluation techniques expl a in them in deta il ? '
Answer : At each po int of t ime, business manager , has to evalua te a number o f proposa ls as regards
var ious projec ts where he can invest money. He compares and evaluates projects and dec ides which
one to take up and which to rejec t . Apart from f inancia l considera t ions , there are many o ther factors
considered whi le taking a capi tal budget ing decision. At t imes a project may be undertaken only to
es tabl i sh footho ld in the market or for bet ter wel fare o f the soc ie ty as a whole or of t he business or
for increas ing the safe ty and securi ty o f workers, or due to requirements o f law or because of
emotional reasons for instance, many industr ia l sector projec ts are taken up a t home towns even i f
bet ter locat ions are ava ilab le. The major consi derat ion in taking a capita l budgeting decis ion is to
evalua te i t s returns as compared to i t s investments. Evaluat ion of capi tal budgeting proposa ls have
two dimensions i . e . prof i tab il i ty and r i sk, which are direct ly re lated. Higher the prof i tabil i ty, h igh er
would be the r i sk and vice versa. Thus, the f inance manager has to s tr ike a ba lance be tween
prof i tab il i ty and r i sk. Follo wing are some of the techniques used to evalua te f inancia l aspects of a
project :
1) Payback period :
i t i s one of the simples t method to calcula te per iod wi thin which enti re cost o f p roject
would be comple tely recovered. I t i s the per iod wi thin which to ta l cash inf lo ws from projec t would
be equal to total cash out flo w of projec t , cash inf low means prof i t a fter tax but before deprec ia t ion.
Merits:
a) this method of evaluating proposa ls for capi tal budgeting is simple and easy to understand , i t has
an advantage of making clear tha t i t has no prof i t on any project unti l the payback per iod is over i .e .
unt i l cap ital i nvested is recovered . When funds are l imi ted , they may be made to do more by se lect ing
projects having shor ter payback per iods. This method i s par t icular ly sui table in the case o f industr ies
where r i sk o f technologica l services i s very high. In such indust r ies, only those projec ts having a
shorter payback per iod should be financed since changing technology would make the projects to tal ly
obsolete , before a l l cos ts are recovered.
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b) in case o f routine projects also use o f payback per iod method favours pro jec ts tha t genera tes cash
inf lo ws in ear l ier years, thereby e l iminating projects br inging cash inf lows in la ter years tha t
genera l ly are conceived to be r i sky as this tends to increase wi th futur i ty .
c) by st ress ing ear l ier cash inf lo ws, l iquidi ty dimen sion i s a lso considered in select ion cr i te r ia . This
is
important in si tuat ions o f l iquidi ty crunch and high cost o f capi ta l .
d) payback per iod can be compared to break -even point , the po int at which costs are ful ly recovered
but profi t s are yet to com mence.
e) the r i sk assoc ia ted wi th a project ar i ses due to uncertainty assoc ia ted wi th cash inf lows. A shorter
payback per iod means that uncertainty wi th respect to projec t i s reso lved fas ter .
Limitat ions : Technique of payback per iod i s not a sc ient i f ic one due to the fo l lo wing reasons:
a) I t s tresses capi ta l recovery rather than prof i tabil i ty. I t does not take into account returns from the
project a f ter i t s payback per iod. For example : project A may have payback per iod of 3 years and
project B of 8 years, according to this method project A would be selected, however , i t i s possib le
that a fter 3 years projec t B earns returns @ 20 % for ano ther 3 years whi le projec t A stops yie lding
returns a fter 2 years. Thus, payback per iod is no t a good measure t o evalua te where the compar ison i s
between 2 projects, one involving long gestat ion per iod and the other yi elding quick result s but for a
short per iod .
b) this method becomes an inadequate measure o f evalua ting 2 projects where the cash inf lo ws are
uneven.
c) th is method does no t give any considerat ion to t ime value of money, cash f lo ws occurr ing at a l l
points o f t ime are s imply added. This treatment is in contravent ion of the bas ic pr inc iple o f f inancia l
analys is tha t s t ipulates compounding or discoun t ing of cash flo ws and when they ar i se at d i fferent
points o f t ime.
Some accountants ca lculate payback per iod after discount ing cash flo ws by a pre -
determined rate and the payback per iod so calculated i s cal led "discounted payback per iod" .
2) Payback rec iprocal :
i t i s rec iproca l o f the payback per iod. A major drawback of the payback per iod method of
capi tal budget ing i s that i t does not indica te any cut o ff per iod for the purpose of investment
decision. I t is , argued tha t rec iproca l o f payback would be a close approximat ion of the interna l ra te
of return i f the l i fe o f the projec t i s a t leas t twice the payback per iod and projec t genera tes equal
amount o f f inal cash inf lows. In pract ice, payback reciproca l i s a he lpful tool fo r quickly est imating
rate o f return of a project provided i t s l i fe i s at least twice the payback per iod. Payback reciprocal =
average annual cash inf lows/ini t ia l investment
3) Accounting or average rate of return method (ARR) :
Accounting or average ra te o f re turn means average annual yield on the project . Under this
method prof i t a fter tax and deprec ia t ion as percentage of to tal investment i s considered .
Rate o f return = ( total p rof i t * 100)/(ne t investments in the proj ect * number o f years o f prof i t s)
This ra te i s compared wi th the rate expected on the projec ts, had the same funds been
invested al terna tively in those projec ts. Sometimes, the management compares this rate with
minimum ra te kno wn as cut -off rate .
Merits : I t i s a simple and popular method as i t i s easy to understand and inc ludes inco me from the
project throughout i t s l i fe .
Limitations : I t i s based upon crude average prof i t s o f the future years. I t ignores the e ffect o f
f luctuat ions in p rofi t s from year to year . And thus ignores t ime va lue of money which i s very
important in capi tal budgeting dec is ions.
4) Net present value method :
The best method for evaluat ion of investment proposa l i s ne t present va lue method or
discounted cash f low technique. This method takes into account the t ime value of money. The net
present value of investment p roposal may be def ined as sum of the present va lues o f a l l cash inf lows
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as reduced by the present va lues o f a l l cash out f lo ws associa te d wi th the proposa l . Each project
involves cer ta in investments and commitment of cash a t cer ta in point of t ime. This i s kno wn as cash
out f lo ws. Cash inflo ws can be ca lculated by adding depreciat ion to prof i t a fter tax ar i sing out of tha t
par t icular projec t .
Discounting cash inf lows : Once cash inf lows and out f lows are determined, next s tep i s to
discount each cash inf low and work out i t s present va lue. For the purpose, discounting ra tes
must be known. Normally, the discount ing rate equals the opportunity cost o f capi ta l as a
project must earn at leas t that much as i s paid out on the funds locked in the projec t . The
concept o f present va lue i s easy to unders tand .To ca lculate present va lue of var ious cash
inf lo ws reference shal l be had to the present va lue tab le.
Discounting cash outf lows : The cash out f lows a lso requires discount ing as the whole of
investment i s not made at the ini t ia l stage i tsel f and wi l l be spread over a per iod of t ime. This
may be due to interes t - free defer red cred it fac i l i t ies fro m supplie rs o f plant or some other
reasons. Another change in cash flo ws to be considered in the capi tal budget ing dec ision i s
the change due to requirement o f working capi ta l . Apart from investment in fixed assets, each
project invo lves commi tment o f funds in working cap ita l . The commi tment on this account
may ar ise as soon as the plant star t s product ion. The working cap ita l commitment ends a f ter
the fixed assets o f the project are so ld out . Thus, whi le consider ing the to ta l out f lows,
working capi ta l requir ement must a lso be considered in the year the plant s tar t s production. At
the end of the projec t , the working capi tal wi l l be recovered and can be treated as cash inf low
of last year .
Acceptance rule : A project can be accep ted i f NPV is posit ive i .e . NPV > 0 and rejec ted ; i f i t
is negative i .e . NPV < 0 . I f NPV = 0, projec t may be accepted as i t impl ies a project generates
cash flo ws at the rate just equal to the oppor tuni ty cost o f cap ital .
Merits :
1) NPV method takes into account the t ime value of money.
2) The whole s tream of cash flo ws i s considered .
3) NPV can be seen as add it ion to the weal th o f shareholders. The cr i ter ion of NPV is thus in
conformi ty wi th basic financia l objec tives .
4) NPV uses d iscounted cash f lows i .e . expresses cash flo ws in terms of current rupees. NPV's o f
di fferent projects therefore can be compared. I t impl ies that each project can be evalua ted
independent o f o thers on i t s o wn mer it s .
Limitations :
1) I t involves d i fferent calcula t ions.
2) The appl ica t io n of this method necess i tates forecast ing cash flo ws and the discount rate . Thus
accuracy of NPV depends on accura te es t imat ion of these 2 fac tors tha t may be quite di ff icul t in
real i ty.
3) The ranking of projec ts depends on the d iscount ra te .
5) Desirabil ity factor/Profitabi l ity Index : In cases o f, a number o f capi tal expenditure proposals, each involving d i fferent amounts o f
cash inflo ws, the method of working out desi rabil i ty factor or prof i tabil i ty index i s fol lowed. In
genera l ter ms, a project is acceptable i f i t s prof i tabi l i ty index va lue i s greater than 1.
Merits :
1) This method a lso uses the concept o f t ime va lue of money.
2) I t i s a be tter projec t eva lua tion technique than NPV.
Limitations of Profitabi l ity index :
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1) Profi tab il i ty index fa i l s as a guide in resolving 'capi ta l rat ioning ' where projects are ind ivisib le .
Once a single large project wi th high NPV is se lec ted, possib il i ty o f accept ing several smal l projects
that toge ther may have higher NPV, then a s i ngle projec t i s excluded.
2) Situat ions may ar ise where a project se lec ted wi th lower profi tabi l i ty index may generate cash
f lows in such a manner that another project can be taken up one or two years la ter , the total NPV in
such case being more than th e one with a projec t having highest Profi tabil i ty Index.
The prof i tabil i ty index approach thus, cannot be used indiscr iminately but al l o ther type of
al terna tives o f projects would have to be worked out .
6) Internal Rate of Return(IRR) : IRR is that rate o f return a t which the sum to ta l of discounted cash inflo ws equals to
discounted cash out f lows. The IRR of a projec t is the d iscount rate tha t makes the net present va lue
of the projec t equal to zero.
The d iscount rate i .e . cost o f capi tal i s assumed to be kno wn in the de termination of NPV,
whi le in the IRR, the NPV is se t a t 0(zero) and discount ra te sa t i s fying this condi t ion i s determined.
IRR can be interpre ted in 2 ways :
1) IRR represents the ra te o f return on the unrecovered investment ba lance in the p roject .
2) IRR is the ra te o f return earned on the in t ial investment made in the project .
I t may no t be poss ible for a l l f i rms to reinvest in termediate cash f lows at a rate o f return
equal to the project 's IRR, hence the fir s t in terpreta t ion seems to be more rea l i s t ic . Thus, IRR should
be viewed as the ra te o f return on unrecovered balance of projec t rather than co mpounded rate o f
return on ini t ial investment over the l i fe o f the p rojec t .
Acceptance Rule : The use o f IRR, as a c r i ter ion to accept capi tal investment decision involves a comparison of IRR
wi th required ra te o f re turn cal led as Cutoff ra te . The project should the accep ted i f IRR is greater
than cut o ff rate . I f IRR is equal to cut o ff rate the f irm is ind i ffe rent . I f IRR less than cutoff rate , the
project i s rejected.
Merits: 1) This method makes use o f the concept o f t ime value of money.
2) Al l the cash f lo ws in the projec t are considered.
3) IRR is eas ier to use as instantaneous unders tanding of desi rabi l i ty i s de termined by compar ing i t
wi th
the cost o f capi tal .
4) IRR technique helps in achieving the objec tive o f minimisat ion of shareholders wealth .
Demerits:
1) The ca lculat ion process i s ted ious i f there ar e more than one cash out f low interspersed between the
cash inf lows then there would be mul t ip le IRR's , the interpre tat ion of which i s d i ff icul t .
2) The IRR approach crea tes a pecul iar s i tuation i f we compare the 2 projects wi th di fferent
inf lo w/out flo w patte rns.
3) I t i s assumed that under this method a l l future cash inf lows of a proposa l are re invested a t a rate
equal to IRR which i s r idiculous assumption.
4) In case o f mutua lly exclusive projects, investment options have considerably di fferent cash
out lays . A projec t wi th large fund commitments but lo wer IRR contr ibute more in terms of absolute
NPV and increases the shareholders ' wealth then decis ions based only on IRR may not be cor rec t .
Quest ion : What is the signif icance of cut of f rate?
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Answer : Cut o ff rate i s the minimum that the management wishes to have from any projec t , usually i t
is based on cost o f capita l . The technica l ca lculat ion of cos t of capita l involves a co mpl icated
procedure, as a concern procures funds fro m any sources i .e . e quity shares, capi ta l genera ted from it s
own operat ions and reta ined in general reserves i .e . retained earnings, debentures, preference share
capi tal , long/shor t term loans, etc . Thus, the firm's cos t o f cap ital can be kno wn only by working out
weighted average of the var ious costs of ra is ing var ious types o f capita l . A firm should no t and
would no t invest in projects yield ing re turns a t a rate be low the cut o ff rate .
Quest ion : Dist inguish between desirabil ity factor, NPV and IRR method of ranking proje cts?
Answer : In case o f an under taking having 2 o r more compet ing projects and a l imi ted amount o f
funds at i t s disposal , the question of ranking the projects ar i ses. For every projec t , desirabil i ty factor
and NPV method would give the same s ignal i .e . accep t or reject . But, in case o f mutual ly exc lusive
projects , NPV method i s preferred due to the fact that NPV indicates economic contr ibut ion of the
project in absolute terms. The projec t giving higher economic contr ibut ion i s preferred .
As regards NPV vs.IRR method, one has to consider the bas ic presumpt ion under each. In
case o f IRR, the presumption i s that in termediate cash inflo ws wi l l be reinvested at the ra te i . e . IRR,
whi le tha t under NPV is tha t in termedia te cash inf lows are presume d to be reinvested at the cut o ff
rate . I t i s obvious tha t reinvestment o f funds a t cut o ff ra te i s possib le than a t the interna l rate o f
return, which a t t imes may be very high. Hence the NPV obta ined af te r discount ing a t a f ixed cut o ff
rate are more re l iable fo r ranking 2 or more projects than the IRR.
Quest ion : Write a note on capital rat ioning?
Answer :Usually, f irms decide maximum amount that can be invested in cap ital projects, during a
given per iod of t ime, say a year . The f irm, then at tempts to select a combinat ion of investment
proposa ls , tha t wil l be wi thin spec i f ic l imi ts providing maximum profi tab il i ty and rank them in
descending order as per their ra te o f re turn, this i s a cap ital rat ioning s i tuat ion. A f irm should accept
al l investment projects wi th posi t ive NPV, wi th an object ive to maximise the wealth o f shareholders.
However , there may be resource constra ints due to which a firm may have to selec t from amongst
var ious projec ts. Thus, there may ar ise a si tua tion of capi tal ra t ioning wh ere, there may be interna l or
external constraints on procurement o f funds needed to invest in a l l investment proposals with
posi t ive NPV's . Capi ta l rat ioning can be experienced due to externa l fac tors , mainly imper fect ions in
capi tal markets at tr ibutable to non-availab il i ty of market information, investor a t t i tude , and so on.
Interna l capi ta l rat ioning i s due to se l f -imposed restr ic t ions imposed by management as, not to raise
addit iona l debtor lay down a speci f ied minimum rate o f return on each project . Th ere arevar ious ways
of resor t ing to cap ital rat ioning. I t may put up a cei l ing when i t has been financing investment
proposa ls only by way of re tained earnings i .e . p loughing back of prof i t s . Capi ta l rat ioning can also
be introduced by fol lowing the concep t o f 'Responsib il i ty Account ing ' , whereby management may
introduce capi tal ra t ioning by authoris ing a par t icular depar tment to invest upto a speci f ied l imi t ,
beyond which dec isions would be taken by the higher -ups. Se lec tion of a project under capita l
rat ioning involves :
1) Ident i ficat ion of the projects tha t can be accepted byusing eva luat ion technique as d iscussed.
2) Se lec tion of the combinat ion of projec ts.
In cap ital ra t ioning, i t would be desirable to accept several small investment proposa ls than a few
large ones , for a ful ler ut i l i sat ion of the budgeted amount. This would result in accepting
rela t ivelyless prof i table investment proposals i f ful l u t i l i sat ion of budget i s a pr imary considerat ion.
I t may a lso mean tha t the f irm forgoes the next prof i tab le investment fo l lo wing af ter the budget
cei l ing, even i f i t i s es t imated to yie ld a rate of re turn higher than the required rate . Thus capita l
rat ioning does no t a lways lead to opt imum result s .
Quest ion : Discuss the est imation of future cash f lows?
Answer : In order to use any technique of f inancia l evalua tion, da ta as regards cash flo ws from the
project i s necessary, implying that costs o f operat ions and returns f rom the projec t for a considerable
per iod in future should be es t imated . Futur e, i s always uncertain and predic t ions can be made about i t
only wi th re ference to cer ta in probabil i ty levels , but , s t i l l would not be exac t , thus, cash flo ws area t
bes t only a probabil i ty . Fol lowing are the var ious stages or s teps used in develop ing re lev ant
information for cash f low analys is :
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1)Estimat ion of costs : To est imate cash out flows, informat ion as regards fo l lo wing are needed which
may be ob tained from vendors or cont rac tors or by inte rnal est imates :
i ) Cost o f new equipment;
i i ) Cost o f removal and disposa l o f o ld equipment less scrap va lue;
i i i ) Cost o f prepar ing the s i te and mounting of new equipment; and
iv) Cost o f anci l lary services required for new equipment such as new conveyors or new power
suppl ies and so on.
The vendor may have related da ta on costs o f simi lar equipment or the company may have to
es t imate costs from i t s own experience . But, cost o f a new projec t specia l ly the one involving long
ges tat ion per iod, must be es t imated in view of the changes in pr ic e levels in the economy. For
ins tance high ra tes o f inf lat ion has caused very high increases in the cost o f var ious capi tal pro jects .
The impact o f possib le inf lat ion on the value of capi tal goods must thus, be assessed and est imated in
working out es t imat ed cash out f low. Many f irms work out a spec i fic index sho wing changes in pr ice
leve ls o f capi ta l goods such as bui ldings, machinery, p lant and machinery, e tc . The index i s used to
es t imate the l ike ly increase in costs for future years and as per i t , es t ima ted cash out f lows are
adjusted . Another adjus tment required in cash out f lo ws es t imates i s the possibi l i ty o f delay in the
execut ion of a projec t depending on a number o f factors, many of which are beyond the management 's
control . I t is impera tive tha t an e s t imate may be made regarding the increase in project cost due to
delay beyond expected t ime. The increase would be due to many fac tors as inf la t ion, increase in
overhead expendi ture, e tc .
2)Estimat ion of addit ional working capital requirements : The next step i s to ascer tain addi t iona l
working cap ital required for f inancing increased activi ty on account of new cap ital expenditure
project . Project p lanners of ten do not take into account the amount requi red to finance the increase in
addit iona l working cap i tal tha t may exceed amount o f capi ta l expendi ture required. Unless and unti l
th is factor i s taken into account, the cash out flow wi l l remain incomplete. The increase in working
capi tal requirement ar ises due to the need for maintaining higher sundry debtor s, stock-in-hand and
prepaid expenses , e tc . The f inance manager should make a careful es t imate o f the requirements o f
addit iona l working capita l . As the new cap ita l projec t commences operat ion, cash out f lows
requirement should be sho wn in terms of cash ou t f lo ws. At the exp iry o f the useful l i fe o f the p roject ,
the working cap ital would be released and can be thus , t reated as cash inf low. The impact o f inf lat ion
is also to be brought into account, whi le working out cash out flo ws on account o f working cap ita l . In
an inf lat ionary economy, working cap ita l requirements may r i se progressively even though there i s
increase in ac t ivi ty o f a new project . This i s because the va lue of stock, etc . may r i se due to
inf la t ion, hence , addi t iona l working cap ital requi rement s on this account should be sho wn as cash
out f lo ws.
3)Estimat ion of production and sa les : Planning for a new projec t requires an est imate o f the
production that i t would generate and the sa le that i t would enta i l . Cash inf lo ws are highly dependent
on the est imation of production and sales levels. This dependence i s due to peculiar na ture o f f ixed
cost . Cash inf lows tend to increase considerab ly a fter the sa les are above the break -even point . I f in a
year , sales are belo w the break -even point , which is qui te possib le in a large cap ital in tensive project
in the ini t ial year o f i t s commerc ia l production, the company may even have cash out flo ws in terms
of losses. On the bas is o f addit iona l production uni t s that can be so ld and pr ice at which they may be
sold, the gross revenues from a project can be worked out . In do ing so ho wever , possib il i ty o f a
reduct ion in sale pr ice, in troduction of cheaper or more e ff ic ient product by compet i tors, recess ion in
the market condi t ions and such o ther fac tors are to be consi dered .
4)Estimat ion of cash expenses : In this s tep, the amount o f cash expenses to be incurred in running
the projec t a f ter i t goes into co mmerc ia l production are to be est imated. I t i s obvious tha t whichever
leve l of capac ity ut i l i sat ion is a t tained b y the project , f ixed costs remains the same. However ,
var iab le costs vary wi th changes in the level o f capaci ty ut i l i sa t ion.
5)Working out cash inf lows: The d i fference between gross revenues and cash expenses has to be
adjusted for taxa tion before cash i nf lows can be worked out . In view of deprec iat ion and other
taxab le expenses, e tc . the tax l iab il i ty o f the company may be worked out . The cash inflo w would be
revenues less cash expenses and l iabi l i ty for taxation.
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One problem is o f trea tment o f dividends and interest . Some accountants suggest that
in teres t being a cash expense is to be deducted and dividends to be deducted from cash inf lows.
However , this seems to be incorrec t . Both dividends and interes t invo lve a cash out f low, the fac t
remains that these const i tute cost o f capi ta l , hence, i f d iscount ing ra te , is i t se l f based on the cost o f
capi tal , in teres t on long term funds and dividends to equity or preference shareholders should not be
deducted whi le working out cash inf lows. The rate o f return yielded by a project at a cer tain rate o f
return i s compared wi th cost o f capi ta l for de termining whether a par t icular project can be taken up
or not . I f the cost o f capita l becomes par t o f cash out f lows, the co mpar ison becomes vi t ia ted. Thus,
capi tal cos t l ike interest on long term funds and dividends should not be deducted from gross
revenues in order to work out cash inf lows. Cash inf lows can also be worked out back wards, on
adding interes t on long term funds and deprecia t ion to ne t profi t s and deduct ing l iabi l i ty for taxa tion
for the year .
Question : Write a note on soc ial benefit analysis?
Answer : I t i s be ing increasingly recognised that commerc ial eva luat ion of industr ial projec ts is no t
enough to just i fy commitment o f funds to a p roject spec ia l ly, i f i t belongs to the publ ic sector and
ir respec tive of i t s f inancia l viab il i ty, i t i s to be implemented in the long te rm interest o f the nation.
In the context o f the national po licy of making huge public investments in var ious sec tors o f the
economy, the need for a pract ica l method of making social cost benefi t analys is has acquired great
urgency. Hundreds o f c rores o f rupees are commit ted every year to var ious public projects of a l l
types - industr ial , commercial and those providing basi c infras truc ture faci l i t ies , e tc . Analysis o f
such projects has tobe done wi th re ference to socia l cos ts and benefi t s as they cannot be expected to
yield an adequate commercial re turn on the funds employed, at leas t during the short run. Socia l cos t
benefi t analys is i s important for pr iva te corporations having a mora l responsib il i ty to undertake
soc ial ly des irab le p rojects. In analys ing var ious al ternat ives o f capita l expendi ture, a p r ivate
corporat ion should keep in view the social contr ibution aspec t . I t can thus be seen tha t the purpose of
soc ial cost benefi t analys is technique i s no t to replace the exis t ing techniques o f financial ana lys is
but to supplement and strengthen them. The concept o f soc ia l cos t benefi t analys is has progressed
beyond the s tage o f intel lectual specula t ion. The planning commiss ion has already dec ided tha t in
future, the feas ibi l i ty s tudies for publ ic sec tor projects wil l have to include an ana lys is of the socia l
rate o f return. In case of pr iva te sector also , a social ly benefic ia l project may be more easi ly
accep tab le to the government and thus , th is analys is would be relevant whi le grant ing var ious
l icenses and approvals, e tc . Also, i f the pr iva te sector includes socia l cos t benefi t analys is in i t s
project evaluat ion techniques, i t wi l l ensure tha t i t i s no t ignor ing i t s own long -te rm interest , as in
the long run only those projects wi l l survive tha t are socia l ly benefic ial and acceptable to soc ie ty.
Need for Socia l Cost Benef it Analysis (SCBA) :
1) Market pr ices used to measure costs and benefi t s in projec t ana lys is do no t represent soc ia l values
due to market imper fections.
2) Monetary cost benefi t analys is fa i l s to consider the external i t ies or external e ffects o f a project .
The external e ffec ts can be posi t ive l ike developme nt o f infras truc ture or negat ive l ike pol lut ion and
imbalance in environment .
3) Taxes and subsid ies a re monetary costs and gains, but these are only transfer payments f rom soc ial
viewpoint and thus ir re levant .
4) SCBA is essent ia l for measur ing the re dis tr ibut ion effect o f benefi t s of a projec t as benefi t s going
to poorer sect ion are more impor tant than one go ing to sect ions which are economica lly bet ter o f f.
5) Projects manufac tur ing l iqueur and c igare t tes are not d is t inguished fro m those generat ing
elec tr ici ty or producing necessi t ies o f l i fe . Thus, meri t wants are important appra isal cr i ter ion for
SCBA.
I t i s essent ia l to unders tand that ac tual cos t or revenues do not essent ia l ly re f lect cost or
benefi t to the soc iety. I t i s so , because the market pr ice o f goods and services are o ften grossly
dis tor ted due to var ious a r t i fic ia l res tr ict ions and controls f rom authori t ies. Thus, a di f ferent
yards t ick i s to be adopted in eva luat ing a par t icular proposal and i t s cost benefi t ana lys is are usu a lly
va lued a t "opportuni ty cost" or shado w prices to judge the real impact o f the ir burden as costs to
soc iety. The soc ia l cos t va lua tion so met imes completely changes the est imates of working resul t s of a
project .
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Quest ion : Is there any relat ionship be tween r isk and return, if yes, of what sort?
Answer :
Risk: The term r isk wi th re ference to investment decis ion is def ined as the var iabi l i ty in actua l
return emanat ing fro m a project in future over i ts working l i fe in relat ion to the es t imated re turn as
forecasted at the t ime of ini t ia l cap ita l budgeting dec isions. Risk i s d i ffe rent ia ted wi th uncertainty
and i s def ined as a si tuation where the facts and figures are no t avai lable or probabil i t ies cannot be
assigned.
Return: I t cannot be denied that re t urn i s the motivat ing force and the pr inc ipa l reward to the
investment process . The return may be defined in terms of :
1) real i sed re turn i .e . the return which was earned or could have been earned, measuring the real i sed
return a l lo ws a f irm to assess h ow the future expected re turns may be.
2) expected re turn i .e . the re turn tha t the f irm anticipa tes to earn over some future per iod. The
expected re turn is a predicted re turn and may or may not occur .
For , a f irm the return from an inve stment is the expected cash inflo ws. The re turn may be
measured as the total gain or loss to the firm over a given per iod of t ime andmay be defined as
percentage on the ini t ial amount invested.
Relat ionship between r isk and return : The main objec tive o f financial management i s to maximise
wealth o f shareholders ' as re f lected in the market pr ice o f shares , that depends on r i sk -return
charac ter i st ics o f the financia l decisions taken by the f irm. I t a l so emphasizes that r i sk and return are
2 impor tant de ter minants o f value of a share. So , a f inance manager as a lso investor , in genera l has to
consider the r isk and re turn of each and every f inancia l dec ision. Acceptance of any proposa l does
not al ter the business r i sk o f f irm as perce ived by the suppl ier o f ca p i tal , but , d i f ferent investment
projects would have di ffe rent degree of r isk . Thus, the impor tance of r i sk d imension in capital
budgeting can hardly be over -st ressed. In fac t , r isk and re turn are c losely re lated, investment project
that i s expected to yie ld high return may be too r i sky tha t i t causes a signi f icant increase in the
perce ived r i sk o f the f irm. This trade off between r i sk and re turn would have a bear ing on the
investor ' percep tion of the f irm before and af ter accep tance of a spec i fic proposal . The return from an
investment dur ing a given per iod is equal to the change in va lue of investment plus any income
rece ived from investment . I t i s thus , important tha t any capi ta l or revenue income from investments
to investor must be inc luded, otherwise t he measure o f return wi l l be defic ient . The re turn from
investment cannot be fo recasted wi th cer ta inty as there i s r isk tha t the cash inf lows from project may
not be as expected . Greater the var iab il i ty be tween the es t imated and actua l return, more r isky i s the
project .
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Important Questions
Que:- Excel Ltd. manufactures a special chemical for sale at Rs. 30 per kg. The variable cost of manufacture is Rs. 15 per kg. Fixed cost
excluding depreciation is Rs. 2,50,000. Excel Ltd. is currently operating at 50% capacity. It can produce a maximum of 1,00,000 kgs at full
capacity.
The Production Manager suggests that if the existing machines are fully replaced the company can achieve maximum capacity in
the next five years gradually increasing the production by 10% per year.
The Finance Manager estimates that for each 10% increase in capacity, the additional increase in fixed cost will be Rs. 50,000. The
existing machines with a current book value of Rs. 10,00,000 can be disposed of for Rs. 5,00,000. The Vice-President (finance) is willing to
replace the existing machines provided the NPV on replacement is about Rs. 4,53,000 at 15% cost of capital after tax.
(i) You are required to compute the total value of machines necessary for replacement.
For your exercise you may assume the following:
(a) The company follows the block assets concept and all the assets are in the same block. Depreciation will be on straight-
line basis and the same basis is allowed for tax purposes.
(b) There will be no salvage value for the machines newly purchased. The entire cost of the assets will be depreciated over
five year period.
(c) Tax rate is at 40%.
(d) Cash inflows will arise at the end of the year.
(e) Replacement outflow will be at the beginning of the year (year 0).
Year 0 1 2 3 4 5
Discount factor at 15% 1 0.87 0.76 0.66 0.57 0.49
(ii) On the basis of data give above, the managing director feels that the replacement, if carried out, would at least yield post tax return
of 15% in the three years provided the capacity build up is 60%, 80% and 100% respectively. Do you agree?
Que:- A company is planning to set up a Project at a cost of Rs. 3 crores. It has to decide whether to locate the plant in Bombay or Janupur
(a backward district). Locating the plant in Janupur would mean a cash subsidy of Rs. 15 lakhs from the Central Government. In addition,
the taxable profits to the extent of 20% would be exempt for 10 years. The project envisages a borrowings of Rs. 2 crores in either case. The
cost of borrowing would be 12% for Bombay and 10% for Janupur. However, the revenue costs are likely to be higher in Janupur. The
borrowings have to be repaid in four equal annual instalments beginning from the end of the fourth year. With the help of following
information and by using Cost of Equity of 15%, advise as to where the project should be set up:
Profit (Loss) before Interest and Depreciation
(Rs. In Lacs)
Present Value Factors
(at 15%)
Year Bombay Janupur
1
2
3
4
5
6
7
8
9
10
(6.00)
34.00
54.00
75.00
110.00
140.00
150.00
250.00
350.00
450.00
(50.00)
(20.00)
10.00
20.00
50.00
100.00
150.00
200.00
225.00
350.00
0.87
0.76
0.66
0.57
0.50
0.43
0.38
0.33
0.28
0.25
Notes:
(i) Income-tax is payable @ 30% on profits.
(ii) Central subsidy receipt is not to affect depreciation and income-tax.
(iii) Useful Life of the Plant is estimated as 10 years.
Que:- PQR Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is Rs. 40 lakhs the company has two
alternatives:
(i) Taking the car on finance lease; or (ii) Borrowing and purchasing the car.
LMN Limited is willing to provide the car on finance lease of PQR Limited for five years at annual rental of Rs. 8.75 lakhs, payable at the
end of the year. The vehicled is expected to have useful life of 5 years, an it will fetch a net salvage value of Rs. 10 lakhs at the end of yeare
five. The depreciation rate for tax purpose is 40% on written – down value basis. The applicable tax rate for the company is 35% and
incremental borrowing rate of the co. is 13.8462%.
What is the net advantage of leasing for the PQR Limited? Ignore Tax on capital profits
The values of Present value interest factor at different rate of discount are as under:
Rate of Discount T1
0.8784
0.9174
T2
0.7715
0.7715
T3
0.6777
0.7722
T4
0.5953
0.7084
T5
0.5229
0.6499
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Practical Questions:-
Que. 1: - Dolly company has an investment opportunity costing Rs. 40,000 with the following expected cash inflow (i.e. after tax and before
depreciation)
Year Inflows (Rs.) PVF (10%)
1 7,000 0.909
2 7,000 0.826
3 7,000 0.731
4 7,000 0.653
5 7,000 0.621
6. 8,000 0.564
7. 10,000 0.513
8. 15,000 0.467
9. 10,000 0.424
10 4,000 0.386
Using 10% as the cost of capital (rate of discount) determine the (i) Net Present value; and (ii) Profitability Index.
Que. 2: - Consider the following investment opportunity: A machine is available for purchase at a cost of Rs. 80,000. We expect it to have a
life of five years and to have a scrap value of Rs. 10,000 at the end of the five –year period. We have estimated that it will generate
additional profits over its life as follows:
Year Amount (Rs.)
1 20,000
2 40,000
3 30,000
4 15,000
5 5,000
These estimates are of profits before depreciation. You are required to calculate the return on capital employed.
Que. 3: - L & T Ltd. has decides to purchase a machine to augment the company‟s installed capacity‟s to meet the growing demand for its
products. There are machine under consideration of the management. The relevant details including estimated yearly expenditure
and sales are given below: All sales are on cash. Corporate Income Tax rate is 40%.
Assuming Profit or loss on sale of assets at end has no tax effect.
Advise whether the company should accept the project or reject it on the basis of NPV of the project.
Que. 42- Sagar industries, is planning to introduce a new product with a projected life of 8 years. The project, to be set up in a backward
region, qualifies for a one – time (as it5s starting) tax – free subsidy from the government of Rs. 20 lakhs equipment cost will be
Rs. 140 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning of the third year. At the end of 8
years the original equipment will have no resale value, but the supplementary equipment can be sold for Rs. 1 lakh. A working
capital of Rs. 15 lakhs will be needed. The sales volume over the eight – year period have been forecasted as follows:
Year Units
0 80,000
1 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of sales revenue. Fixed cash operating costs
will amount to Rs. 16 lakhs per year. In addition, an extensive advertising will be implemented, requiring annual outlays as
follows:
Year (Rs. in lakhs)
1 30
2 15
3-5 10
6-8 4
The company is subject to 50% tax and considers 12% to be an appropriate after –tax cost of capital for this project. The company
follows the straight line method of depreciation.
Should the project be accepted? Assume that the company has enough income form its existing products.
You Should Know
1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV
A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.
The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So
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unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a yardstick to accept or reject a project.
Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the business world, entails more problems than a practitioner may think.
2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS
When comparing two projects, the use of the NPV and the IRR methods may give different results. A project selected according to the NPV may be rejected if the IRR method is used.
Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trial and error method explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens to your decision if the NPV method is used? The answer is that the decision will change depending on the discount rate you use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a discount rate of 8%, Project X is preferred because of a higher NPV.
The purpose of this numerical example is to illustrate an important distinction: The use of the IRR always leads to the selection of the same project, whereas project selection using the NPV method depends on the discount rate chosen.
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Another important tool in the hands of finance managers for ascertaining the changes in financial position of
a firm between two accounting periods is known as funds flow statement. Funds flow statement analyses the reasons for
change in financial position between two balance sheets. It shows the inflow and outflow of funds i.e., sources and application
of funds during a particular period. Fund Flow Statement summarises for a particular period the resources made available to
finance the activities of an enterprise and the uses to which such resources have been put. A fund flow statement may serve as
a supplementary financial information to the users. Fund. means working capital. Working capital is viewed as the difference
between current assets and current liabilities.
Importance of Funds Flow Statement
The balance sheet and profit and loss account failed to provide the information which is provided by funds flow statement i.e.,
changes in financial position of an enterprise. This statement indicates the changes which have taken place between the two
accounting dates. This statement by giving details of sources and uses of funds during a given period is of great help to the
users of financial information. It is also a very useful tool in the hands of management for judging the financial and operating
performance of the company. It also indicates the working capital position which helps the management in taking policy
decisions regarding dividend etc. The projected funds flow statement can also be prepared and thus budgetary control and
capital expenditure control can be exercised in the organisation.
Funds Flow Statement vs. Cash Flow Statement
Both funds flow and cash flow statements are used in analysis of past transactions of a business firm. The
differences between these two statements are given below:
(a) Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statements all
transactions effecting the cash or cash equivalents only is taken into consideration.
(b) Funds flow statement analyses the sources and application of funds of long-term nature and the net increase or decrease in
long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or
decrease in current assets and current liabilities in calculating the cash flow of funds from
operations.
(c) Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and
correcting the current liquidity problems of the firm.
(d) Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow
statement starts with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and
uses.
Practical Questions:-
Que. 1 From the following particulars, calculate Cash Flows from Operating Activities by Indirect Method.
Dr. Profit & Loss Account of X Ltd. Cr.
For the year ended 31st March, 20X2
Particulars Rs Particulars Rs
To Depreciation
To Discount on Issue of Debentures w/o
To Interest on Long-term Borrowings
To Loss on Sale of Machine
To Patents w/o
To Provision for Tax
To Transfer to Reserve
To Interim Divided
To Proposed Divided
To Premium payable on redemption
of Red. Pre. Share
To Net Profit
1,40,000
1,000
28,000
30,000
1,50,000
1,00,000
90,000
72,000
10,000
By Operating Profit before
Depreciation
By Profit on Sale on Investments
By Dividend on Shares
By Interest on Investments
By Rent from a plot of Land
By Insurance Proceeds from
earthquake disaster settlement
By Refund of Tax
9,18,000
20,000
10,000
6,000
30,000
1,00,000
3,000
Chapter : Fund Flow Statements
Chapter : Cash Flow Statements
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4,36,000
10,87,000 10,87,000
Additional information:
Particulars 31.3.20X1
Rs
31.3.20X2
Rs
Stock
Trade Debtors
Trade Creditors
Provision for Tax
Prepaid Manufacturing Overheads
Outstanding Office & Adm. Expenses
Prepaid Selling & Distribution Expenses
Outstanding Trading Commission Payable
Accrued Trading Commission Receivable
1,00,000
10,000
5,000
50,000
16,000
10,000
10,000
10,000
10,000
1,50,000
6,00,000
1,50,000
82,000
10,000
15,000
14,000
15,000
30,000
Solution
Cash Flows from Opening Activities (Under Indirect Method)
Particulars Rs.
A. Net Profit as per Profit & Loss A/c
Add: Proposed dividend for the current year
Add: Interim dividend paid during the year
Add: Transfer to reserve
Add: Provision for Tax made during the Current Year
Less: Refund of Tax
Less: Extraordinary item (i.e., Insurance proceeds from Earthquake
disaster settlement)
B. Net profit before taxation, and extraordinary item
C. Add: Items to be added:
Depreciation
Interest on Long term borrowings
Discount on Issue of Debenture w/o
Patents written off
Loss on sale of Machinery
Premium payable on redemption of Preference shares
D. Less: Items to be deducted:
Interest Income
Dividend Income
Rental Income
Profit on sale of investments
E. Operation Profit before working capital charges [B + C – D]
F. Add: Decrease in Current Assets & Increase in Current Liabilities:
Decrease in Prepaid Mfg. Overheads
Increase in Creditors for goods
Increase in Outstanding Trading Commission
Increase in Outstanding Office & Adm. Expenses
G. Less: Increase in Current Assets & Decrease in Current Liabilities:
Increase in Stock
Increase in Debtors
Increase in Prepaid Selling & Distribution Expenses
Increase in Accrued Commission
H. Cash generated from operations [E + F – G]
I. Less: Income taxes paid (Net of Refund)
J. Cash flow before extraordinary item [H – I]
K. Extraordinary items
L. Net Cash from Operating Activities
4,36,000
72,000
90,000
1,00,000
1,50,000
3,000
1,00,000
7,45,000
1,40,000
28,000
1,000
30,000
30,000
10,000
10,000
6,000
30,000
20,000
6,000
1,45,000
5,000
5,000
50,000
5,90,000
4,000
20,000
2,39,000
66,000
9,18,000
1,161,000
6,64,000
4,15,000
1,15,000
3,00,000
1,00,000
4,00,000
Que. 2 From the following Balance Sheets of X Ltd., prepare Cash Flow Statement:
Liabilities 31.3.20X1
Rs.
31.3.30X2
Rs
Assets 31.3.20X1
Rs
31.3.20X2
Rs
Equity Share Capital
15% Redeemable Pref.
Share Capital
General Reserve
3,00,000
1,50,000
40,000
4,00,000
1,00,000
70,000
Goodwill
Land & Building
Plant &Machinery
Debtors
1,15,000
2,00,000
80,000
1,60,000
90,000
1,70,000
2,00,000
2,00,000
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Profit & Loss A/c
Creditors
Bills Payable
Provision for Taxation
Proposed Dividend
30,000
55,000
20,000
40,000
42,000
48,000
83,000
16,000
50,000
50,000
Stock
Bills Receivable
Cash in Hand
Cash at Bank
77,000
20,000
15,000
10,000
1,09,000
30,000
10,000
8,000
6,77,000 8,17,000 6,77,000 8,17,000
Additional Information:
(a) Depreciation of Rs 10,000 and Rs 20,000 has been charged on plant and land and buildings respectively.
(b) An interim dividend of Rs 20,000 has been paid, and
(c) Income-tax Rs 35,000 has been paid.
Solution
Cash Flow Statement
For the year ended 31st March, 20X2
Particulars Rs. Rs.
I. Cash Flows from Operating Activities:
A. Closing Balance as per Profit & Loss A/c
Less: Opening balance as per Profit & Loss A/c
Add: Proposed dividend during the year (on equity & Preference
shares)
Add: Interim dividend paid during the year
Add: Transfer to reserve
Add: Provision fo Tax
B. Net Profit before taxation, and extraordinary item
C. Add: Items to be added
Depreciation
Goodwill w/o
D. Operating Profit before working capital charges [B + C]
E. Add: Decrease in Current Assets & Increase in Current Liabilities:
Increase in Creditors for goods
F. Less: Increase in Current Assets & Decrease in Current Liabilities:
Increase in Stock
Increase in Debtors (Gross)
Increase in Bills Receivable
Decrease in Bills Payable
G. Cash generated from operations [D + E – F]
H. Less: Income taxes paid (Net of Refund)
I. Net Cash from Operating Activities
II. Cash Flows from Investing Activities:
Purchases of Plant
Proceeds from sale of Building
Net Cash used in investing activities
III. Cash Flows from Financing Activities:
Proceeds from issuance of share capital
Redemption of Preference shares
Interim Dividend Paid
Final Dividend paid (on equity & preference shares)
Net Cash used in financing activities
IV. Net Decrease in Cash and Cash Equivalents [I + II + III]
V. Cash and Cash Equivalents at Beginning of Period
Cash in hand
Cash at Bank
VI. Cash and Cash Equivalents at end of Period [IV + V]
Cash in hand
Cash at bank
30,000
25,000
32,000
40,000
10,000
4,000
15,000
10,000
10,000
8,000
48,000
(30,000)
50,000
20,000
30,000
45,000
1,63,000
55,000
2,18,000
28,000
(86,000)
1,60,000
(35,000)
1,25,000
(1,30,000)
10,000
(1,20,000)
1,00,000
(50,000)
(20,000)
(42,000)
(12,000)
(7,000)
25,000
18,000
Working Notes:
Dr. (i) Plant Account Cr.
Particulars Rs Particulars Rs
To Balance b/d
To Bank A/c (Purchases)
(Balancing figure)
80,000
1,30,000
By Depreciation A/c
By Balance c/d
10,000
2,00,000
2,10,000 2,10,000
Dr. (ii) Land & Building Account Cr.
Particulars Rs Particulars Rs
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To Balance b/d 2,00,000 By Depreciation A/c
By Bank A/c (Sale)
(Balancing figure)
By Balance c/d
20,000
10,000
1,70,000
2,00,000 2,00,000
Que. 3 From the following particulars, prepare Cash Flow Statement.
Liabilities 20X2
Rs.
20X1
Rs
Assets 20X2
Rs
20X1
Rs
Equity Share Capital
12% Pre. Share Capital
General Reserve
Profit & Loss A/c
15% Debentures
Creditors
Provision for Taxation
Proposed Dividend
Bank Overdraft
80,000
20,000
4,000
2,400
14,000
22,000
8,400
11,600
13,600
55,000
25,000
4,000
2,000
12,000
24,000
6,000
10,000
25,000
Fixed Assets
Less: Accumulated
Depreciation
Debtors
Stock
Prepaid Expenses
Cash
80,000
30,000
50,000
48,000
70,000
1,000
7,000
82,000
22,000
60,000
40,000
60,000
600
2,400
1,76,000 1,63,000 1,76,000 1,63,000
Additional Information: (a) Provision for Tax made Rs 9,400, (b) Fixed Assets sold for Rs 10,000, their cost Rs 20,000 and
accumulated depreciation till date of sale of them Rs 6,000 (c) An Interim Dividend paid during the year Rs 9,000.
Que. 4 From the following particulars, prepare the Cash Flows Statement:
Liabilities 20X2
Rs.
20X1
Rs
Assets 20X2
Rs
20X1
Rs
Share Capital
Reserve
10% Loans
10% Public Deposits
Creditors
Outstanding Expenses
Provision for Doubtful
Debts
5,00,000
80,000
3,00,000
30,000
1,50,000
6,000
4,000
5,00,000
1,50,000
1,00,000
50,000
1,40,000
7,000
3,000
Lands & Building
Plant & Machinery
Stock
Debtors
Cash
1,20,000
6,00,000
75,000
1,60,000
1,15,000
80,000
5,00,000
1,00,000
1,50,000
1,20,000
10,70,000 9,50,000 10,70,000 9,50,000
During the year, Rs 50,000 depreciation has been provided on Plant & Machinery and a machine costing Rs 15,000
(Depreciation provided thereon Rs 10,000) was sold at 60% profit on book value.
Que. 5 From the following Balance Sheets of X Ltd. prepare a Cash flow Statement.
Liabilities 20X1
Rs.
20X2
Rs
Assets 20X1
Rs
20X2
Rs
Equity Share Capital
General Reserve
Profit & Loss A/c
10% Debentures
Sundry Creditors
Bills Payable
Provision for Depreciation
On Machinery
30,000
10,000
6,000
15,000
7,500
1,000
9,000
35,000
15,000
7,000
25,000
11,000
1,500
13,000
Goodwill
Machinery
10% Investments
Stock
Debtors
Cash and Bank Balance
Discount on Debentures
10,000
41,000
3,000
4,000
8,000
12,000
500
8,000
54,000
8,000
5,500
19,000
13,000
78,500 1,07,000 78,500 1,07,000
Additional Information: Investments costing Rs 3,000 were sold Rs 2,800 during the year 20X2. A new machine was
purchased for Rs 13,000.
Que. 6 XYZ Ltd. company‟s Comparative Balance Sheet for 2009 and the Company‟s Income Statement for the year follows:
XYZ Ltd.
Comparative Balance Sheet December 31, 2009 and 2008 (Rs. Crores)
Particulars 2009 2008
Sources of Funds:
Share holder‟s Funds:
Share capital
Retained earnings
Loan Funds:
Bonus payable
140
110 250
135
385
140
92 232
40
272
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Application of Funds:
Fixed Assets:
Plant and equipment
Less: Accumulated depreciation
Investments
Current Assets:
Inventory
Accounts receivable
Prepaid expenses
Cash
Less: Current Liabilities and Provisions
Accounts payable
Accrued Liabilities
Deferred income-tax provision
430
(218) 212
60
205
180
17
26
428
230
70
15
315 113
385
309
(194) 115
75
160
270
20
10
460
310
60
8
378 82
272
XYZ Ltd.
Income Statement for the year ended December 31, 2009 (Rs.Crores)
Particulars
Sales
Less: Cost of goods sold
Gross margin
Less: Operating expenses
Net operating income
Non- operating items:
Loss on sale of equipment
Income before taxes
Less: Income- taxes
Net income
1,000
530
470
352
118
(4)
114
48
66
Additional Information:
(i) Dividends of Rs 48 crores were paid in 2009.
(ii) The loss on sale of equipment of Rs 4 crore reflects a transaction in which equipment with an original cost of Rs
12 crores and accumulated depreciation Rs 5 crore were sold for Rs 3 crore in cash.
Required: Using the indirect method, determine the net cash provided by operating activities for 2009 and construct a
statement of cash flows.
Que. 7 The following is the Income statement of XYZ Company for the year 2009
(Rs.)
Sales
Add: Equity in ABC Company‟s earning
Expenses:
Cost of goods sold
Salaries
Depreciation
Insurance
Research and development
Patent amortization
Interest
Bad debts
Income tax:
Current
Deferred
Total expenses
Net income
1,62,700
6,000
1,68,700
89,300
34,400
7,450
500
1,250
900
10,650
2,050
6,600
1,550 8,150
1,54,650
14,050
Additional information are;
(i) 70% gross revenue from sales were on credit.
(ii) Merchandise purchases amounting to Rs 92,000 were on credit.
(iii) Salaries payable totaled Rs 1,600 at the end of year.
(iv) Amortisation of premium on bonds payable was Rs 1,350.
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(v) No dividends were received from the other company.
(vi) XYZ Company declared cash dividend of Rs 4,000.
(vii) Charges in Current assets and Current liabilities were as follows: Increase (Decrease)(Rs.)
Cash
Marketable securities
Accounts receivable
Allowance for bad debt
Inventory
Prepaid insurance
Accounts payable (for merchandise)
Salaries payable
Dividends payable
500
1,600
(7,150)
(1,900)
2,700
700
5,650
(2,050)
(3,000)
Prepare a statement showing the amount of cashflow from operations.
Que. 8 From the following summary Cash account of X Ltd. prepare Cashflow statement for the year ended 31st March, 2009
in accordance with AS-3 (Revised) using the direct method. The company does not have any cash equivalents.
Summary Cash Account for the year ended 31.3.2009 (Rs. „000)
Balance on 1-4-2005
Issue of equity Shares
Receipts from customers
Sale of fixed assets
50
300
2,800
100
Payment of suppliers
Purchase of fixed assets
Overhead expenses
Wages and salaries
Taxation
Dividend
Repayment of bank loan
Balance on 31.3.2006
2,000
200
200
100
250
50
300
150
3,250 3,250
Que. 9 Ms. Jyothi of Star Oils Limited has collected the following information for the preparation of Cashflow statement for
the year 2009:
Net Profit
Dividend (including dividend tax) paid
Provision for Income-tax
Income-tax paid during the year
Loss on sale of assets (net)
Book value of the assets sold
Depreciation charged to Profit and Loss A/c
Amortisation of capital grant
Profit on sale of investments
Carrying amount of investment sold
Interest income on investments
Interest expenses
Interest paid during the year
Increase in working capital (excluding cash and bank balances)
Purchases of fixed assets
Investment in Joint venture
Expenditure on construction work-in-progress
Proceeds from calls-in-arrear
Receipt of grant for capital projects
Proceeds from long-term borrowings
Proceeds from short-tem borrowings
Opening cash and bank balance
Closing cash and bank balance
25,000
8,535
5,000
4,248
40
185
20,000
6
100
27,765
2,506
10,000
56,075
14,560
3,850
34,740
2
12
25,980
20,575
20,575
5,003
6,988
Required- Prepare the Cashflow statement for the year 2009 in accordance with „AS -3, Cashflow Statements‟ issued by the
Institute of Chartered Accountants of India. (Make necessary assumptions).
Que. 10 From the information contained in Income Statement and Balance Sheet of „A‟ Ltd., prepare cash flow statement:
Income Statement for the year ended March 31, 2009 (Rs)
Net Sales (a)
Less:
Cash cost of sales
Depreciation
Salaries and wages
Operating expenses
2,52,00,000
1,98,00,000
6,00,000
24,00,000
8,00,000
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Provision for taxation
(b)
Net operating profit (a) – (b)
Non-recurring income (profit on sale of equipment)
Retained earnings and profit brought forward
Dividends declared and paid during the year
Profit and Loss account balance as on March 31, 2009
8,80,000
2,44,80,000
7,20,000
1,20,000
8,40,000
15,18,000
23,58,000
7,20,000
16,38,000
(Rs)
Balance Sheet as on March 31
2009
March 31
2008
Assets
Fixed Assets:
Land
Buildings and equipment
Current Assets:
Cash
Debtors
Stock
Advances
Liabilities and Equity
Share capital
Surplus in Profit and Loss account
Sundry creditors
Outstanding expenses
Income-tax payable
Accumulated depreciation on Buildings and equipment
4,80,000
36,00,000
6,00,000
16,80,000
26,40,000
78,000
90,78,000
36,00,000
15,18,000
24,00,000
2,40,000
1,20,000
12,00,000
90,78,000
9,60,000
57,60,000
7,20,000
18,60,000
9,60,000
90,000
1,03,50,000
44,40,000
16,38,000
23,40,000
4,80,000
1,32,000
13,20,000
1,03,50,000
The original cost of equipment sold during the year 2008-09 was Rs 7,20,000.
Que. 11 The Balance Sheet of JK Limited as on 31st March, 2008 and 31
1. During the year, additional equity capital was issued to the extent of Rs. 25,000 by way of bonus shares fully paid up.
2. Final dividend on preference shares and an interim dividend of Rs. 4,000 on equity shares were paid on 31st March, 1996.
3. Proposed dividends for the year ended 31st March, 1995 were paid in October, 1995.
4. Movement in Reserve for replacement of machinery account represents transfer to Profit and Loss Account.
5. During the year, one item of plant was up valued by Rs. 3,000 and credit for this was taken in the Profit and Loss Account.
6. Rs. 1,700 being expenditure of fixed assets for the year ended 31st March, 1995 wrongly debited to Sundry Debtors then, was
corrected in the next year.
7. Fixed Assets costing Rs. 6,000 (accumulated depreciation Rs. 4,800) were sold for Rs. 250. Loss arising therefrom was written off.
8. Preference shares redeemed in year (June, 1995) were out of a fresh issue of equity shares, Premium paid on redemption was 10%.
Que. 23- The Balance Sheet of Zee Ltd. as on 31st March, 1989 was as follows:
Equity Share Capital
(fully paid shares of Rs. 10 each)
11% Redeemable Preference Share Capital
(fully paid shares of Rs. 100 each)
Capital Redemption Reserve A/c
General Reserve
10% Debentures
Creditors for goods
Provision for Income tax
Proposed Equity Dividend
5,00,000
2,00,000
1,00,000
2,50,000
2,50,000
1,70,000
1,80,000
70,000
Land & Buildings
Plant and Machinery
Patents
Trade Investments
Investments in Government
Securities as current assets
Stock in trade
Trade Debtors
Cash
Preliminary Expenses
2,00,000
6,80,000
1,00,000
2,50,000
70,000
1,20,000
1,60,000
1,30,000
10,000
17,20,000 17,20,000
Trade company has prepared the following Summarised projected Profit and Loss Account for the year ending on 31st March,
1990.
Rs. Rs.
To Opening Stock
To Purchases
To Wages
To Salaries and Other Expenses
To Interest on Debentures
To Provision for Depreciation
To Preliminary Expenses written off
To Provision for Income Tax
To Preference Dividend Paid
To Proposed Equity Dividend
To Balance of Profit
1,20,000
15,00,000
2,60,000
2,62,500
25,000
1,10,500
5,000
1,67,150
22,000
75,000
85,150
By Sales
By Closing Stock
By Income from Investments
By profit on sale of machinery
By savings in provision for income tax
for 19888-89
24,00,000
1,80,000
31,300
6,000
15,000
26,32,300 26,32,300
You are given the under mentioned further information:-
(i) Provision for depreciation as on 31.3.1989 was Rs. 2,30,000 against Plant and Machinery and Rs. 20,000 against Land and
Buildings. Of the amount provided against depreciation in 1989-90, Rs. 10,000 will be for Land and Buildings.
(ii) At the ends of March, 1990 the Redeemable Preference Shares are to be redeemed.
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(iii) New Machinery costing Rs. 1,50,000 will be installed towards the end of March, 1990. The machine, which will be disposed
of , cost Rs. 40,000 against which Rs. 30,000 has been provided as depreciation till 31.3.1989 – the sale will take place in the
beginning of April, 1989.
(iv) The 10% Debentures are to be redeemed at the end of March, 1990. Debenture – holders for half of the amount are expected
to agree to take new 14% Debentures while the remaining debenture – holders are expected to agree to get their debentures
converted into equity shares at par.
(v) The company allows one month‟s credit to its customers and receives one and a half month‟s credit from its suppliers. On
31.3.1990, outstanding wages will be Rs. 45,000.
Prepare the Balance sheet of the company as it likely to be at 31st March, 1990. Also prepare a statement showing sources and
application of funds during the year. Assume that to the necessary extent, government securities will be sold at book value and no bank
overdraft will be raised. Payment of tax should be shown separately.
Que.24- The Balance Sheet of North Mills Ltd. as at 31st March, 1988 was as follows:
Liabilities Rs. Assets Rs.
Equity share capital
General Reserve
Profit and loss account
Trade creditors
Provision for tax
10,00,000
1,50,000
2,50,000
1,62,850
1,95,000
Plant and Machinery (cost)
Less: depreciation
Furniture: fittings and fixtures (cost)
Less: dep.
Long –term investments
Stock
Debtors
Less: provision for bad debts
Cash at Bank
Advance Payment of income tax
6,00,000
2,21,050 3,78,950
1,00,000
27,100 72,900
2,00,000
4,50,000
80,000
4,000 76,000
3,80,000
2,00,000
17,57,850 17,57,850
On 1st April, 1988 the company took over a business for Rs. 5,00,000. The purchase consideration was satisfied by
allotment to vendor 27,000 equity shares of Rs. 10 each at par and a cash payment of Rs. 2,30,000 which was raised by sale of all the
long –term investments. The assets and liabilities taken over and their agreed values were as follows:-
Plant and Machinery 3,00,000
Furniture, fittings and fixtures 40,000
Stock 1,05,000
Trade Debtors 45,000
Trade Creditors 15,000
In July, 1988, the company paid a dividend @ 20% per annum for the year ended 31st March, 1988.
In Dec. 1988 the Income tax officer settled the income tax liability for the accounting year, ended 31st March, 19888 for
Rs. 2,00,000.
In Feb. 1989 the company made a public issue of 1,00,000 equity shares of Rs. 10 each at par, the whole amount being
payable along with applications. The issue was got underwritten for the maximum commission allowed by law. The purpose of the
issue was to finance a new plant which was acquired for Rs. 9,00,000 in last week of march, 1989.
The balance sheet of North Mills Ltd. as at 31st March, 1989 stood as follows:-
Liabilities Rs. Assets Rs.
Equity share capital
(of the above shares, 27,000 shares of Rs.,
10 each have been allotted as fully paid up
pursuant to a contract without payment
being received in cash)
General reserve
Profit and loss a/c
Trade creditors
Provision for income tax
22,70,000
2,00,000
3,00,000
1,43,100
3,10,000
Goodwill
Plant and machinery (cost)
18,00,000
Less: dep. (3,21,893)
Furniture, fittings and fittings
(cost) 1,40,000
Less: dep. (38,390)
Stock
Debtors 98,000
Less: provision
for bad debts 4,900
Cash at Bank
Advance payment of income tax
Underwriting commission
25,000
14,78,107
1,01,610
5,05,283
93,100
6,70,000
3,00,000
50,000
32,23,100 32,23,100
You are required to prepare Cash flow Statement
Que. 25- The Balance sheet of Pragati Ltd. for the year ended 31st March 2001 & 2002 were summarized thus:
Liability 31.3.01 31.3.02 Assets 31.3.01 31.3.02
Equity share capital
Pref. share capital
Capital Reserve
General reserve
Profit & Loss
Hire vendor
10% debenture
Creditors
Provision for Tax
5,00,000
2,00,000
----
50,000
20,000
----
-----
95,000
30,000
9,00,000
1,00,000
24,000
70,000
30,000
28,000
2,00,000
85,000
45,000
Goodwill
Land & Building
Plant and machinery
Car
Investments
Stock
Debtors
Cash
Advances tax
10,000
4,50,000
1,70,000
-----
40,000
60,000
75,000
45,000
35,000
14,000
6,90,000
1,60,000
40,000
20,000
1,00,000
1,45,000
2,61,000
50,000
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Unclaimed dividend ----- 7,000 Underwriting
Commission
10,000
9,000
8,95,000 14,89,000 8,95,000 14,89,000
1. Tax for year ended 31st March was assessed to be 50,000.
2. A car of 50,000 was purchased on Hire Purchase and Rs. 25,000 was paid to Hire Vendor during the year.
3. The debentures were issued @ 10% premium which was taken to Capital Reserve on 1st April, 2001.
4. Accumulated Depreciation on Land and Building was 1,50,000 and 2,10,000 respectively.
5. Accumulated Depreciation on Plant and Machinery was 1,30,000 and 1,40,000 respectively.
6. investment was sold @ 20% premium, the profit of which was taken to capital reserve.
7. bonus shares of 1 for every 5 held was issued in the beginning the year.
8. land and building worth 1,50,000
Plant and machinery worth 50,000
Stock worth 20,000
Debtors worth 70,000
Creditors worth 30,000
were purchased by issue of shares of Rs. 2,50,000 shares @ 10% premium
9. Dividend paid during the year = Rs. 43,000
10. The preference shares were redeemed @ 25% premium.
11. Plant and Machinery costing Rs,. 50,000 (WDV 22,000) was disposed off.
12. Bad debts written off Rs. 5,000
13. Dividend received was Rs. 17,000 of which Rs. 7,000 was post acquisition.
Prepare Cash flow Statement.
Ratio Analysis: It is concerned with the calculation of relationships, which after proper identification & interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgments.
Types of Ratios
Liquidity
Measurement Profitability
Indicators Financial
Leverage/Gearing Operating Performance Investment
Valuation
Current Ratio Profit Margin
Analysis Equity Ratio Fixed Assets Turnover Price/Earnings
Ratio
Quick Ratio Return on Assets Debt Ratio Sales/ Revenue Price/Earnings to
Growth ratio
Return on Equity Debt-Equity Ratio Average Collection Period Dividend Yield
Return on Capital
Employed Capitalization Ratio Inventory Turnover Dividend Payout
Ratio
Interest Coverage Ratio Total assets Turnover
Liquidity Measurement Ratios
Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern
of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. The greater the coverage
of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in
the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red
flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting
its obligations.
Ratio Formula Meaning Analysis
Chapter : Ratio Ananlysis
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Current Ratio Current Assets/Current
Liabilities
Current assets includes cash,
marketable securities, accounts
receivable and inventories.
Current liabilities includes
accounts payable, short term
notes payable, short-term
loans, current maturities of
long term debt, accrued income
taxes and other accrued
expenses
The number of times that the
short term assets can cover the
short term debts. In other
words, it indicates an ability to
meet the short term obligations
as & when they fall due
Higher the ratio, the better it is,
however but too high ratio
reflects an in-efficient use of
resources & too low ratio leads
to insolvency. The ideal ratio is
considered to be 2:1.,
Quick Ratio or
Acid Test Ratio (Cash+Cash
Equivalents+Short Term
Investments+Accounts
Receivables) / Current
Liabilities
Indicates the ability to meet
short term payments using the
most liquid assets. This ratio is
more conservative than the
current ratio because it
excludes inventory and other
current assets, which are more
difficult to turn into cash
The ideal ratio is 1:1. Another
beneficial use is to compare the
quick ratio with the current
ratio. If the current ratio is
significantly higher, it is a clear
indication that the company's
current assets are dependent on
inventory.
Profitability Indicators Ratios
Profitability is the ability of a business to earn profit over a period of time.The profitability ratios show the combined effects of
liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of
a business is the profitability which results from the effective use of its resources.
Ratio Formula Meaning Analysis
Gross Profit
Margin (Gross Profit/Net Sales)*100 A company's cost of goods
sold represents the expense
related to labor, raw materials
and manufacturing overhead
involved in its production
process. This expense is
deducted from the company's
net sales/revenue, which
results in a company's gross
profit. The gross profit margin
is used to analyze how
efficiently a company is using
its raw materials, labor and
manufacturing-related fixed
assets to generate profits.
Higher the ratio, the higher is
the profit earned on sales
Operating Profit
Margin (Operating Profit/Net
Sales)*100 By subtracting selling, general
and administrative expenses
from a company's gross profit
number, we get operating
income. Management has
much more control over
operating expenses than its
cost of sales outlays. It
Measures the relative impact of
operating expenses
Lower the ratio, lower the
expense related to the sales
Net Profit Margin (Net Profit/Net Sales)*100 This ratio measures the
ultimate profitability Higher the ratio, the more
profitable are the sales.
Return on Assets Net Income / Average Total This ratio illustrates how well Higher the return, the more
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Assets
( Earnings Before Interest &
Tax = Net Income)
management is employing the
company's total assets to make
a profit.
efficient management is in
utilizing its asset base
Return on Equity Net Income / Average
Shareholders Equity*100 It measures how much the
shareholders earned for their
investment in the company
Higher percentage indicates the
management is in utilizing its
equity base and the better
return is to investors.
Return on Capital
Employed Net Income / Capital
Employed
Capital Employed = Avg. Debt
Liabilities + Avg. Shareholders
Equity
This ratio complements
the return on equity ratio by
adding a company's debt
liabilities, or funded debt, to
equity to reflect a company's
total "capital employed". This
measure narrows the focus to
gain a better understanding of a
company's ability to generate
returns from its available
capital base.
It is a more comprehensive
profitability indicator because
it gauges management's ability
to generate earnings from a
company's total pool of capital.
Financial Leverage/Gearing Ratios
These ratios indicate the degree to which the activities of a firm are supported by creditors‟ funds as opposed to owners as the
relationship of owner‟s equity to borrowed funds is an important indicator of financial strength. The debt requires fixed
interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed
time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors
against possible losses from default in payment.
Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is
greater than the rate payable on borrowed funds.
Ratio Formula Meaning Analysis
Equity Ratio (Ordinary Shareholder’s
Interest / Total assets)*100 This ratio measures the
strength of the financial
structure of the company
A high equity ratio reflects a
strong financial structure of the
company. A relatively low
equity ratio reflects a more
speculative situation because
of the effect of high leverage
and the greater possibility of
financial difficulty arising
from excessive debt burden.
Debt Ratio Total Debt / Total Assets This compares a company's
total debt to its total assets,
which is used to gain a general
idea as to the amount of
leverage being used by a
company. This is the measure
of financial strength that
reflects the proportion of
capital which has been funded
by debt, including preference
shares.
With higher debt ratio (low
equity ratio), a very small
cushion has developed thus not
giving creditors the security
they require. The company
would therefore find it
relatively difficult to raise
additional financial support
from external sources if it
wished to take that route. The
higher the debt ratio the more
difficult it becomes for the
firm to raise debt.
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Debt – Equity
Ratio Total Liabilities / Total
Equity . This ratio measures how
much suppliers, lenders,
creditors and obligors have
committed to the company
versus what the shareholders
have committed.
This ratio indicates the extent
to which debt is covered by
shareholders‟ funds.
A lower ratio is always safer,
however too low ratio reflects
an in-efficient use of equity.
Too high ratio reflects either
there is a debt to a great extent
or the equity base is too small
Capitalization
Ratio Long Term Debt / (Long
Term Debt + Shareholder’s
Equity)
This ratio measures the debt
component of a company's
capital structure, or
capitalization (i.e., the sum of
long-term debt liabilities and
shareholders' equity) to
support a company's
operations and growth.
A low level of debt and a
healthy proportion of equity in
a company's capital structure is
an indication of financial
fitness.
A company too highly
leveraged (too much debt) may
find its freedom of action
restricted by its creditors
and/or have its profitability
hurt by high interest costs.
This ratio is one of the more
meaningful debt ratios because
it focuses on the relationship of
debt liabilities as a component
of a company's total capital
base, which is the capital
raised by shareholders and
lenders.
Interest Coverage
Ratio EBIT / Interest on Long
Term Debt This ratio measures the
number of times a company
can meet its interest expense
The lower the ratio, the more
the company is burdened by
debt expense. When a
company's interest coverage
ratio is only 1.5 or lower, its
ability to meet interest
expenses may be questionable.
Operating Performance Ratios:
These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales
into cash, i.e how efficiently & effectively a company is using its resources to generate sales and increase shareholder value.
The better these ratios, the better it is for shareholders.
Ratios Formula Meaning Analysis
Fixed Assets
Turnover Sales / Net Fixed Assets This ratio is a rough measure
of the productivity of a
company's fixed assets with
respect to generating sales
High fixed assets turnovers are
preferred since they indicate a
better efficiency in fixed
assets utilization.
Average Collection
Period ( Accounts
Receivable/Annual Credit
Sales )*365 days
The average collection period
measures the quality of
debtors since it indicates the
speed of their collection.
The shorter the average
collection period, the better
the quality of debtors, as a
short collection period implies
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the prompt payment by
debtors. An excessively long
collection period implies a
very liberal and inefficient
credit and collection
performance. The delay in
collection of cash impairs the
firm‟s liquidity. On the other
hand, too low a collection
period is not necessarily
favorable, rather it may
indicate a very restrictive
credit and collection policy
which may curtail sales and
hence adversely affect profit.
Inventory Turnover Sales / Average Inventory It measures the stock in
relation to turnover in order to
determine how often the stock
turns over in the business.
It indicates the efficiency of
the firm in selling its product.
High ratio indicates that there
is a little chance of the firm
holding damaged or obsolete
stock.
Total Assets
Turnover Sales / Total Assets This ratio indicates the
efficiency with which the firm
uses all its assets to generate
sales.
Higher the firm‟s total asset
turnover, the more efficiently
its assets have been utilised.
Investment Valuation Ratios:
These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its
valuation.
Ratio Formula Meaning Analysis
Price Earning Ratio
( P/E Ratio ) Market Price per Share /
Earnings Per Share This ratio measures how many
times a stock is trading (its
price) per each rupee of EPS
A stock with high P/E ratio
suggests that investors are
expecting higher earnings
growth in the future compared
to the overall market, as
investors are paying more for
today's earnings in
anticipation of future earnings
growth. Hence, stocks with
this characteristic are
considered to be growth
stocks. Conversely, a stock
with a low P/E ratio suggests
that investors have more
modest expectations for its
future growth compared to the
market as a whole.
Price Earnings to
Growth Ratio ( P/E Ratio ) / Earnings Per
Share The price/earnings to growth
ratio, commonly referred to as
the PEG ratio, is obviously
closely related to the P/E ratio.
The PEG ratio is a refinement
of the P/E ratio and factors in
a stock's estimated earnings
The general consensus is that
if the PEG ratio indicates a
value of 1, this means that the
market is correctly valuing
(the current P/E ratio) a stock
in accordance with the stock's
current estimated earnings per
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growth into its current
valuation. By comparing a
stock's P/E ratio with its
projected, or
estimated, earnings per share
(EPS) growth, investors are
given insight into the degree
of overpricing or under pricing
of a stock's current valuation,
as indicated by the traditional
P/E ratio.
share growth. If the PEG ratio
is less than 1, this means that
EPS growth is potentially able
to surpass the market's current
valuation. In other words, the
stock's price is being
undervalued. On the other
hand, stocks with high PEG
ratios can indicate just the
opposite - that the stock is
currently overvalued.
Dividend Yield
Ratio ( Annual Dividend per Share
/ Market Price per
Share ) *100
This ratio allows investors to
compare the latest dividend
they received with the current
market value of the share as an
indictor of the return they are
earning on their shares
This enables an investor to
compare ratios for different
companies and industries.
Higher the ratio, the higher is
the return to the investor
Dividend Payout
Ratio (Dividend per Share /
Earnings per Share ) * 100 This ratio identifies the
percentage of earnings (net
income) per common share
allocated to paying
cash dividends to
shareholders. The dividend
payout ratio is an indicator of
how well earnings support the
dividend payment.
Practical Questions:-
Que. 1- Following is the Trading and Profit and Loss Account of Adarsh Trading House for the year ended 31st March, 1989:-
Trading and Profit and Loss Account
Rs. Rs.
To Stock on 1.4.1988 75,000 By Sales 5,00,000
To Purchase 3,10,000 By Stocks on 31.3.1989 1,00,000
To Freight 15,000
To Gross Profit c/d 2,00,000
6,00,000 6,00,000
To Administrative Expenses 85,000 By Gross Profit b/d 2,00,000
To Selling and Distribution Exp 40,000 By Interest on Investments 5,000
To Financial Expanses 6,000
To Other Non –operating Exp. 3,000
To Net Profit 71,000
2,05,000 2,05,000
You are required to calculate:-
(i) Gross profit Ratio
(ii) Net Operating Profit Ratio
(iii) Operating Ratio
(iv) Administrative Expenses Ratio
(v) Selling and Distribution Expenses Ratio.
Que. 2- Calculate Debt Equity Ratio from the balance sheet f Prestige Ltd. as at 31st March, 1989:
Liabilities Rs Assets Rs
80,000 Equity Share of Rs. 10 each Land and Buildings 6,20,000
Fully paid up 8,00,000 Plant and Machinery 12,00,000
4,000 11% Redeemable Preference Furniture and Fittings 1,80,000
Shares of Rs. 100 each, fully Stock 5,30,000
Paid up 4,00,000 Trade debtors 4,70,000
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Share Premium Account 80,000 Cash in hand 65,000
General Reserve 5,80,000 Cash at Bank 3,00,000
Profit and Loss A/c 1,40,000 Bills Receivable 1,35,000
10,000 12.5% Convertible Debentures
Of Rs. 100 each, fully paid up 10,00,000
Bills Payable 80,000
Trade Creditors 1,40,000
Outstanding Expenses 60,000
Provision for tax 2,20,000
__
35,00,000 35,00,000
Que. 3- You are required to calculate Return on Investment from the following details of Rahu Ltd. for the year ending 31st March, 1989:
Rs. Net Profit after tax 6,50,000
Rate of Income tax 50%
12.5% Convertible Debentures of Rs. 100 each, fully paid up 8,00,000
Fixed Assets, at cost 24,60,000
Depreciation up to date 4,60,000
Current Assets 15,00,000
Current Liabilities 7,00,000
Que. 4- M/s Jupiter Ltd. intends to supply goods on credit to M/s Pluto Ltd. and M/s Mars Ltd. The relevant details for the year ending 31st
March, 1989 are is follows:-
M/s Pluto Ltd. M/s Mars Ltd.
Rs. Rs.
Trade Creditors 3,00,000 1,60,000
Total Purchases 9,30,000 6,60,000
Cash Purchases 30,000 20,000
Advise with reasons as to which company he should prefer to deal with.
Que. 5- Compute the amount of capital employed from the balance sheet of Mars Ltd. as at 31st March, 1989:-
Liabilities Rs Assets Rs
Equity Share Capital 7,00,000 Land and Buildings 5,00,000
12% Pre. Share Capital 2,60,000 Plant and Machinery 6,00,000
General Reserve 3,20,000 Furniture and Fittings 1,00,000
Profit and Loss A/c 1,60,000 Investments (Non –trading) 1,00,000
Que. 6- The balance sheet of Star Ltd. as at 31st March, 1989 is given below:-
Liabilities Rs Assets Rs
Equity share Capital 6,00,000 Plant and Machinery 4,50,000
Reserves 1,80,000 Furniture 50,000
Creditors 1,20,000 Stock 1,80,000
Debtors 1,20,000
Cash at Bank 1,00,000
9,00,000 9,00,000
The other details are as follows:
(i) Total sales during the year have been Rs. 10,00,000 out of which cash sales amounted to Rs. 2,00,000.
(ii) The Gross Profit has been earned @ 20%.
(iii) Amounts as on 1.4.88: Rs.
Debtors 80,000
Stock 1,40,000
Creditors 30,000
(iv) Cash paid to creditors during the year, Rs. 2,10,000.
You are required to calculate the following ratios:
(i) Debtors Turnover Ratio;
(ii) Creditors Turnover Ratio;
(iii) Stock Turnover Ratio.
Que. 7- (a) Calculate Debt Collection Period of Confident Ltd. for the year ending 31st March, 1989:
Rs. Sales During the year 3,65,000
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Debtors as on 31.3.1989 42,500
Bills Receivable as on 31.3.1989 7,500
(b) Compute Debtors Turnover Ratio and Average Collection Period of Prosperous Ltd. for the year ending 31st March, 1989:
Rs.
Net Credit Sales 8,00,000
Opening Trade Debtors 1,80,000
Closing Trade Debtors 1,40,000
The sixty days credit is common to the industry to which the company belong. State whether the debts are being collected
efficiently or not.
Que. 8- Calculate the following ratios from the financial statements given below for AB Ltd.:
(a) Current Ratio;
(b) Acid Test Ratio;
(c) Stock Turnover Ratio;
(d) Debt Equity Ratio;
(e) Interest Coverage Ratio;
Income Statement of AB Ltd. for the year ending 31st March, 1989:
Rs. Rs.
Sales 5,00,000
Cost of Goods Sold:
Stock, April 1, 1988 40,000
Add: Purchases 2,45,000
Direct Expenses 25,000
3,10,000
Less: Stock, March 31, 1989 60,000 2,50,000
Gross Profit 2,50,000
Operating Expenses 1,10,000
Interest Expenses 20,000 1,30,000
Net Profit before Tax 1,20,000
Provision for Income Tax 60,000
Net Profit 60,000
Balance Sheet of AB Ltd. as at 31st March, 1989:
Assets Rs Rs
Fixed Assets (cost) 5,40,000
Less: Accumulated Depreciation 1,40,000 4,00,000
Stock 60,000
Debtors 2,30,000
Cash at Bank 1,55,000
Bills Receivable 43,000
Prepaid Expenses 12,000
Total Assets 9,00,000 Liabilities
Equity share capital 1,50,000
Reserves and Surplus 3,00,000
10% Debentures 2,00,000
Creditors 1,80,000
Bills Payable 70,000
Total Liabilities 9,00,000
Que. 9- The following data have been abstracted from the annual accounts of a company:
Rs. (in lakhs)
Share Capital:
20,00,000 Equity Shares of Rs. 10 each 200
General Reserve 150
Investment Allowance Reserve 50
15% Long –term Loan 300
Profit before Tax 140
Provision for Tax 84
Proposed Dividend 10
Calculate, from the above, the following ratios:
(i) Return on Capital Employed
(ii) Return on Net Worth
Que. 10- Mr. T Munim is made an offer by the promoters of S Enterprises Ltd. to invest in the project of the company by purchasing a
substantial portion of the share capital. He is promised good return by way of dividends and capital appreciation.
Mr. Munim desires you to compute the following ratios for financial analysis. Working should form part of your answer.
(i) Return on Investment Ratio
(ii) Net Profit Ratio
(iii) Stock Turnover Ratio
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(iv) Current Ratio
(v) Debt Equity Ratio
The figures given to him are as under:
(Rs. „000)
Sales……………………………………………………………….. 16,000
Raw Materials Consumed…………………………………………. 7,800
Consumables………………………………………………………. 800
Direct Labour……………………………………………………… 750
Other Direct Expenses…………………………………………….. 480
Administrative Expenses………………………………………….. 1,200
Selling Expenses………………………………………………….. 260
Interest……………………………………………………………. 1,440
Fixed Assets………………………………………………………. 14,000
Income –tax………………………………………………………... 50
Depreciation……………………………………………………… 700
Share Capital……………………………………………………… 5,000
Reserves and Surplus………………………………………………… 1,500
Secured Term Loans………………………………………………… 12,000
Unsecured Term Loans……………………………………………… 1,500
Trade Creditors……………………………………………………… 3,350
Investments………………………………………………………… 400
Inventories………………………………………………………… 6,000
Receivables………………………………………………………… 3,700
Cash in hand and at Bank…………………………………………… 100
Provisions………………………………………………………… 650
Other Current Liabilities…………………………………………… 200
Que. 11- Some years ago, the sales manager of a company persuaded the management to increase the stocks of finished goods (to improve
delivery period) and to sell more on credit (terms being 6 weeks). The following figures are given to you:
Year Sales Finished Goods Debtors at Gross Profit
Stock end
Rs. Rs. Rs. Rs.
1985-86 5,00,000 50,000 40,000 60,000
1986-87 5,50,000 54,000 45,000 65,000
1987-88 7,00,000 90,000 90,000 75,000
1988-89 7,50,000 1,00,000 1,00,000 80,000
Assuming the stock levels and debtors to be true for the whole year, comment upon the wisdom of the decision taken.
The company financed working capital by borrowing from banks. What remedial action do you suggest?
Que. 12- You are given the following figures:
Current Ratio 2.5
Liquidity Ratio 1.5
Net Working Capital Rs. 3,00,000
Stock Turnover Ratio 6
Ratio of Gross Profit to Sale 20%
Ratio of Turnover to Fixed Assets (net) 2
Average Debt Collection Period 2 months
Fixed Assets to Net Worth 0.80
Reserves and Surplus to Capital .5
Draw up the Balance Sheet of the concern to which the figures relate.
Que. 13- The assets of ABC Ltd. consist of fixed assets and current assets while its current liabilities comprise bank credit and trade credit in
the ratio of 2:1. Form the following figures relating to the company for the year 1988-98, prepare its balance sheet showing the
details of working:
Share Capital Rs. 1,99,500
Working Capital i.e. Current Assets – Current Liabilities Rs. 45,000
Gross Margin 20%
Inventory Turnover 6
Average Collection Period 2 months
Current Ratio 1.5
Quick Ratio 0.9
Reserves and Surplus to Cash 3
Que. 14- You are advised by the Management of ABC Ltd. to project a Trading and Profit and Loss Account and the Balance Sheet on the
basis of the following estimated figures and ratios, for the next financial year ending March 31, 1990:
Ratio of Gross Profit………………………………………………….. 25%
Stock Turnover Ratio………………………………………………… .5 times
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Average Debt Collection Period……………………………………… 3 times
Creditors‟ Velocity…………………………………………………… 3 times
Current Ratio………………………………………………………….. 2
Proprietary Ratio (Fixed Assets to Capital Employed)……………….. 80%
Capital Gearing Ratio (Preference Shares & Debentures to Equity)…. .30%
Net Profit to issued capital (Equity)…………………………………… 10%
General Reserve and P/L to Issued Capital (Equity)…………………… 25%
Preference Share Capital to Debentures…………………………. ……. 2
Cost of Sales consists of 50% for Materials
Gross Profit, Rs. 12,50,000.
Working notes should be clearly shown.
Que. 15- From the following information, prepare the projected Trading and Profit and Loss Account for the next financial year
ending March 31, 1989 and the projected Balance Sheet as on the date:
Gross Profit Ratio……………………………………………………… 25%
Net Profit to Equity Capital…………………………………………….. 10%
Stock Turnover ratio……………………………………………………. 5 times
Average Debt Collection Period………………………………………... 2 times
Creditors Velocity……………………………………………………… 3 times
Current Ratio…………………………………………………………… 2
Proprietary Ratio
(Fixed Assets to Capital Employed)…………………………………. ... 80%
Capital Gearing Ratio
(Preference Shares and Debentures to Equity)…………………………. 30%
General Reserve and Profit and Loss to Issued Equity Capital………… 25%
Preference Share Capital to Debentures………………………………... 2
Cost of Sales consist of 40% for Materials and balance for Wages and Overheads. Gross Profit is Rs. 6,00,000. Working
notes should be clearly shown.
Question 16:-
From the following particulars prepare the Balance Sheet of X ltd:-
Working Capital Rs 300000
Current Ratio 1.6
Current Asset / Fixed Asset 1 : 1.25
Fixed Asset to turnover 1 : 1.5
Gross Profit 20%
Debt Equity ratio 1 : 1.6
Debtors Velocity ratio 2.4 months
Creditors Velocity ratio 3 months
Stock Velocity ratio 2 months
Total Liabilities / Current Liabilities 2
Question 17-
Current Ratio 2
Working Capital Rs 400000
Capital Block to Current Asset 3 : 2
Fixed Asset to Turnover 1 : 3
Sales Cash / Credit 1 : 2
Creditors Velocity ratio 2 months
Stock Velocity Ratio 2 months
Debtors Velocity ratio 3 months
Capital Block:-
Net Profit 10% of turnover
Reserve 2.5% of turnover
Debenture / Share Capital 1 : 2
Gross Profit ratio 25% (to sales)
Question 18-
Prepare Profit & Loss account & Balance sheet with the following information:-
Current asset to Stock 3 : 2
Acid test ratio 1
EPS (Per share @10/) 10
Average Collection Period 30 days
Fixed Asset turnover ratio 1.2
Working Capital Rs 10 lacs
Variable Cost 60%
Taxation Nil
Current Ratio 3
Financial Leverage 2.2
Book Value per Share Rs 40
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Stock Turnover Ratio 5
Total Liabilities to Net Worth 2.75
Net Profit to Sales 10%
Long Term Loan Interest 12%
Quest ion : List down the f inancial needs and the sources available with a business enti ty to
sat isfy such needs ?
Answer : One of the most impor tant considera t ion for an entrepreneur -co mpany in implement ing a
new projec t or undertaking expansion, diversi f ica t ion, modernisat ion and rehab il i ta t ion scheme is
ascer taining the cost o f project and the means of f inance. There are several sources o f finance / funds
avai lable to any company. An effec ti ve appra isa l mechanism of var ious sources o f funds ava ilab le to
a company must be ins t i tuted in the co mpany to achieve i t s main objectives . Such a mechanism is
required to evaluate r i sk, tenure and cost of each and every source of fund. This se lec t ion of f und
source is dependent on the financial s tra tegy pursued by the company, the leverage planned by the
company, the f inancial condi t ions prevalent in the economy & the r isk profi le o f both i . e . the
company and the indust ry in which the company opera tes. Eac h and every source of fund has some
advantages and d isadvantages.
I) F inancial needs of a business are grouped as fo l lows :
1) Long term f inancial needs : Such needs general ly re fer to those requi rements of funds which are
for a per iod exceeding 5 - 10 years. All investments in plant and machinery, land, build ings, e tc . are
considered as long te rm f inancia l needs . Funds required to finance permanent or hard core working
capi tal should a lso be procured from long term sources.
2) Medium term f inancial needs : Such requirements re fer to those funds which are required for a
per iod exceed ing one year but no t exceed ing 5 years. Funds requi red for deferred revenue expenditure
( i .e benefi t o f expense expi res a f ter a per iod of 3 to 5 years) , are class i f ied a s medium term f inancia l
needs . Sometimes long term requirements, for which long term funds cannot be arranged immediately
may be met from medium term sources and thus the demand of medium term financial needs are
genera ted, as and when the desired long -term funds are ava ilable medium term loan may be paid off.
3) Short term f inancia l needs : Such type of f inancia l needs ar i se fo r f inancing current asse ts as,
stock, debtors, cash, e tc . Investment in these asse ts i s known as meet ing of working capita l
requirements o f the concern. Firms require working cap ital to employ f ixed asse ts gainfully . The
requirement o f working capital depends on a number of factors tha t may di ffer from industry to
industry and from company to company in the same industry. The main c haracter i st ic o f short term
f inancia l needs is tha t they ar i se for a shor t per iod of t ime no t exceed ing the accounting per iod i .e .
one year .
The bas ic pr inc iple for categoris ing the f inancia l needs into shor t term, medium term and
long te rm is that they are met from the corresponding viz . short term, medium term and long term
sources respect ive ly. Accordingly the source of f inancing i s dec ided wi th re ference to the per iod for
which funds are required. Basica lly, there are 2 sources o f rais i ng funds for any business enterpr ise
viz . owners capi ta l and borrowed cap ital . The owners cap ita l i s used for meet ing long term financia l
needs and i t pr imar i ly comes from share cap ital and retained earnings. Borro wed cap ita l fo r a l l o ther
types of require ment can be raised from di fferent sources as debentures, publ ic deposi t s , f inancia l
ins t i tut ions , commerc ial banks, etc .
II) Sources of f inance of a business are :
1) Long term : i ) Share capi ta l or Equity share cap ital
i i ) Preference shares
i i i ) Retained earnings
Chapter : Sources of Finances
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iv) Debentures/Bonds of di fferent types
v) Loans from f inancia l ins t i tut ions
vi ) Loans fro m Sta te Financia l Corporat ion
vi i) Loans from commercia l banks
vi i i ) Venture cap ital funding
ix) Asse t secur i t i sat ion
x) Internat ional financing l ike Euro-issues, Foreign currency loans.
2) Medium term : i ) Preference shares
i i ) Debentures /Bonds
i i i ) Public deposi t s / f ixed deposit s for a dura t ion of 3 years
iv) Commercial banks
v) Financial inst i tut ions
vi ) S ta te f inancia l corporations
vi i) Lease f inancing/Hire -purchase f inancing
vi i i ) Externa l commerc ial borro wings
ix) Euro - issues
x)Fore ign currency bonds.
3) Short-term : i ) Trade credi t
i i ) Commercia l banks
i i i ) F ixed deposit s fo r a per iod of 1 year o r less
iv) Advances rece ived from customers
v) Var ious shor t - term provis ions
III) Financia l sources of a business can also be classif ied as fo l lows on using different basis :
1) According to per iod : i ) Long term sources
i i ) Medium term sources
i i i ) Shor t term sources
2) According to ownership : i ) Owners capi ta l or equity capi ta l , re ta ined earnings, etc .
i i ) Borro wed capi ta l such as, debentures, pub lic deposit s , loans, e tc .
3) According to source of generation : i ) Interna l sources e .g. reta ined earnings and depreciat ion funds, e tc .
i i ) Exter nal sources e .g. debentures , loans , e tc .
However , for convenience, the di ffe rent sources of funds can a lso be c lassi f ied into the
fo l lo wing :
a) Securi ty f inancing - f inancing through shares and debentures
b) Internal f inancing - f inancing through re ta ined earning, depreciat ion
c) Loans f inancing - this includes both shor t term and long term loans
d) Internat ional financing
e) Other sources .
Quest ion : Write a note on long term sources of f inance.
Answer : There are di fferent sources o f funds avai lab le to meet long term f inancia l needs o f the
business. These sources may be broad ly class i fied into share capi ta l (both equi ty and preference) and
debt ( includ ing debentures, long term borrowings or other debt instruments) . In Ind ia, many
companies have raised long te rm f inance by offer ing var ious ins truments to publ ic l ike deep discount
bonds, ful ly convert ible debentures, e tc . These new instruments have charac ter i st ics o f both equity
and debt and i t is d i fficult to ca tegor ise them into equit y and debt . Different sources o f long term
f inance are :
1) Owners' capita l or equity capital : A publ ic l imi ted company may raise funds from promoters or from the invest ing public by
way of o wners capi tal o r equi ty cap ital by i ssuing ord inary equi ty shares. Ordinary shareholders are
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owners of the company and they under take r i sks of business. They e lect the d irec tors to run the
company and have the optimum control over the management o f the company. Since equity shares can
be paid o ff only in the event in l iquida tion, th is source has the leas t r i sk involved , and more due to
the fac t tha t the equity shareholders can be paid dividends only when there are dis tr ibutab le prof i t s .
However , the cost o f ordinary shares is usually the highest . This is due to the fac t tha t such
shareholders expect a higher ra te o f re turn on the ir investments co mpared to other suppl iers of long
term funds. The dividend payable on shares i s an appropr ia t ion of prof i t s and not a charge against
prof i t s , meaning that i t ha s to be paid only out o f prof i ts a f ter tax. Ordinary share capi ta l a l so
provides a secur i ty to other suppliers of funds. Thus, a company having substant ial ord inary share
capi tal may f ind i t easie r to raise funds, in view of the fact that the share capi ta l provides a secur i ty
to other suppl iers o f funds. The Companies Act , 1956 and SEBI Guidel ines for d isclosure and
investors ' pro tec tions and the c lar i f icat ions thereto lays do wn a number of provis ions regarding the
issue and management o f equi ty share cap it a l .
Advantages of rais ing funds by i ssue of equity shares are :
i ) I t i s a permanent source of f inance.
i i ) The i ssue of new equity shares increases the company's f lexibil i ty.
i i i ) The company can make fur ther issue of share cap ita l by making a r ig ht i ssue.
iv) There i s no mandatory payments to shareholders o f equi ty shares .
2) Preference share capita l :
These are spec ial kind of shares, the holders o f which enjoy pr ior i ty in both, repayment o f
capi tal a t the t ime of wind ing up of the company and payment o f fixed dividend. Long -term funds
from preference shares can be ra ised through a public i ssue of shares. Such shares are normal ly
cumula tive, i . e . the dividend payable in a year of loss ge ts carr ied over to the next t i l l , there are
adequate profi ts to pay cumulat ive dividends. Rate of dividend on preference shares i s normally
higher than the ra te o f interest on debentures, loans, e tc . Most o f preference shares no w a days carry
a st ipulat ion of per iod and the funds have to be repa id a t the end of a st ipula ted per iod. Preference
share cap ital i s a hybrid form of f inancing tha t par takes some charac ter i st ics o f equi ty capi ta l and
some a t tr ibutes o f debt capital . I t is simi lar to equity because preference dividend, l ike equi ty
dividend i s not a tax deductib le payment. I t resembles debt capital as the ra te o f preference d ividend
is f ixed. When preference dividend i s skipped, i t i s payable in future due to the cumula tive feature
assoc iated wi th most o f preference shares. Cumulat ive Conver t ible P reference Shares (CCPs) may
also be offered, under which the shares would carry a cumulat ive dividend of spec i f ied l imi t for a
per iod of say 3 years , af ter which the shares are converted into equi ty shares. These shares are
at trac t ive for projec ts wi th a long gestat ion per iod. For normal preference shares, the maximum
permissib le rate of dividend i s 14 %. Preference share capi tal may be redeemed at a predecided future
date or at an ear l ier s tage inter al ia out o f the company's prof i ts . This enab les t he promoters to
wi thdraw thei r capi ta l f rom the company which is no w se l f -sufficient , and the wi thdrawn cap ita l may
be re invested in other prof i tab le ventures. I r redeemable preference shares cannot be issued by any
company. Preference shares gained importa nce af ter the Finance Bil l 1997 as dividends became tax
exempted in the hands of the ind ividual investor and are taxable in the hands of the company as tax i s
imposed on dist r ibutable prof i t s a t a f la t rate . The Budget , for 2000 - 01 has doubled the divide nd tax
from 10 % to 20 % besides a surcharge of 10 %. The budget for 2001 - 2002 has reduced the d ividend
tax fro m 20 to 10 %. Many companies fo l lo wed this route dur ing 1997 espec ial ly through pr ivate
placement or preference shares as the capital markets w ere no t vibrant .
The advantages of taking the preference share capita l are as fol lows :
1) No di lut ion in EPS on enlarged cap ital base : I f equity i s i ssued i t reduces EPS, thus a ffec ting the
market percept ion about the co mpany.
2) There i s leveragi ng advantage as i t bears a f ixed charge.
3) There i s no r isk o f takeover .
4) There i s no d ilut ion of manager ia l control .
5) Preference capi tal can be redeemed after a speci f ied per iod.
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3) Retained Earnings : Long term funds may a lso be provided b y accumulat ion of company's prof i t s
and on ploughing them back into business. Such funds be long to the ordinary shareholders and
increases the company's ne t worth. A public l imi ted company must p lough back a reasonable amount
of profi t every year , keeping in view the lega l requirements in this regard , and i t s own expansion
plans. Such funds enta i l a lmost no r i sk and the present o wner 's contro l is mainta ined as there is no
dilut ion of contro l .
4) Debentures or bonds :Loans can be ra ised from publ ic on i ss ue of debentures or bonds by public
l imi ted companies. Debentures are normally i ssued in di fferent deno minations ranging from Rs. 100
to 1000 and carry di fferent ra tes o f interes t . On issue of debentures, a company can raise long term
loans from public . Us ually, debentures are i ssued on the basis o f a debenture trust deed which l i st s
terms and condit ions on which debentures a re floated . They are normal ly secured agains t the
company's asse ts. As compared wi th preference shares , debentures provide a more conv enient mode
of long term funds. Cost o f cap ital raised through debentures i s lo w as the interes t can be charged as
an expense before tax. From the investors ' v iew point , debentures o ffer a more at trac t ive prospec t
than preference shares as interest on debe ntures is payable whether or no t the company makes prof i t s .
Debentures are thus , ins truments for raising long term deb t capi ta l . Secured debentures are pro tected
by a charge on the company's asse ts. Whi le the secured debentures of a wel l -establ ished company
may be a t tract ive to investors , secured debentures o f a new company do not normal ly evoke same
interes t in the invest ing public .
Advantages :
1) The cost o f debentures i s much lower than the cost o f preference or equi ty cap ital as the interest is
tax-deduct ible . Also, investors consider debenture investment safer than equity or prefer red
investment and thus, may require a lower re turn on debenture investment .
2) Debenture financing does no t result in di lut ion of contro l .
3) In a per iod of r i sing pr ices, debenture i ssue is advantageous. The fixed monetary outgo decreases
in rea l terms as the pr ice level increases.
Disadvantages of debenture f inancing are as below :
1) Debenture interest and capi ta l repayment are obliga tory payments.
2) The pro tec tive covenants associated wi th a debenture i ssue may be res tr ic t ive.
3) Debentures f inancing enhances the f inancia l r isk associa ted wi th the f irm.
These days many companies are i ssuing conver t ib le debentures or bonds wi th a number of
schemes/ incentives l ike warrants /opt ions, e tc . These bonds or debentures are exchangeable at the
ordinary share holder 's option under speci f ied terms and condi t ions. Thus, for the fir s t few years
these secur i t ies remain as debentures and late r they can b e conver ted into equi ty shares at a pre -
determined conversion pr ice. The i ssue of conver t ib le debentures has dis t inc t advantages from the
view point o f the i ssuing company.
- such as i ssue enab les the management to raise equity capi tal indirect ly wi thout d i lut ing the equity
holding, unti l the capi ta l ra ised star t s earning an added re turn to suppor t addi t ional shares.
- such secur i t ies can be issued even when the equi ty market i s no t very good.
- conver t ib le bonds are normally unsecured and, thus, the ir i ssuance may ord inar i ly no t impair the
borrowing capaci ty.
These debentures /bonds are i ssued subject to the SEBI guidel ines no ti f ied fro m t ime to t ime.
Publ ic i ssue of debentures and pr ivate p lacement to mutual funds, requi re that the i ssue be ra ted by a
credi t ra t ing agency as CRISIL (Cred it Rat ing and Informat ion Services o f Ind ia Ltd. ) . The cred it
rat ing i s given after evalua ting fac tors as t rack record of the company, profi tabi l i ty, debt service
capac ity, cred it wor thiness and the percei ved r i sk o f lend ing.
5) Loans fro m financial inst itut ions : In Ind ia spec ia l i sed ins t i tut ions provide long -term f inancia l
assis tance to industr ies. Some of them are , Indust r ia l Finance Corporations, Li fe Insurance
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Corpora tion of India, National Smal l Indu str ies Corporat ion Limi ted , Industr ia l Cred it and
Investment Corpora tion, Industr ial Development Bank of Ind ia and Industr ial Reconst ruc tion
Corpora tion of India. Before sanct ioning of a term loan, a company has to sa t i s fy the concerned
f inancia l inst i tut ion regard ing the technical , commerc ia l , economic, f inancia l and manager ia l
viabi l i ty o f the projec t for which the loan i s requi red. Such loans are avai lable at d i fferent ra tes o f
interes t under d i fferent schemes of f inancial inst i tut ions and are to be rep a id as per a s t ipulated
repayment schedule. The loans in many cases st ipula te a number of condit ions as regards the
management and cer ta in other f inancia l polic ies of the company. Term loans represent secured
borrowings and are an important source of funds fo r new projects. They general ly, car ry a ra te o f
interes t inclus ive of inte res t tax, depending on the cred it rat ing of the borrower, the perceived r isk o f
lending and cost o f funds and general ly repayable over a per iod of 6 to 10 years in annual , semi -
annual or quar ter ly insta l lments. Term loans are also provided by banks, Sta te Financial /Development
ins t i tut ions and a l l Ind ia term lend ing financial ins t i tut ions. Banks and State Financia l Corporations
provide term loans to p rojects in the small scale sect or whi le , for medium and large industr ies term
loans are provided by State developmental inst i tut ions alone or in consort ium wi th banks and Sta te
f inancia l corpora tions. For large sca le projects Al l India financial ins t i tut ions provide bulk of term
f inance s ingly or in consort ium wi th other such ins t i tut ions, S tate leve l inst i tut ions and /or banks .
After independence , the inst i tut ional se t up in India for the provis ion of medium and long term credit
for industry has been broadened. The ass istance sanct ioned and d isbursed by these specia l i sed
ins t i tut ions has increased impress ive ly over the years. A number o f special ised ins t i tut ions are
es tabl i shed over the country.
6) Loans fro m co mmercial banks : The pr imary ro le o f the commerc ia l banks i s to cater to the short
term requi rement o f industry. However , o f la te , banks have star ted taking an interest in term
f inancing of industr ies in severa l ways , though the formal term lending i s , s t i l l , smal l and confined to
major banks . Terms lendings by bank i s a cont rover s ial i ssue these days. I t is argued that term loans
do not sat is fy the canon of l iquid ity tha t i s a major considerat ion in al l bank operat ions . Accord ing to
tradi t ional values, banks should provide loans only for short per iods and opera t ions result ing in
automatic l iquida tion of such credi ts over shor t per iods. On the other hand , i t i s contended that the
tradi t ional concept needs modif ica t ion. The proceeds o f term loan are used for what are broadly
kno wn as f ixed asse ts or expansion in p lant capaci ty. Their repayment i s usual ly scheduled over a
long per iod of t ime. The l iquid ity o f such loans i s sa id to depend on the ant ic ipated income of
borrowers.
Working capi tal loan is more permanent and long term as compared to a term loan. The
reason be ing that a term loan i s a lways repayable on a fixed da te and ul t imate ly, the account wi l l be
tota l ly adjus ted. Ho wever , in case o f working capi tal finance , though payable on demand, in actua l
pract ice i t i s not iced that the account i s never adjusted as suc h and i f a t a l l the payment i s asked
back, i t is wi th a clear purpose and intention of re finance being provided a t the beginning of next
year or hal f year . This technique of provid ing long term f inance i s known as, " rol led over for
per iods exceed ing more than one year" . Instead of indulging in term f inancing by the rol led over
method, banks can and should extend credi t te rm af ter a proper appra isal o f appl icat ions for term
loans. The degree of l iquid ity in the provision for regular amort i sa t ion of term loa ns is more than in
some of these so ca l led demand loans which are renewed from year to year . Actual ly, te rm f inancing,
discip lines both the banker and borro wer as long te rm p lanning i s required to ensure that cash
inf lo ws would be adequate to meet the inst ruments o f repayments and al low an ac tive turnover o f
bank loans. The adopt ion of the formal term loan lend ing by commercial banks wi l l not hamper the
cr i ter ia o f l iquidity, and wi l l introduce f lexibi l i ty in the operat ions o f the banking sys tem.
The rea l l imi ta t ion to the scope of bank act ivi t ies i s tha t a l l banks a re not well equipped to
appraise such loan proposa ls . Term loan proposals invo lve an element of r isk because of changes in
condit ions a ffec ting the borrower. The bank making such a loan, thus, has to assess the s i tuat ion to
make a proper appraisal . The decision in such cases depends on var ious fac tors a ffec t ing the
concerned industry 's condit ions and borro wer 's earning po tential .
7) Bridge f inance : I t re fers to loans taken by a company fro m commercia l banks for a short per iod,
pending disbursement of loans sanc tioned by financial inst i tut ions. Normal ly, i t takes t ime for
f inancia l ins t i tut ions to disburse loans to co mpanies. Ho wever , loans once approved by the term
lending inst i tut ions pending the signing of regular term loan agreement , that may be delayed due to
non-co mpl iance of condit ions st ipulated by the ins t i tut ions whi le sanc tioning the loan. The br idge
loans are repaid /adjus ted out o f term loans as and when d isbursed by t he concerned inst i tut ions. They
are secured by hypothecat ing movable asse ts , personal guarantees and demand promissory notes.
General ly, the interes t rate on them is higher than on te rm loans .
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Quest ion : What do you mean by Venture Capita l F inancing ?
Answer : Venture cap i tal f inancing refers to f inancing of new high r isky venture p romoted by
quali f ied entrepreneurs lacking exper ience and funds to give shape to their ideas . Under i t venture
capi tal i st make investment to purchase equi ty or debt secur i t i es from inexperienced entrepreneurs
under taking highly r i sky ventures wi th a potent ial o f success. The venture cap ita l industry in India i s
jus t a decade old. The venture cap ital is t f inance ventures tha t a re in na tional pr ior i ty areas such as
energy conser va tion, quali ty upgradation, e tc . The Government o f India in November 1988 issued the
f irs t set o f guide lines for venture capi ta l companies, funds and made them el igib le for capi tal ga in
concessions. In 1995, cer ta in new c lauses and amendments were made in the guide lines tha t require
the venture cap ita l i s ts to meet the requirements o f di fferent sta tutory bodies and this makes i t
d i f ficult for them to operate as they do not have much flexib il i ty in st ructur ing investments . In 1999,
the exis t ing guide lines we re re laxed for increasing the at trac t iveness of the venture schemes and to
induce high net wor th investors to commit the ir funds to 'sunrise ' sec tors, par t icular ly the
information technology sector . Ini t ia l ly the cont r ibution to the funds avai lab le for ven ture capi tal
investment in the country was from the All Ind ia develop ment f inancia l inst i tut ions, Sta te
development financial inst i tut ions, commercial banks and companies in p r iva te sec tor . Lately many
offshore funds have been star ted in the country and ma ximum contr ibution is from foreign
ins t i tut iona l investors. A few venture cap ita l companies opera te as both investment and fund
management companies, o ther se t up funds and funct ion as asse t management company. I t i s hoped
that changes in the guidelines fo r implementa t ion of venture capi tal schemes in the country would
encourage more funds to be se t up to give the required momentum for venture cap ital investment in
Ind ia. Some common methods of venture capi ta l f inancing are :
1) Equity f inancing : The venture cap ital under takings usual ly require funds for a longer per iod but ,
may not be ab le to provide re turns to investors dur ing the ini t ial s tages. Thus , the venture capital
f inance i s genera l ly provided by way of equi ty share cap ita l . The equi ty contr ibut ion of venture
capi tal f irm does no t exceed 49 % of the to ta l equity capi ta l o f venture cap ita l under takings so that
the e ffec tive cont rol and ownership remains wi th the entrepreneur .
2) Condit ional loan : I t i s repayable in the fo rm of a royalty a f ter t he venture i s ab le to generate
sa les. No interes t i s pa id on such loans. In India venture cap ital f inancers charge royal ty ranging
between 2 and 15 %, actua l rate depends on o ther fac tors o f the venture as ges ta t ion per iod, cash
f low pat terns, r iskiness and other fac tors o f the enterpr ise . So me venture capi ta l financers give a
cho ice to the enterpr ise of paying a high rate of interes t , which can be wel l belo w 20 %, ins tead of
royalty on sales once i t becomes co mmerc ia l ly sounds.
3) Inco me note : I t i s a hybr id secur i ty combining fea tures o f both convent ional and condit ional
loan. The ent repreneur has to pay interes t and royalty on sa les but , a t substant ial ly lo w ra tes. IDBI 's
Venture Capital Fund (VCF) provides funding equal to 80 - 87.5 % of the projec t cos t for commercial
applicat ion of indigenous technology.
4) Participating debentures : Such securi ty carr ies charges in 3 phases - in the star t up phase no
interes t i s charged, next stage - a lo w rate of interest i s charged up to a par t icular leve l o f op erat ion
and after that , a high ra te o f interes t i s required to be pa id.
Question : Write a note on Debt Securit isat ion ?
Answer : Debt secur i t i sat ion i s a method of recycling of funds. I t i s especia l ly beneficial to financia l
in termediar ies to suppor t the lending volumes. Asse ts genera t ing steady cash flo ws are packaged
together and against th is asse t pool market secur i t ies can be i ssued. The basic debt securi t i sa t ion
process can be c lass i fied in the fol lowing 3 functions :
1) The Orig ination funct ion : A borro wer seeks a loan from a finance company, bank, housing
company or a lease from a leasing company. The cred itworthiness o f the borrower i s evaluated and a
contract is entered into wi th repayment schedule s truc tured over the l i fe o f the loan.
2) The Pooling function : Similar loans or receivab les are clubbed together to create an underlying
pool o f assets. This pool i s t ransferred in favour o f a SPV (Specia l Purpose Vehic le) , which ac ts as a
trus tee for the investor . Once the assets are transfer red, they are he ld in the or iginators ' por t fo l io .
3) The Securit isat ion function : I t i s the SPV's job now to structure and i ssue the securi t ies on the
bas is o f the asse t pool . The secur i t ies carry a coupon and an expected matur i ty which can be asse t
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based or mor tgage based. These are general ly so ld to investors through merchant bankers . The
investors interested in this type of securi t ies are general ly ins t i tut iona l investors l ike mutua l funds,
insurance co mpanies , e tc . The or iginator usua lly keeps the sp read ava i lable i .e . d i f ference be tween
yield from secured asse ts and interest pa id to investors. The process of securi t i sat ion i s general ly
wi thout recourse i .e . the investor bears the credit r isk or r isk o f defaul t and the i ssuer i s under an
obliga tion to pay to investors only i f the cash f lows are rece ived by him from the col la tera l . The r i sk
run by the investor can be fur ther reduced through cred it enhancement faci l i t ies as insurance, le t ter s
of cred it and guarantees . In a simple pass through s truc ture, the investor owns a proport ionate share
of the asset pool and cash f lows when generated are passed on d irect ly to the investor . This i s done
by i ssuing pass through cer t i ficates. In mortgage or asse t backed bonds, the investor has a l ien on the
under lying asse t pool . The SPV accumulates payments from borrowers f rom time to t ime and make
payments to investors a t regular predetermined interva ls. The SPV can invest the funds rece ived in
short term inst ruments and improve yie ld when there i s a t ime lag between receip t and payment.
Benef it s to the Orig inator :
1) The assets are shi f ted off the balance shee t , thus, giving the o r iginator recourse to o ff ba lance
shee t funding.
2) I t converts i l l iquid asse ts to l iquid port fo l io .
3) I t faci l i ta tes bet ter bala nce sheet management as assets are t ransferred off balance shee t
faci l i ta t ing sa t i s fact ion of capi ta l adequacy norms.
4) The or igina tor 's credi t ra t ing enhances.
For the investor , secur i t i sat ion opens up new investment avenues. Though the investor bear s the
credi t r i sk. The secur i t ies a re t ied up to def ini te assets. As compared to factor ing or bi l l d iscount ing
which large ly solve the problems of shor t term trade f inancing. Secur i t isat ion he lps to conver t a
stream of cash receivab les into a source of lon g term f inance. For a developed securi t i sat ion market ,
high qual i ty asse ts wi th lo w default rate are essentia l wi th standard ised loan documenta tion and
stable interes t rate structure and suff ic ient da ta on asset per formance, developed secondary debt
markets are essent ial fo r this . In Indian context debt securi t i sa t ion has began to take off. The ideal
candida tes for this are hi re purchase and leasing companies, asset f inance and rea l es ta te finance
companies . ICICI, HDFC, Ci t ibank, Bank of America, e tc . hav e or are planning to ra ise funds by
securi t i sa t ion.
Quest ion : Explain brief ly the term Lease Financing ?
Answer : Leasing i s a genera l contract between the owner and user o f the asset over a spec i fied
per iod of t ime. The asse t i s purchased ini t ia l l y by the lessor ( leasing company) and thereafter leased
to the user ( lessee company) tha t pays a speci f ied rent a t per iodical interva ls . Thus, leasing is an
al terna tive to the purchase of an asse t out o f own or borro wed funds. Moreover , lease f inancing can
be arranged much faster as compared to term loans from financial inst i tut ions. In recent years,
leasing has become a popular source of financing in Ind ia. From the lessee 's view point , leasing has
the at trac t ion of el iminating immediate cash out flow and t he lease rentals can be deducted for
computing the total income under the Income tax act . As against this , buying has the advantages o f
deprec iat ion al lowance inclus ive of addi t ional deprec iat ion and interest on borro wed capi ta l being
tax deduct ible . Thus, an evaluat ion of the 2 al te rna tives i s to be made in order to take a dec is ion.
Quest ion : Explain the various sources of short term f inance ?
Answer : Follo wing are the var ious sources o f shor t term f inance :
1) Trade credit : I t represents credi t granted by suppl iers o f goods , e tc . as an inc ident o f sa le . The
usual durat ion of such credi t i s 15 to 90 days. I t generates automatica l ly, in the course o f business
and i s co mmon to a lmost a l l business opera t ions. I t can be in the form of an 'open account ' or 'b i l l s
payable ' . Trade credi t i s preferred as a source of finance as i t i s wi thout any explici t cos t and t i l l a
business i s a go ing concern, i t keeps on ro tat ing. I t a l so, enhances automatica l ly wi th the increase in
the volume of business.
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2) Advances fro m customers : Manufac turers and cont rac tors engaged in producing or construc ting
cost ly goods involving considerab le length of manufac tur ing or construc tion t ime usual ly, demand
advance money from the ir customers a t the t ime of accep ting th e i r orders for executing the ir
contracts or supplying the goods. This i s a cos t free source of f inance and real ly useful .
3) Bank advances : Banks receive deposi t s from public for di fferent per iods at varying rates o f
interes t there are funds invested and lent in such a manner tha t when required, they may be called
back. Lending result s in gross revenues out o f which costs , such as interes t on deposi t s ,
adminis tra t ive costs, e tc . are met and a reasonable prof i t i s made . A bank 's lend ing pol icy is no t
merely prof i t mot iva ted but has to keep in mind the soc io -economic development o f the country. As a
prudent po licy, banks normal ly spread out their funds as under :
i ) About 9 - 10 % in cash.
i i ) About 32 % in approved government and semi -government securi t ies.
i i i ) About 58 % in advances to the ir credi ts .
Banks advances a re in the fo rm of loan, overdraf t , cash cred it and bil l s
purchased/d iscounted, e tc . Banks do no t sanc tion advances on long term basis beyond a small
proport ion of the i r demand and t ime l iab il i t ies. Advances are granted aga inst tangib le securi t ies such
as goods, shares, government pro missory no tes , b i l l s , e tc . In rare cases, c lean advances may a lso be
al lo wed.
a) Loans : In a loan account, the ent ire advance i s d isburs ed a t one t ime in cash or by transfer to the
cur rent account o f the borrower. I t i s a single advance, except by way of interes t and other charges,
no fur ther adjustments are made in this account. Loan accounts a re not running accounts l ike
overdraft and ca sh credi t accounts, repayment under the loan account, may be ful l amounts or by way
of schedule o f repayments agreed upon as in case o f terms loans. The securi t ies may be shares,
government secur i t ies, l i fe insurance pol icies and f ixed deposit receip ts and so on.
b) Overdrafts : Under this faci l i ty, cus tomers are a l lo wed to wi thdraw in excess o f credi t balance
standing in the ir current deposi t account. A fixed l imi t i s thus, granted to the borro wer wi thin which
the borrower is a l lo wed to overdraw his acc ount . Opening of an overdraft account requires that a
cur rent account is formally opened. Although overdraf ts are repayable on demand, they usually
continue for long per iods by annual renewals of l imi ts. This i s a convenient arrangement for the
borrower, as he i s in a posi t ion to ava il the sanct ioned l imi t as per his requirements. Interest is
charged on dai ly ba lances, cheque books are provided, these accounts being operat ive as cash credi t
and cur rent accounts . Secur i ty, as in case of loan accounts, may be shares, debentures and
government secur i t ies, l i fe insurance pol ic ies and f ixed deposi t rece ipts a re a lso accep ted in specia l
cases.
c) Clean overdrafts : Request for such faci l i ty is enter tained only from financial ly sound par t ies tha t
are reputed for the ir in tegr i ty. Bank i s to re ly on personal secur i ty o f the borrowers , thus, i t has to
exerc ise a good dea l o f res tra int in enter ta ining such proposals, as they have no backing of any
tangib le securi ty. In case par t ies are a lready enjoying secured advanc e faci l i t ies, this may be a point
in favour and may be taken into account whi le screening such proposa ls . The turnover in the account,
sa t i s factory dealings for considerab le per iod and reputat ion in the market are a lso considered by the
bank. As a safeguar d, banks take guarantees from o ther persons who are credi t worthy before granting
this fac i l i ty. A clean advance i s general ly granted for a short per iod and must not be cont inued for
long.
d) Cash credits : Cash credi t i s an arrangement under which, a cu s tomer is al lowed an advance upto
cer tain l imi t aga ins t credit granted by bank. Under i t , a cus tomer need not borro w, the ent ire amount
of advance at one t ime. He can only draw to the extent o f his requi rements and deposit h is surp lus
funds in his account. Interest is not charged on the ful l amount o f advance but , on the amount
actua lly avai led by him. Usually, credi t l imi ts a re sanct ioned aga inst the securi ty o f goods by way of
pledge or hypothecat ion, though they are repayable on demand, banks usual ly do no t recal l them,
unless they are compel led to do so by adverse fac tors. Hypotheca tion i s an equi tab le charge on
movable goods fo r an amount o f deb t where neither possess ion nor ownership i s passed on to the
credi tor . For p ledge, the borrower de livers the g oods to the credi tor as securi ty for repayment o f
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debt. S ince the banker , as credi tor , i s in possession of the goods, he i s ful ly secured and in case o f
emergency he may fal l back on the goods for real isat ion of his advance under proper no tice to the
borrower.
e) Advances against goods : Advances aga ins t goods occupy an impor tant place in total bank credit ,
goods as securi ty have cer ta in dis t inc t advantages :
- they provide a re l iable source of repayment
- advances aga ins t goods are safe and l iquid
Genera lly, goods are charged to the bank by way of pledge or hypotheca tion. The term
'goods ' inc ludes al l fo rms of movables tha t are o ffered to the bank as secur i ty. They may be
agr icultural commodi t ies, industr ial raw mater ials , par t ly f inish ed goods and so on. RBI issues
direc t ives from t ime to t ime imposing res tr ict ions on advances against cer ta in commodit ies. I t is
obliga tory on banks to fol lo w these direct ives in let ter and spir i t , they may so met imes, also st ipulate
changes in margin.
f ) Bil l s purchased/discounted : These advances are al lowed against the secur i ty o f bi l l s tha t may be
clean or documentary. Bi l l s are sometimes, purchased from approved customer, in whose favour
l imi ts are sanc tioned. Before granting a l imi t , the banker sa t i s f ies himsel f as to the credi twor thiness
of the drawer. Al though the term 'b i l ls purchased ' g ives the impress ion that the bank becomes the
owner or purchaser o f such bi l l s , in real i ty, the bank holds the b i l l s as securi ty only, for the advance.
In add it ion to the r ights aga inst the par t ies l iable on the bi l ls , the banks can a lso exerc ise a pledgee 's
r ights over the goods covered by the documents. Usuance bi l l s matur ing at a future da te or s ight are
discounted by the banks for approved par t ies . When a b i l l i s discounted, the borrower i s paid the
present wor th. The bankers, ho wever , col lec t the ful l amounts on maturi ty, the di ffe rence between the
2 i .e . the amount o f the bi l l and the discounted amount represents earnings o f bankers for the per iod;
i t is termed as 'd iscount ' . So met imes, overdraf t or cash credi t l imi ts are al lo wed agains t the secur i ty
of b i l l s . A suitable margin i s usua lly mainta ined. Here the bi l l i s not a pr imary secur i ty but , only a
collate ral one. In such case , the banker does not become a pa r ty to the bi l l , but merely co llects i t as
an agent for i t s customer. When a banker purchases o r discounts a bi l l , he advances agains t the bi l l ,
he thus , has to be very caut ious and grant such faci l i t ies only to cred itworthy customers, having an
es tabl i shed steady rela t ionship wi th the bank. Credit reports are also complied on the drawees.
g) Advance against documents of t it le to goods : A document becomes of document o f t i t le to goods
when i ts possession i s recognised by law or business custo m as possess ion of the goods. These
documents inc lude a b i l l o f lad ing, dock warehouse keeper 's cer t i f icate , ra i lway receip t , e tc . A
person in possession of a document to goods can by endorsement or delivery or both of document,
enables ano ther person to take del ivery of the goods in his r ight . An advance aga ins t p ledge of such
documents i s equivalent to an advance aga inst the pledge of goods themselves.
h) Advance against supply of bi l l s : Advances against b i l l s for supply of goods to government or
semi-government departments aga ins t firm orders a f ter accep tance of tender fal l under this category.
Other type of bi l l s under this ca tegory are bi l l s f rom contrac tors for work executed wholly or
par t ial ly under fi rm contrac ts entered into wi th the here in mentioned governm ent agencies. These are
clean bi l l s , wi thout being accompanied by any document o f t i t le o f goods. But, they evidence supply
of goods direct ly to Governmental agencies. They may, sometimes, be accompanied by inspect ion
notes from representa t ives o f governme nt agencies for inspec ting the goods before despatch. I f b i l l s
are wi thout inspect ion report , banks l ike to examine them wi th the accepted tender or cont ract for
ver i fying that the goods supplied under the bi l l s s tr ict ly conform to the terms and condi t ions in the
accep tance tender . These supply bi l l s represent deb t in favour o f suppliers /cont rac tors, for goods
suppl ied to government bodies or work executed under contrac t fro m the Government bodies . This
debt i s ass igned to the bank by endorsement of supply b il l s and execut ing ir revocable power o f
at torney in favour of banks for rece iving the amount o f supply bil l s f rom the Government
departments. The po wer of at torney has got to be regis tered wi th the depar tment concerned . The
banks a lso take separate let te r from the suppliers/contractors ins truc ting the Government body to pay
the amount o f bi l l s d irect to the bank. Supply b il l s do no t enjoy the legal s ta tus o f negotiab le
ins truments as they are not b i l l s o f exchange. The secur i ty ava ilab le to a banker i s by way of
assignment o f deb ts represented by the supply b il l s .
i ) Term loans by banks : I t i s an instalment credi t repayable over a per iod of t ime in
monthly/quar ter ly/ha l f -year ly or year ly instalments. Banks grant te rm loans for smal l projects fa l l ing
under the pr ior i ty sec tor , small scale sec tor and big unit s . Banks have now been permi tted to sanc tion
term loan for projects as well wi thout assoc ia t ion of financial inst i tut ions. The banks grant loans for
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periods normal ly ranging from 3 to 7 years and at t imes even more. These loans are granted on the
securi ty o f fixed asse ts .
j ) Financing of exports by banks : Advances by commerc ia l banks for expor t f inancing are in the
form of :
a) Pre-shipment f inance i . e . before shipment of goods : This usua l ly, takes the form of packing
credi t fac i l i ty, which i s an advance extended by banks to an exporter for the purpose of buying,
manufac tur ing, process ing, packing, shipping goods to overseas buyers. Any exporter , having at hand
a firm expor t order placed wi th him by his fore ign buyer o r an ir revocable let ter o f credi t opened in
his favour , can approach a bank for ava il ing packing credi t . An advance so taken requires to be
l iquidated wi thin 180 days from the date o f i t s commencement by negotia t ion of export proceeds in
an approved manner . Thus, packing credi t i s essentia l ly a short te rm advance. Usually, banks ins ist
on their cus tomers to lodge wi th them irrevocable le t ter s o f cred it opened in favour o f the customers
by overseas buyers. The le t ter o f cred it and f irm sale contracts no t only serve as evidence of a
def ini te arrangement fo r rea l i sa t ion o f the export proceeds but also indica te the amount o f finance
required by the expor ter . Packing c redi t in case of cus tomers o f long s tand ing, may also be granted
against f irm contracts entered into by them wi th overseas buyers. Fo llowing are the types o f packing
credi t avai lable :
i ) Clean packing credit : This i s an advance avai lable to an expor ter only on product ion of a f irm
expor t order or a le t te r o f credi t wi thou t exercising any charge or control over raw mater ial or
f inished goods. Each proposa l i s weighted according to par t icular requirements o f trade and credit
worthiness o f the expor ter . A sui tab le margin has to be mainta ined. Also, Expor t Credi t Guarantee
Corpora tion (E.C.G.C.) cover should be obtained by the bank.
i i ) Packing credit against hypothecation of goods : Expor t f inance i s made avai lable on cer tain
terms and condi t ions where the expor ter has pledgeable interes t and the goods are hypotheca ted to th e
bank as securi ty wi th s t ipula ted margin. At the t ime of ut i l i sing the advance, the exporter i s requi red
to sub mit , a long wi th the firm export order or le t ter o f credi t , re la t ive s tock s ta tements and thereafter
continue submitt ing them every for tnight and /or whenever there i s any movement in s tocks.
i i i ) Packing credit against pledge of goods : Expor t finance i s made ava ilable on cer ta in terms and
condit ions where the expor table f inished goods are p ledged to the banks wi th approved clear ing
agents who wo uld ship the same from time to t ime as required by the expor ter . Possession of goods
so pledged l ies wi th the bank and are kep t under i t s lock and key.
iv) E.C.G.C. guarantee : Any loan given to an expor ter for the manufacture, process ing, purchasing
or packing of goods meant for export agains t a f irm order quali f ies for packing. Credi t guarantee i s
issued by the Expor t Credit Guarantee Corpora t ion (E.C.G.C.) .
v) Forward exchange contract : Another requi rement o f packing cred i t fac i l i ty is tha t i f the e xpor t
bi l l is to be drawn in a foreign currency, the exporter should enter into a forward exchange cont rac t
wi th the bank, thereby avoiding r i sk involved in a poss ible change in the exchange ra te .
Documents required : - In case o f par tnership f irms, ban ks usua lly requi re the fo l lo wing documents :
Joint and severa l demand pronote s igned on behal f o f the f irm as also by par tners
ind ividual ly;
Let ter o f cont inui ty, signed on behal f o f the f irm and par tners individually;
Let ter o f p ledge to secure deman d cash credi t against stock, in case o f p ledge or agreement
of
hypothecat ion to secure demand cash cred it , in case o f hypothecat ion.
Let ter o f author i ty to operate the account ;
Declarat ion of Par tnership , in case o f so le traders, so le propr ie tors hip declarat ion;
Agreement to ut i l i se the monies drawn in terms of contract ;
Let ter o f hypotheca tion for bi l l s .
- Fol lowing documents a re requi red by banks , in case o f l imi ted companies :
Demand pro -note;
Let ter o f cont inui ty;
Agreement o f hypoth ecation of let ter o f p ledge, signed on behal f o f the company;
General guarantee o f the directors ' resolution;
Agreement to ut i l i se the monies drawn in terms of contract should bear the company's seal;
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Let ter o f hypotheca tion for bi l l s
b) Post shipment f inance : I t takes the be low mentioned forms :
i ) Purchase /Discount ing of documentary export bil ls : Finance i s provided to expor ters by
purchasing expor t bi l ls drawn payable at sight or by discounting usuance export bi l l s cover ing
confirmed sales and backed by documents inclusive of documents o f t i t le to goods such as bi l l o f
lading, post parce l receipts o r a ir consignment notes. Documents to be obtained are :
Let ter o f hypothecat ion covering the goods; and
General guarantee o f directors or par tners o f the f irm, as the case may be.
E.C.G.C. Guarantee : Post -shipment f inance , given to an expor ter by bank through purchase,
negotiat ion or discount of an expor t bi l l aga ins t an order , qua li f ies for post -shipment expor t c redit
guarantee. I t i s necessary, t ha t exporters obta in a shipment or contrac ts r isk pol icy of E.C.G.C. Banks
ins ist on the exporters to take a contracts shipments (co mprehensive r isks) pol icy covering both
poli t ical and commercia l r isks. The Corpora tion, on acceptance of the policy, would fix cred it l imi ts
for ind ividual exporters and the Corporat ion 's l iabi l i ty wi l l be l imi ted to the extent o f the l imit so
f ixed for the exporter concerned ir respect ive o f the policy amount.
i i ) Advance against export bil ls sent for col lect ion : Finance is provided by banks to expor ters by
way of advance agains t expor t bi l ls forwarded through them for col lect ion, taking into account the
par ty's cred itworthiness , na ture o f goods exported, usuance , s tanding of drawee, e tc . appropriate
margin is kept . Document s to be obta ined :
Demand promissory no te;
Let ter o f cont inui ty;
Let ter o f hypothecat ion covering b il l s;
General guarantee o f directors or par tners o f the f irm, as the case may be.
i i i ) Advance against duty draw backs, cash subsidy, etc . : To finance export losses sustained by
expor ters, bank advance aga inst duty draw -back, cash subsidy, e tc . rece ivable by them against expor t
per formance. Such advances are o f c lean nature, hence, necessary precaut ion is to be exercised .
Condit ions : Bank providing fin ance in this manner should see tha t the rela t ive expor t bi l l s a re e i ther
negotiated or forwarded for col lec t ion through i t so that , i t i s in a posi t ion to ver i fy the exporter 's
c la ims for duty draw-backs, cash subsidy, e tc . An advance so ava iled by an exp orter i s required to be
l iquidated wi thin 180 days from the date o f shipment o f relat ive goods.
Documents to be obtained are :
Demand promissory no te;
Let ter o f cont inui ty;
General guarantee o f directors or par tners o f the f irm, as the case may be.
Undertaking fro m the borrowers that they wi l l deposit the cheques/payments received from the
appropria te author i t ies immediately wi th the bank and wi l l not ut i l ise such amounts in any
other way.
c) Other faci l it ies extended to exporters :
i ) On behal f o f approved exporters, banks estab li sh le t ter s o f cred it on the ir overseas o r up -country
suppl iers.
i i ) Guarantees for waiver o f excise duty, etc . due per formance of cont rac ts , bond in l ieu of cash
securi ty deposi t , guarantees for advance payments, e tc . are a lso i ssued by banks to approved c l ients.
i i i ) To approved c l ients under taking expor ts on deferred payment terms, banks also provide f inance.
iv) Banks a lso endeavour to secure for their expor ter -customers status repor ts o f their buyers and
trade
information on var ious commodit ies through thei r correspondents .
v) Economic inte l l igence on var ious countr ies is al so provided by banks to the ir exporte r c l ients.
5) Inter corporate deposit s : The companies can borrow funds for a shor t per iod say 6 m onths from
other companies having surp lus l iquidi ty. The rate o f interest on i t var ies depending on the amount
involved and t ime per iod.
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6) Cert if icate of deposi t (CD) : I t i s a document of t i t le s imi lar to a t ime deposit rece ipt issued by a
bank excep t , tha t there i s no prescr ibed interes t rate on such funds. I t s main advantage i s tha t banker
is not required to encash the deposi t before matur i ty per iod and the investor is assured of l iquidity as
he can se l l i t in the secondary market .
7) Public deposit s : They are important source of shor t and medium term f inances par t icular ly due to
credi t squeeze by the RBI. A company can accept such deposi ts subject to the st ipula t ions o f the RBI
from t ime to t ime maximum upto 35 % of i ts paid up capi tal and reserves , fro m the publ ic and the
shareholders. These may be accep ted for a per iod of 6 months to 3 years. Publ ic deposi t s are
unsecured loans, and no t meant to be used for acquisi t ion of fixed asse ts, s ince, they are to be repaid
wi thin a per iod of 3 years. These are mainly used to finance working capita l requirements.
Quest ion : Enumerate and expla in the other sources of f inancing ?
Answer : The o ther sources o f financing are as d iscussed belo w :
1)Seed capital ass istance : The seed cap ita l assis tance scheme is designed by IDBI for
profess ional ly or technical ly quali f ied entrepreneurs and/or persons possess ing relevant exper ience,
ski l l s and entrepreneur ial t ra i t s . All the projects el igib le for financial assis tance from IDBI , d irec t ly
or ind irec tly thro ugh ref inance are el igib le under the scheme. The project cost should not exceed Rs.
2 crores and the maximum ass istance under the project wi l l be res tr icted to 50 % of the requi red
promoter 's cont r ibut ion or Rs. 15 lakhs, whichever i s lower. Seed capi tal a ssis tance is in teres t free,
but carr ies a service charge of 1 % per annum for the f irs t 5 years and at increas ing rate thereaf ter .
However , IDBI wi l l have the op tion to charge interest a t such ra te as determined by i t on the loan i f
the financial posi t ion and prof i tab il i ty o f the company so permi ts dur ing the currency of the loan.
The repayment schedule is f ixed depending on the repaying capacity o f the unit wi th an ini t ia l
morator ium upto 5 years. For projec ts wi th cost exceeding Rs. 200 lakhs, seed cap ita l may be
obtained from the Risk Capital and Technology Corporat ion Ltd. (RCTC). For smal l projec ts cost ing
upto Rs. 5 lakhs , assistance under the National Equity Fund of the SIDBI may be avai led.
2)Internal cash accruals : Exist ing profi t making compani es under taking an
expansion/d ivers i ficat ion programme may be permit ted to invest a par t of the ir accumulated reserves
or cash profi ts for creat ion of cap ita l asse ts . In such cases, the company's pas t per formance permits
capi tal expendi ture from wi thin the company by way of disinvestment of working/invested funds. In
other words, the surp lus generated from operat ions, a f ter meet ing al l the contractua l , s ta tutory and
working requirement o f funds, is ava ilable for fur ther capi ta l expenditure.
3)Unsecured loans : They are provided by promoters to meet the promoters ' contr ibution norm.
These loans are subord inate to inst i tut ional loans and interes t can be paid only a f ter payment o f
ins t i tut iona l dues. These loans cannot be repaid wi thout the pr ior approval o f f inancia l ins t i tut ions.
Unsecured loans are considered as par t o f the equi ty for the purpose of calculat ing deb t equity ra t io .
4)Deferred payment guarantee : Many a t ime supplie rs o f machinery provide a deferred credi t
faci l i ty under which payment for th e purchase of machinery may be made over a per iod of t ime. The
entire cost o f machinery i s f inanced and the company is not required to contr ibute any amount
ini t ia l ly to wards acquis i t ion of machinery. Normally, the supplier o f machinery would insis t that t he
bank guarantee be furnished by the buyer . Such a fac i l i ty does no t have a morator ium period for
repayment. Hence, i t is advisable only for an exis t ing profi t making company.
5)Capital Incent ives : Backward area development incentives avai lab le of ten determine the locat ion
of a new industr ial unit . They usually consist o f a lumpsum subsidy and exemption fro m or deferment
of sa les tax and octro i duty. The quantum of incentives i s de termined by the degree of backwardness
of the loca tion. Specia l capi tal incent ive in the form of a lumpsum subsidy i s a quantum sanct ioned
by the implement ing agency as a percentage of the f ixed capi tal investment subjec t , to an overal l
cei l ing. This amount fo rms a par t o f the long -term means of f inance for the project . Ho weve r , the
viabi l i ty o f the projec t must no t be dependent on the quantum and avai lab il i ty o f incentives.
Inst i tut ions, whi le appraising the projec t , assess i t s viab il i ty per se, without consider ing the impact
of incentives on the cash f lo ws and the project 's p rofi tab il i ty. Specia l capi tal incent ives a re
sanc tioned and released to the unit s only a f te r they have compl ied wi th the requi rements of the
relevant scheme. The requirements may be classi f ied into ini t ial effec t ive s teps, that inc lude
format ion of the f ir m/company, acquis i t ion of land in the backward area and registra t ion for
manufac ture o f the p roducts. The fina l e ffec t ive s teps include obtaining clearances under FEMA,
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capi tal goods clearance/ import l icense , conversion of Let ter o f Intent to Industr ial Li cense, t ie up of
the means of finance, a l l c learances required for the se t t ing up of the uni t , aggregate expenditure
incurred for the projec t should exceed 25 % of the project cos t and a t leas t 10 %, i f the fixed asse ts
should have been crea ted/acquired at si te . The release of spec ia l capi ta l incent ives by the concerned
Sta te Government general ly takes 1 to 2 years. Promoters thus, find i t convenient to avai l the br idge
f inance agains t the cap ita l incent ives. Provis ion for the same should be made in the pre -operat ive
expenses considered in the projec t cost . As the b r idge finance may be available to the extent o f 85 %,
the ba lance i .e . 15 % may have to be brought in by the promoters fro m the ir o wn resources .
6)Various short term provisions/accruals account : Accruals accounts are a spontaneous source of
f inancing as they are sel f -genera t ing. The most common accrual accounts are wages and taxes. In
both cases, the amount becomes due but is not pa id immediate ly.
Quest ion : Write short notes on :
1) Deep Discount Bonds 2) Secured Premium Notes
3) Zero interest fully convert ible debentures 4) Zero Coupon Bonds
5) Double Opt ion Bonds 6) Option Bonds
7) Inflat ion Bonds 8) F loating Rate Bonds
Answer :
1) Deep Discount Bonds : I t i s a form of a zero interes t bond , so ld at a discounted value and on maturi ty face va lue i s
paid to the investors. In such b onds, there i s no interes t paid during lock in per iod . IDBI was the fir st
to issue a deep discount bond in India in January, 1992. I t had a face va lue of Rs. 1lakh and was so ld
for Rs. 2700 wi th a matur i ty per iod of 25 years. The investor could hold the bo nd for 25 years o r
seek redemption at the end of every 5 years wi th matur i ty value as be low :
Holding period (years) 5 10 15 20 25
Maturity value (Rs.) 5700 12000 25000 50000 100000
Annual rate of interest
(%) 16.12 16.09 15.99 15.71 15.54
The investor can se l l the bonds in stock market and rea li se the di fference between face
va lue (Rs. 2700) and the market pr ice as cap ita l ga in.
2) Secured Premium Notes : I t i s i ssued along wi th a detachable warrant and i s redeemable af t er a not i fied per iod of say
4 to 7 years. The conversion of detachable warrant into equity shares wil l have to be done wi thin the
t ime per iod not i fied by the company.
3) Zero interest fully convert ible debentures : These are ful ly convert ib le debentures which do not carry any interest . They are
compulsori ly and automatica l ly conver ted after a speci f ied per iod of t ime and holders thereof are
enti t led to new equi ty shares of the company at predetermined pr ice . From the company's view point ,
th is kind of ins trument i s benefic ia l in the sense , that no interest i s to be paid on i t , i f the share pr ice
of the company in the market i s very high, then the investor tends to get equi ty shares of the
company a t a lower ra te .
4) Zero Coupon Bonds : A zero coupon bond does not carry any interest , but i t i s sold by the i ssuing company at a
discount. The di fference between the discounted and matur ing or face value represents the interes t to
be earned by the investor on them.
5) Double Opt ion Bonds : Double Opt ion Bonds are recent ly issued by the IDBI. The face value of each bond is Rs .
5000, i t carr ies interes t at 15 % per annum compounded hal f year ly from the date o f a l lo tment. The
bond has a matur i ty per iod of 10 years. Each h aving 2 par ts , in the fo rm of 2 separate cer t i f icates,
one for the pr incipa l o f Rs. 5000 and other for interest , inc luding redemption premium of Rs. 16500.
Both these cer t i ficates a re l i sted on al l major stock exchanges. The investor has the fac i l i ty o f se l l ing
ei ther one or both par ts anyt ime he l ikes.
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6) Opt ion bonds : These are cumulat ive and non -cumula tive bonds where inte rest i s payable on matur i ty or
per iodica lly. Redemption premium is a lso o ffered to a t t rac t investors. These were r ecently i ssued b y
IDBI, ICICI, etc .
7) Inflat ion bonds : They are bonds in which interes t ra te is adjusted for inf la t ion. The investor , thus, ge ts an
interes t free fro m the e ffects o f inf lat ion. For instance, i f interest rate i s 12 % and inf la t ion rate i s 5
%, the investor wi l l earn 17 %, meaning that the investor i s pro tec ted aga inst inflat ion.
8) Float ing Rate Bonds : As the name suggests , F loa ting Rate Bonds are ones, where the ra te o f interest i s no t f ixed
and i s al lowed to float depending upon the market condit ions. This is an idea l instrument tha t can be
resor ted to by the i ssuer to hedge themselves against the vola t i l i ty in interest rates. This has become
more popular as a money market inst rument and has been successfull y i ssued by f inancia l inst i tut ions
l ike IDBI, ICICI, e tc .
Question : Give a deta iled account of International Financing ?
Answer : The essence of financial management is to raise & uti l i se the funds raised effec tive ly.
There are var ious avenues for o rganisat ions to raise funds ei ther through interna l or external sources.
Externa l sources inc lude :
Commercial banks : Like domest ic loans, commerc ial banks al l over the world extend
Fore ign Currency (FC) loans, for internat ional operat ions . These banks a l so provide to
overdraw over and above the loan amount .
Development banks : o ffer long and medium term loans includ ing FC loans. Many agencies a t
the na tional leve l o ffer a number o f concessions to foreign companies to invest wi thin their
country and to f inance expor ts from their countr ies e .g. EXIM Bank of USA.
Discounting of trade bil l s :This i s used as a shor t term financing method widely, in Europe
and Asian countr ies to f inance both domest ic and internat ional business.
International agencies : A number of inte rnat ional agencies have emerged over the years to
f inance interna tional t rade and business . The more no table among them inc ludes :
Interna tional Finance Corpora tion ( IFC), Interna tional Bank for Reconstruc tion &
Development ( IBRD), Asian Devel opment Bank (ADB), Interna tional Monetary Fund (IMF),
etc .
International capita l markets : Modern organisat ions inc luding MNC's depend upon s izeable borrowings in Rupees as a lso
Fore ign Currency. In order to ca ter to the needs o f such orga nisat ion , interna tional capi ta l markets
have sprung a l l over the globe such as in London. In Interna tional cap ital market , the ava ilab il i ty o f
FC is assured under the 4 main sys tems, as :
Euro-currency market
Expor t credi t faci l i t ies
Bonds i ssues
Financial Ins t i tut ions
The or igin o f the Euro -currency market was wi th the do llar denominated bank deposi t s &
loans in Europe par t icular ly, London. Euro -dollar deposit s are dol lar denominated t ime deposit s
avai lable a t foreign branches o f US bank s and at some fore ign banks. Banks based in Europe accept &
make dol lar denominated deposit s to the cl ients. This forms the backbone of the Euro -cur rency
market a l l over the globe. In this market , funds are made avai lab le as loans through syndica ted Euro -
credi t o f ins truments as FRN's, FR cer t i f ica tes o f deposit s .
Below ment ioned are some of the f inancial instruments : 1) Euro Bonds : Euro Bonds are deb t instruments denominated in a currency issued outs ide the
country o f tha t currency, fo r instance : a ye n no te floa ted in Germany.
2) Foreign Bonds : These are deb t instruments denominated in a currency which i s fore ign to the
borrower and i s sold in the country o f that currency.
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3) Ful ly Hedged Bonds : In foreign bonds, the r isk o f currency f luc tuations exists . They el iminate
the r isk by sel l ing in forward markets the ent ire stream of pr inc ipa l and interest payments.
4) Floating Rate Notes : They are i ssued upto 7 years matur i ty. Interest rates are adjus ted to re f lec t
the prevai l ing exchange rates. The y provide cheaper money than foreign loans.
5) Euro Co mmercial Papers (ECP) : ECP 's are short term money market instruments, wi th maturi ty
of less than 1 year and des ignated in US dol lars.
6) Foreign Currency Option : A FC Option is the r ight to buy or se l l , spot o r future or forward, a
spec i fied fore ign currency. I t p rovides a hedge aga inst f inancia l and economic r isks.
7) Foreign Currency Futures : FC Futures are obligat ions to buy or sel l a speci f ied currency in the
present for set t lement at a futu re da te.
8) Euro Issues : In the Indian context , Euro Issue denotes tha t the issue is l i s ted on a European Stock
Exchange. Ho wever , subscr ipt ion can come from any par t o f the world excep t India. Finance can be
raised by Global Deposi tory Receipts (GDR), Foreign Currency Conver t ible Bonds (FCCB) and pure
debt bonds. However , GDR's and FCCB's are more popular .
9) Global Depository Receipts : A deposi tory receip t i s basica l ly a negotiab le cer t i f icate ,
denominated in US Dollars representing a non US company 's publicly traded loca l currency (Indian
Rupee) equi ty shares, . Theoret ical ly, though a depository rece ipt can also s igni fy debt instrument,
pract ica l ly i t rare ly does so. DR's are created when the loca l currency shares o f an Ind ian company
are del ivered to the deposi tory's local cus todian bank, against which the deposi tory bank i ssues DR's
in US Dol lars. These DR's may be freely traded in the overseas - markets l ike any o ther dollar
denominated securi ty via ei ther a fore ign stock exchange or through a over the counter market or
among a restr ic ted group as Qual i fied Ins t i tut iona l Buyers (QIB). Rule 144 A of the Secur i t ies and
Exchange Co mmission (SEC) of USA permi ts companies fro m outs ide USA to o ffer the ir GDR's to
cer tain ins t i tut iona l buyers, known as QIBs.
10) GDR with Warrant : These receip ts are more at trac t ive than p la in GDR's in view of add it ional
va lue of at tached warrants.
11) American Deposito ry Receipts (ADR's) : Deposi tory Receipts i ssued by a company in USA is
kno wn as ADR's. Such receip ts have to be i ssued in accordance wi th the provisions st ipulated by the
SEC, USA that are s tr ingent . In a bid to bypass such str ingent d isclosure norms mand ated by the SEC
for equity shares, the Indian companies have, ho wever , chosen the indirec t route to tap the vast
Amer ican financial market through pr iva te debt p lacement o f GDR's l i s ted in London and
Luxembourg stock exchanges .
Indian companies have preferred the GDR's and ADR's as the US market exposes them to a
higher level or responsibil i ty than a European l is t ing in the areas o f disc losure, costs, l iabi l i t ies and
t iming. The SECs regulat ions set up to protec t the retai l investor base are some what more s tr ingent
and onerous, even for companies a lready l i sted and he ld by reta i l investors in the ir home country.
Most onerous aspec t of a US l is t ing for companies i s to provide full , ha l f year ly and quarter ly
accounts in accordance wi th or at le as t reconciled with US GAAPs. However , Ind ian companies are
shedding the ir reluctance to tap the US markets as evidenced by Infosys Technologies Ltd. recent
l i st ing in NASDAQ. Most o f India 's top no tch companies in the pharmaceut ica l , info - tech and other
sunrise indust r ies are p lanning forays into the US markets. Another prohibit ive aspec t o f the ADR's
vis -à -vis GDR's i s the cost involved of prepar ing and f i l l ing US GAAP accounts. Addit iona lly, the
ini t ia l SEC registrat ion fees based on a percentage of issu e size anmd 'Blue Sky' regis tra t ion costs ,
permi tt ing the secur i t ies to be o ffered in al l S tates o f US, wi l l have to be met. The US market i s
wide ly recognised as the most l i t igious market in the wor ld. Accordingly, the broader the targe t
investor base in US, higher i s the potent ia l legal l iabi l i ty. An important aspec t of GDR is tha t they
are non vot ing and hence spe ll s no dilut ion of equi ty. GDRs are se t t led through CEDEL and Euro -
clear Interna tional Book Entry Systems.
Other types of Internat ional i ss ues :
Foreign Euro Bonds : In domestic cap ital markets o f var ious countr ies the Bond issues
referred to above are kno wn by d i fferent names as Yankee Bonds in US, Swiss Frances in
Swi tzer land, Samurai Bonds in Tokyo and Bulldogs in UK.
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Euro Convertible Bonds : A conver t ib le bond i s a deb t ins trument giving the holders o f the
bond an op tion to convert the bonds into a pre -determined number o f equity shares o f the
company. Usual ly, the pr ice o f equi ty shares a t the t ime of conversion wi l l have a premium
element. They car ry a f ixed rate o f interest and i f the i ssuer company so desires may also
include a Call Option, where the i ssuer company has the op tion of ca l l ing/buying the bonds
for redempt ion pr io r to the maturi ty date, or a Put Opt ion, which gives the ho lder the op tion
to put /sel l his bonds to the i ssuer co mpany a t a p re -determined da te and pr ice.
Euro Bonds : Plain Euro Bonds are nothing but debt instruments. These are not very
at trac t ive for an investor who des ires to have va luable add it ions to his inve stments.
Euro Convertible Zero Bonds : These are struc tured as a conver t ib le bond. No interes t i s
payable on the bonds. But convers ion of bonds take place on maturi ty at a pre -determined
pr ice. Usual ly, there i s a 5 years matur i ty per iod and they are treat ed as a deferred equity
issue .
Euro Bonds with Equity Warrants : These car ry a coupon ra te determined by market ra tes.
The warrants are de tachable . Pure bonds are traded at a d iscount. Fixed Income Funds
Management may l ike to invest for the purposes of re gular income.
Important Note for Students
Concentrate equally on theoretical portion of Cost & FM. Near
about 35% to 40% of the questions asked in examination
relates to theory. So, it gives you an assurance to get positive