Financial, Treasury and Forex Management

STUDY MATERIAL
PROFESSIONAL PROGRAMME
FINANCIAL TREASURY
AND FOREX
MANAGEMENT
MODULE 2
PAPER 5
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ii
FINANCIAL, TREASURY AND FOREX MANAGEMENT

The company secretaries by virtue of their expertise in the corporate laws and procedure are in eminently
suitable position to:
(a) Present to the Board of Directors, the financial, legal and personnel aspects of modernisation, expansion,
diversification of the existing projects of new projects;
(b) Obtain the decision from the Board; and
(c) Interact effectively with the financial institutions in the process of procuring the finance.
The legal aspects of finance are becoming increasingly important and a Company Secretary is expected to
successfully and effectively handle, amongst other things, important aspects such as management of public
issues, syndication of loans, obtaining project approvals, raising of finance through public deposits and debentures
or bonds etc. All these essentials require expert knowledge of diverse and complex procedures involved. Realising
that the services of a Company Secretary could be of immense use in this important area, it was thought
necessary to include this paper with a view to equip the students with the requisite fundamentals of the Financial
Management.
It has been the endeavour to provide a blend of theoretical concepts and practical orientation. Topics, such as,
raising finance from financial institutions, dividend policies, etc. requiring legal expertise and procedural knowledge
have been written with a legal bias. Topics such as, project appraisal, financial planning, portfolio management
and securities analysis, working capital management and capital budgeting decisions, treasury management,
forex management, commodity exchange and derivatives have been written keeping in view the financial
management principles and the practical utility. Ample number of practical problems and case studies have
been added to aid the student in their learning process.
Though efforts have been made to provide a self-contained study material yet it may require regular
supplementation as the subject is of a dynamic and fast changing nature. Students are advised to update their
knowledge continuously by reading economic dailies, financial magazines and journal and other relevant literature
including reference and suggested readings on the subject. Students are expected to learn the art of applying
the principles of financial management to real business situations and for this case studies in the area of finance
would prove to be of immense use.
Although care has been taken in publishing this study material, yet the possibility of errors, omissions and/or
discrepancies cannot be ruled out. This publication is released with an understanding that the Institute shall not
be responsible for any errors, omissions and/or discrepancies or any action taken in that behalf.
Should there be any discrepancy, error or omission noted in the study material, the Institute shall be obliged if
the same are brought to its notice for issue of corrigendum in the e-bulletin Student Company Secretary. In the
event of any doubt, students may write to the Directorate of Academics in the Institute for clarification at
[email protected].
iii
SYLLABUS
MODULR II, PAPER 5: FINANCIAL, TREASURY AND FOREX MANAGEMENT (100 Marks)
Level of Knowledge:Expert Knowledge
Objective: To acquire expert knowledge of practical aspects of the management and techniques of financial,
treasury and forex management.
Detailed Contents:
1. Economic Framework
1. Nature and Scope of Financial Management
Nature, Significance, Objectives and Scope (Traditional, Modern and Transitional Approach), Risk-Return
and Value of the Firm, Financial Distress and Insolvency, Financial Sector Reforms and their Impact, Functions
of Finance Executive in an Organisation
2. Capital Budgeting
Time Value of Money, Planning and Control of Capital Expenditure, Capital Budgeting Process Techniques
of Capital Budgeting- Discounted and Non- Discounted Cash Flow Methods, Choice of Methods Capital
Rationing; Risk Evaluation and Sensitivity Analysis, Simulation for Risk Evaluation Linear Programming
and Capital Budgeting Decisions under Constraints and with Multiple Objectives using Mathematical
Programming Models, Inflation, Uncertainty and Evaluation using Statistical Decision Theory, Analysis of
Capital Budgeting, Decisions- Some Case Studies
3. Capital Structure
Meaning and Significance, Capital Structure vis--vis Financial Structure; Planning and Designing; Optimal
Capital Structure, Determinants of Capital Structure; Capital Structure and Valuation - Theoretical Analysis,
EBIT - EPS Analysis, EBITDA Analysis (Earnings before Interest, Tax, Depreciation and Amortization), Risk
and Leverage; Measures of Operating and Financial Leverage, Effects of Leverage on Shareholders Returns
4. Cost of Capital
Meaning; Factors Affecting Cost of Capital ,Measurement of Cost of Capital, Weighted Average Cost of
Capital, Marginal Cost of Capital
5. Financial Services
Meaning, Significance, Scope and Structure of Financial Services, Types of Financial Services- Merchant
Banking, Securitization of Debt, Loan Syndication, Housing Finance, Custodial and Advisory
6. Project Finance
Project Planning - Preparation of Project Report, Project Appraisal under Normal, Inflationary and Deflationary
Conditions, Project Appraisal by Financial Institutions - Lending Policies and Appraisal, Norms by Financial
Institutions and Banks; Loan Documentation, Project Review and Control; Social Cost and Benefit Analysis
of Project. (UNIDO Approach), Term Loans from Financial Institutions and Banks; Lease and Hire Purchase
Finance; Venture Capital Funds; Private Equity; International Finance and Syndication of Loans, Deferred
Payment Arrangements; Corporate Taxation and its Impact on Corporate Financing, Financing Cost
Escalation
iv
7. Dividend Policy
Introduction; Types, Determinants and Constraints of Dividend Policy Forms of Dividend Different Dividend
Theories - Walters Model, Gordons Model and Modigliani-Miller Hypothesis of Dividend Irrelevance Dividend
Policy - Practical and Legal Constraints Corporate Dividend Practices in India
8. Working Capital
Meaning, Types, Determinants and Assessment of Working Capital Requirements, Negative Working Capital
Operating Cycle Concept and Applications of Quantitative Techniques Management of Working Capital Cash, Receivables, Inventories; Financing of Working Capital; Banking Norms and Macro Aspects Factoring
and Forfeiting
9. Security Analysis and Portfolio Management
Security Analysis - Measuring of Systematic and Unsystematic Risk, Fundamental Analysis (Economic,
Industry and Company), Technical Approach and Efficient Capital Market Theory
Portfolio Management - Meaning, Objectives; Portfolio Theory -Traditional Approach; Fixed and Variable
Income Securities, Markowitz Portfolio Theory; Modern Approach - CAPM Model; Economic Value Added,
Sharpe Single & Multi Index Model; Arbitrage Pricing Theory (APT); Risk Adjusted Measure of Performance
10. Derivatives and Commodity Exchanges- An Overview
11. Treasury Management
Meaning, Objectives, Significance, Functions and Scope of Treasury Management, Relationship between
Treasury Management and Financial Management; Role and Responsibilities of Chief Finance Officer
Tools of Treasury Management; Internal Treasury, Controls; Environment for Treasury Management, Liquidity
Management, Regulation, Supervision and Control of Treasury Operations, Implications of Treasury on
International, Banking
12. Forex Management
Nature, Significance and Scope of Forex Management, Foreign Exchange Market and its Structure, Foreign
Exchange Rates and its Determination, Exchange Rate Quotes; Types of Exchange Rates; Forex Trading;
Currency Futures and Options, Foreign Exchange Risk Exposures and their Management; Exchange
Rate Forecasting; Risk in Foreign Exchange Business
13. Practical Problems and Case Studies
LIST OF RECOMMENDED BOOKS

MODULE 2
PAPER 5 : FINANCIAL, TREASURY AND FOREX MANAGEMENT
The students may refer to the given books and websites for further knowledge and study of the subject :
READINGS
1. M.Y. Khan & P.K. Jain
: Financial Management Text and Problems; Tata McGraw Hill Publishing

Co. Ltd., New Delhi.
2. Prasanna Chandra
: Financial Management Theory & Practice; Tata McGraw Hill Publishing

Co. Ltd., New Delhi.
3. I.M. Pandey
: Financial Management (2005); Vikas Publishing House Pvt. Ltd., New Delhi.
4. R.P. Rustagi
: Strategic Financial Management Taxmann Publication Pvt. Ltd.
5. R. Charles Moyer,
James R. McGuign &
William J. Kretlow
: Contemporary Financial Management; West Publishing Company.
6. Rajiv Srivastava &

Anil Mishra
: Financial Management, Oxford University Press
7. J.B. Gupta
8. Ravi M. Kishore
vi
ARRANGEMENT OF STUDY LESSONS

Study Lesson No.
Topic
1.
Nature and Scope of Financial Management
2.
Capital Budgeting
3.
Capital Structure Decisions
4.
Cost of Capital
5.
Financial Services
6.
Project Finance
7.
Dividend Policy
8.
Working Capital
9.
Securities Analysis and Portfolio Management
10.
Derivatives and Commodity Exchanges An Overview
11.
Treasury Management
12.
Forex Management
13.
Practical Problems and Case Studies
vii
CONTENTS
LESSON 1
NATURE, SIGNIFICANCE AND SCOPE OF FINANCIAL MANAGEMENT
Nature, Significance and Scope of Financial Management
Investment Decisions
Financing Decisions
Dividend Decisions
Decision Criteria
Objectives of Financial Management
Profit Maximisation
Wealth Maximisation
Profit Maximization Versus Shareholder Wealth Maximization
Economic Value-Added (EVA)
Value of Firm-Risk and Return
10
Costing and Risk
13
Financial Distress and Insolvency
15
Financial Management as Science or Art
15
Functions of Financial Executives
16
Financial Sector Role and Functions
17
Financial Sector Reforms in India Background
18
Financial Sector Reforms in India: Philosophy and Strategy
18
Salient Features of Financial Sector Reforms in India
19
Improvement in Financial Health
21
Institutional Strengthening
21
Financial Sector Legislative Reforms Commission, 2011
24
Financial Sector Reforms: Some Criticisms
25
Financial Management A New Look
25
LESSON ROUND-UP
26
SELF-TEST QUESTIONS
27
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Page
LESSON 2
CAPITAL BUDGETING
Time Value of Money
30
Use of Time Value of Money
30
Future Value of a lump sum
31
Present Value of a cash flow stream
31
Net Present Value
31
Capital Budgeting- Planning and Control of Capital Expenses
32
Need for Capital Investment
33
Importance of Capital Budgeting
34
Factors Influencing Investment Decision
35
Rationale of Capital Budgeting Decisions
36
Kinds of Capital Budgeting Decisions
36
Planning of Capital Expenditure
37
Capital Rationing
38
Capital Budgeting Process
38
The Payback Method
41
The Average Accounting Rate of Return (ARR) Method
43
Discounted Cash Flow (DCF) Method
45
Comparison of Net Present Value and internal rate of return approach
51
Risk Evaluation and Sensitivity Analysis
54
Simulation for Risk Evaluation
57
Linear Programming and Capital Budgeting Decisions
58
Application of Linear Programming Model
58
Some Case Studies
69
LESSON ROUND-UP
76
SELF-TEST QUESTIONS
77
LESSON 3
CAPITAL STRUCTURE
Meaning of Capital Structure
82
Significant of capital structure
82
Capital Structure vis-a-vis Financial Structure
83
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Page
Planning and Designing of Capital Structure
84
Attributes of a Well Planned Capital Structure
84
Factors Influencing Capital Structure
86
Determinants of Capital Structure
87
Capital Structure and Valuation
88
Capital Structure Theories
88
Criticism of MM Hypothesis
93
EBITDA Analysis (Earnings Before Interest, Tax, Depreciation and Amortization),
97
Limitations of EBITDA
97
Definition of Leverage
98
Types of Leverage
98
Operating Leverage
98
Financial Leverage
99
Distinguish Between Operating Leverage and Financial Leverage
102
Financial BEP
103
Indifference Point
103
Combined Leverage
103
Working Capital Leverage
104
Effects of Leverage oShareholders Returns
105
Risk and Leverage
106
Relationship between Financial Risk and Financial Leverage
109
Some Case Studies
109
LESSON ROUND-UP
112
SELF-TEST QUESTIONS
113
LESSON 4
COST OF CAPITAL
Meaning of Cost of Capital
116
Classification of Cost of Capital
116
Importance of Cost of Capital
117
Factors Determining the Firms Cost of Capital
118
Measurement of Cost of Capital
119
Cost of debt which are issued at Discount
120
Cost of Bond/Debentures redeemable after certain period

x
121
Page
Cost of Preference Share Capital
122
Cost of Irredeemable preference shares
122
Cost of Redeemable preference shares
123
Cost of Equity Capital- CAPM model
123
Cost of Equity Capital -Bond Yield Plus Risk Premium Approach
124
Cost of Equity Capital- Dividend Growth Model Approach
124
Cost of Equity Capital -Earnings-Price Ratio approach
125
Weighted Average Cost of Capital
125
Marginal Cost of Capital (MCC)
127
Cost of Capital and its implications in Budgeting Decisions
128
Some Case Study
128
LESSON ROUND-UP
131
SELF-TEST QUESTIONS
133
LESSON 5
FINANCIAL SERVICES
Meaning of Financial Services
136
Functions of financial services
137
Characteristics and Features of Financial Services
137
Scope of Financial Services
138
Structure of Financial Services Sector
139
Corporate Financial Services
140
Personal Financial Services
140
Significance of Financial Services
141
Merchant Banking Services
142
Loan Syndication
144
Securitization of Debt
146
Housing Finance Services
149
Institutional Infrastructure of Housing Finance Sector in India
150
Housing Development Finance Corporation Limited (HDFC)
150
Housing and Urban Development Corporation of India (HUDCO)
151
National Housing Bank (NHB)
152
New Development in Housing Finance
153
Impediments in Housing Finance
153
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Page
Depository System in India
155
Types of Advisory Services
157
Regulation of the Financial Services Sector
157
LESSON ROUND-UP
157
SELF-TEST QUESTIONS
158
LESSON 6
PROJECT PLANNING
Project Planning
162
Importance of the Project Plan
162
Preparation of Project Report
164
Project Appraisal under Normal Conditions
167
Project Appraisal under Inflationary Conditions
168
Project Appraisal under Deflationary Conditions
169
Project Appraisal by Financial Institutions
170
Lending Policies and Appraisal Norms by Financial Institutions and Banks
174
Loan Policy
175
Lending Exposure Limits
177
Lending Rates
178
Loan Documentation
178
Usual conditions in Loan Agreement
179
Project Review and Control
184
Differentiating Monitoring, Evaluation and Control
184
Social Cost and Benefit Analysis of Project
187
UNIDO Approach of Social Cost benefit Analysis
188
Little Mirrlees (L-M) Approach
188
Difference between UNIDO and L-M Approach
189
Different Sources of Finance
189
Financial Leverage and Term Loan
189
Lease Finance
190
Finance Lease
190
Operating Lease
191
Hire-Purchase
191
Venture Capital
192
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Page
Private Equity
192
Deferred Payment Arrangements
193
International finance and syndication of loans
194
New International Instruments
194
Syndicated Euro Currency Loans
194
Corporate Taxation and the Impact on Corporate Financing
195
Financing Cost Escalation
196
LESSON ROUND UP
196
SELF TEST QUESTIONS
197
LESSON 7
DIVIDEND POLICY
Types of Dividend Policies
200
Determinants/Constraints of Dividend Policy
201
Residual Theory of Dividend Policy
203
Irrelevance of Dividend
203
Marginal Analysis and Residuary Theory
205
Walter Formula
207
Dividend Growth Model
208
Legal Aspects of Dividends
210
Corporate Dividend Practices in India
212
Some Case Studies
212
LESSON ROUND-UP
217
SELF-TEST QUESTIONS
217
LESSON 8
WORKING CAPITAL
Meaning of Working Capital -The Basic Concept
220
Types of Working Capital
220
Determinants of Working Capital
221
Factors Influencing the Amount of Cash, Receivables and Inventories
223
Assessment of Working Capital
224
NEGATIVE WORKING CAPITAL
224
Current Assets and Fixed Assets Financing
225
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Page
Operating Cycle Concept and Application of Quantitative Techniques
226
Quantitative Techniques for Forecasting Working Capital Needs
232
Financing of Working Capital
233
Control of Working Capital
235
235
Ways to Improve Working Capital Position
236
Cash Management
238
Inventory Management
242
Receivables Management
245
Banking Norms and Macro Aspect of Working Capital Management
249
Tandon Committee
249
Chore Committee
254
Marathe Committee
255
Kannan Committee
255
The Concept of Net Working Capital
256
Accounting Policies of Firms for Working Capital Management
258
Factoring Services
259
Factoring vs. Accounts Receivable Loans
261
Factoring vs. Bill Discounting
261
Mechanics of Factoring
261
Fund Flow Statement
263
Forfaiting Services
263
Forfaiting vs. Export Factoring
264
Ratio Analysis
264
Case Studies
265
LESSON ROUND-UP
270
SELF-TEST QUESTIONS
271
LESSON 9
SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

The Concept of Security Analysis
274
Risks and its Types
275
Approaches to Valuation of Security
277
Fundamental Approach to Valuation
280
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Page
Dow Jones Theory
284
Graph of Bullish Phase
284
Tools of Technical Analysis
285
Alternative Approaches to Valuation Random Walk Theory
287
Efficient Market Theory
287
Portfolio management
289
Risk in investment situation
290
Markowitz Model
294
Simple Markowitz Portfolio Optimization
295
Limitation of Markowitz Model
296
Capital Asset Pricing Model
297
Security Market Line
300
Economic Value Added
302
Sharpe Single and Multi Index Models
303
Sharpe Index Model
303
Simple Sharpe Portfolio Optimization
304
Arbitrage Pricing Theory
305
Risk Adjusted Measure of Performance
307
Case Studies
308
Risk Premium for Equity
308
LESSON ROUND-UP
311
SELF-TEST QUESTIONS
312
LESSON 10
DERIVATIVES AND COMMODITY EXCHANGES AN OVERVIEW

Concept of Derivatives
316
Characteristics of Derivatives
318
Participants in the Derivatives Market
318
Types of Derivative Markets
318
Types of Markets
319
Forward Contract
320
Differences between spot contract and forward contract
320
Advantages of forward markets
320
Futures Contract
322
Pricing of Futures
322
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Page
Difference between Forwards and Futures
323
Options Contract
324
Class of Options
325
Tools of Options Derivatives
325
Swaps
326
Swaption
329
Properties of Swaption
329
Development of Derivatives Market in India
329
Equity Derivatives
330
Stock Index Futures
331
Stock Indices in India
332
Financial Derivatives
332
Forex derivatives
332
Interest Rate Derivatives
333
Credit Derivatives
334
Some Modern Credit Derivatives
336
Trading, Clearing and Settlement of Derivatives On Stock Exchanges
337
Settlement of Futures Contracts
339
Settlement of Options Contracts
339
Risk Management System Role of NSCCL
340
NSE-SPAN
341
Parallel Risk Management System (PRISM)
342
Commodities Market
343
Need for commodity trading
344
Advantages of Commodity Trading
344
Evolution of Commodity Markets in India
344
Leading Commodity Exchanges in India
345
Participants in Commodity Futures
345
Types of Commodity Derivatives
346
Advantages of commodity trading
346
Disadvantages of commodity trading
346
Commodity Derivatives vs. Financial Derivatives
346
LESSON ROUND-UP
347
SELF-TEST QUESTIONS
348
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Page
LESSON 11
TREASURY MANAGEMENT
Introduction- Treasury Management
350
Objectives of Treasury Management
350
Role of Treasury Management and benefits
352
Significance of Treasury Management Function
354
Functions and Scope of Treasury Management
355
Relationship between Treasury Management and Financial Management
361
Difference between Financial Management and Treasury Management
362
Treasury Organization: Picking the Right Model
364
Organisation Models: Dimensions
364
Full Service Global Model
364
Full Service Local Model
365
Limited Service Global Model
365
Limited Service Local Model
365
Role and Responsibilities of Treasury Manager
365
Tools of Treasury Management
367
Environment for Treasury Management
369
Role of Information Technology in Treasury Management
369
Liquidity Management vis-a-vis Treasury Management
370
Regulation & Supervision of Treasury Operation
371
Treasury Operations in Banking
372
Present Status of Treasury Management in India
373
LESSON ROUND-UP
376
SELF-TEST QUESTIONS
376
LESSON 12
FOREX MANAGEMENT
Introduction
380
Nature of Forex Management
380
Scope of Forex Management
381
Significance of Forex Management
382
Forex Manager and His Skills
382
Foreign Exchange Market and its Structure
383
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Page
Organisation of Foreign Exchange Market in India
384
Authorised Money Changers
385
Authorised Dealers in Foreign Exchange
385
Foreign Exchange Dealers Association of India
385
Participants in the Foreign Exchange Market
386
Mechanics of Forex Trading
387
Relationship between Spot and Forward Rates
390
Inter-relationship of different variables in Foreign exchange transactions
391
Exchange Rate Quotations and Arbitrage
392
Foreign Exchange Rates
395
Factors Affecting Foreign Exchange Rates
396
Exchange Rate Quotes:
398
Determination of Exchange Rates
399
Forex Trading; Currency Futures and Options
400
Currency Derivatives Trading
400
Currency Options
402
Advantages of Currency Options
402
Features of currency option contracts
403
Factors influencing Currency Options Prices
403
Exposure of Foreign Exchange Risk
404
Transaction Exposure
404
Translation Exposure
406
Economic Exposure
407
General Protection Measures for Foreign Exchange Risk Exposure Management
409
Exchange Rate Forecasting
411
Risk in Foreign Exchange Business
412
Pegging of Currency
412
Some Case Studies
413
LESSON ROUND-UP
418
SELF-TEST QUESTIONS
419
PRACTICAL QUESTIONS AND CASE STUDIES
421
TEST PAPERS
Test Paper 1
518
Test Paper 2
522
xviii
Lesson 1
Lesson 1
Nature, Significance and Scope of
Financial Management
LESSON OUTLINE
LEARNING OBJECTIVES
Introduction
Finance management means the management

of finance of a business or organization in order
to achieve financial objectives. In an
organization the key objectives of financial
management would be to create wealth for
business, generate cash and gain maximum
profits from the investments of the business
considering the risks involved.
Nature, Significance, Objectives and

Scope (Traditional, Modern and
Transitional Approach)
Risk-Return and Value of the Firm
Good financial management is very important for

an organisation. It brings economic growth and
development through investments, financing, and
dividend and risk management decision which
help companies to undertake better projects.
Lack of financial management in business will
lead to losses and closure of business.
Financial Sector Reforms and their Impact

Functions of Finance Executive in an
Organisation
LESSON ROUND UP
The object of the study is enable the students

understand
SELF TEST QUESTIONS
Nature, Significance, and Scope of

Financial Management
Financial Management DecisionInvestment, Financial and Dividend
Decision Making Process
Objective of Financial Management
Economic Value Added real growth of
the organization
Liquidity and Profitability
Role and Function of Financial Executive
Financial Sector Reforms-Role and
Function in an economy
If you want to rear financial blessings, you have to sow financially.

Joel Osteen
Thoughtful financial planning can easily take a backseat to daily life.
Suze Orman
1
2 PP-FT&FM
NATURE, SIGNIFICANCE AND SCOPE OF FINANCIAL MANAGEMENT

In modern times, we cannot imagine a world without the use of money. In fact, money is the life-blood of the
present day world and all our economic activities are carried out through the use of money. For carrying on
business we need resources which are pooled in terms of money. It is used for obtaining physical resources,
carrying out productive activities and business operations affect sales and pay compensation to suppliers of
resources ? physical as well as monetary. Hence financial management is considered as an organic function of
a business and has rightly become an important one.
A group of experts defines Financial Management as simply the task of providing funds needed by the business
or enterprise on terms that are most favourable in the light of its objectives. The approach, thus, is concerned
almost exclusively with the procurement of funds and could be widened to include instruments, institutions and
practices through which to raise funds. It also covers the legal and accounting relationship between a company
and its sources of funds. Financial Management is certainly broader than procurement of funds ? there are other
functions and decisions too.
Other set of experts assume that finance is concerned with cash. Since every business transaction involves
cash directly or indirectly, finance may be assumed to be concerned with everything that takes place in the
conduct of a business. Obviously, it is too broad.
The third set of people whose point of view has been widely accepted considers Financial Management as
procurement of funds and their effective utilisations in the business; though there are other organisations like
schools, associations, government agencies etc., where funds are procured and used. Financial Management
has not only to see that funds can be raised for installing plant and machinery at a cost; but it has also to see that
additional profits adequately compensate for the costs and risks borne by the business while setting up the
project.
Thus from the point of view of a corporate unit, financial management is related not only to fund-raising but
encompasses wider perspective of managing the finances for the company efficiently. In the developed state of
a capital market, raising funds is not a problem; the real problem is to put the capital resources to efficient use
through effective financial planning, financial organisation and financial control and to deal with tasks like ensuring
the availability of funds, allocating them for different uses, managing them, investing funds, controlling costs,
forecasting financial requirements, doing profit planning and estimating rate of return on investment and
assessment of working capital etc.
Financial Management, to be more precise, is, thus concerned with investment, financing and dividend decisions
in relation to objectives of the company. Such decisions have to take care of the interests of the shareholders.
They are upheld by maximisation of shareholders wealth which depends upon increase in the net worth ?
capital invested in the business plus ploughed back profits for growth and prosperity of the company. It is for
such reasons that the market is prepared to pay a lower or higher price for the shares of some company or the
other. Nature of Financial Management therefore can be judged by the study of the nature of investment decisions,
nature of financing decisions and the nature of dividend decisions.
INVESTMENT DECISIONS
Investment ordinarily means utilisation of money for profits or returns. This could be done by creating physical
assets with the money and carrying on business or purchasing shares or debentures of a company or sometimes,
though erroneously, purchasing a consumer durable like building. In an economy, money flows from one type of
business to another depending upon profits expected or in a capital market securities of a concern are purchased
or sold in the expectation of higher or lower profits or gains. However within a firm, a finance manager decides
that in which activity resources of the firm are to be channelised, and more important who should be entrusted
Lesson 1
with the financing decisions. A marketing manager may like to have a new show room, a production manager a
new lathe and a personnel manager higher wages for labour, which may lead to regular and efficient production.
Over and above, the top management may like to enter an entirely new area of production like a textile company
entering electronics. All these are the ventures which are likely to increase profits. But resources are limited.
Hence, the problem of accepting one proposal and leaving other.
Capital budgeting is a major aspect of investment decision making process. Investment decisions and capital
budgeting are considered as synonymous in the business world. Investment decisions are concerned with the
question whether adding to capital assets today will increase the revenue of tomorrow to cover costs. Thus
investment decisions are commitments of monetary resources at different times in expectation of economic
returns in future. Choice is required to be made amongst available resources and avenues for investment. As
such investment decisions are concerned with the choice of acquiring real assets, over the time period, in a
productive process. In making such a choice consideration of certain aspects is essential viz., need for investment,
factors affecting decisions, criteria for evaluating investment decisions and selection of a particular alternative
from amongst the various options available.
Investment decisions have, thus, become the most important area in the decision making process of a company.
Such decisions are essentially made after evaluating the different proposals with reference to growth and
profitability projections of the company. The choice helps achieve the long term objectives of the company i.e.,
survival and growth, preserving market share of its products and retaining leadership in its production activity.
The company likes to avail of the economic opportunity for which investment decisions are taken viz., (1) expansion
of the productive process to meet the existing excessive demand in local market, exploit the global market, and
to avail of the advantages and economies of the expanded scale of production. (2) replacement of an existing
asset, plant and machinery or building, necessary for taking advantages of technological innovations, minimising
cost of production by replacing obsolete and worn out plants, increasing efficiency of labour, etc. (3) The choice
of equipment establishes the need for investment decisions based on the question of quality and latest technology.
(4) Re-allocation of capital is another area of investment, to ensure asset allocation in tune with the production
policy. (5) Mergers, acquisitions, re-organisations and rehabilitation are all concerned with economic and financial
involvement and are governed by investment decisions.
Thus, investment decisions encompass wide and complex matters involving the following areas:
capital budgeting
cost of capital
measuring risk
management of liquidity and current assets
expansion and contraction involving business failure and re-organisations
buy or hire or lease an asset.
Factors affecting investment decisions are essentially the ingredients of investment decisions. Capital is a scarce
resource and its supply cost is very high. Optimal investment decisions need to be made taking into consideration
such factors as are given below viz. (1) Estimation of capital outlays and the future earnings of the proposed
project focusing on the task of value engineering and market forecasting; (2) availability of capital and
considerations of cost of capital focusing attention on financial analysis; and (3) a set of standards by which to
select a project for implementation and maximising returns therefrom focusing attention on logic and arithmetic.
FINANCING DECISIONS
Financing decision is the next step in financial management for executing the investment decision once taken.
A look at the balance-sheet of a sample company indicates that it obtains finances from shareholders ? ordinary
4 PP-FT&FM
or preference, debentureholders on long-term basis, financial institutions as long-term loans, banks and others
as short-term loans and the like. There are variations in the provisions governing the issue of preference shares,
debentures, loan papers, etc. Financing decisions are concerned with the determination of how much funds to
procure from amongst the various avenues available i.e. the financing mix or capital structure. Efforts are made
to obtain an optimal financing mix for a particular company. This necessitates study of the capital structure as
also the short and intermediate term financing plans of the company.
In more advanced companies, financing decision today, has become fully integrated with top-management
policy formulation via capital budgeting, long-range planning, evaluation of alternate uses of funds, and
establishment of measurable standards of performance in financial terms.
Financial decision making is concerned more and more with the questions as to how cost of funds be measured,
proposals for capital using projects be evaluated, or how far the financing policy influences cost of capital or
should corporate funds be committed to or withheld from certain purposes and how the expected returns on
projects be measured.
Optimal use of funds has become a new concern of financing decisions and top managements in corporate
sector are more concerned with planning the sources and uses of funds and measuring performance. New
measurement techniques, utilising computers, have facilitated efficient capital allocation through financing
decisions.
Application of computers, in the area of financial management has made it possible to handle a large
number of operations particularly of repetitive nature. Ranging from routine record-keeping activities like
accounting, computers are now being used in inventory management, budgeting, capital investment
decisions, evaluating uncertainties in decision making, cost estimation, information analysis, security analysis,
etc. Processing of accounting data including general ledger information and trial balance and preparing
income statement and balance sheet has been rendered easy through the use of computers in financial
planning and control. Analysis of funds flow, cash flow and income statement and balance sheet is done
through the use of computers. A great variety of computer analysis are available for forecasting financial
needs and making the best choice from amongst the various sources of finance. Thus, the nature of financial
decisions and the process therefor has undergone a considerable change with the introduction of computer
technology in financial management.
The computer has made making efficient investment decisions and financing decisions easy. These decisions
are jointly made as an effective way of financial management in corporate units. No doubt, the purview of
these decisions is separate, but they affect each other. Financial decisions, as discussed earlier, encompass
determination of the proportion of equity capital to debt to achieve an optimal capital structure, and to balance
the fixed and working capital requirements in the financial structure of the company. This important area of
financing decision making, aims at maximising returns on investment and minimising the risk. The risk and
return analysis is a common tool for investment and financing decisions for designing an optimal capital
structure of a corporate unit. It may be mentioned that debt adds to the riskiness of the capital structure of a
firm.
DIVIDEND DECISIONS
The dividend decision is another major area of financial management. The financial manager must decide
whether the firm should distribute all profits or retain them or distribute a portion and retain the balance.
Theoretically, this decision should depend on whether the company or its shareholders are in the position to
better utilise the funds, and to earn a higher rate of return on funds. However, in practice, a number of other
factors like the market price of shares, the trend of earning, the tax position of the shareholders, cash flow
position, requirement of funds for future growth, and restrictions under the Companies Act etc. play an important
role in the determination of dividend policy of business enterprise.
Lesson 1
DECISION CRITERIA
Decision criteria depends upon the objective to be achieved through the instrumentality of decision making
process. The main objectives which a business organisation pursues are maximisation of return and minimisation
of costs.
A fair decision criterion should distinguish between acceptable and unacceptable proposals and solve the problem
of selection of the best alternatives from amongst the various alternatives available in a given situation to achieve
the above objectives. A fair decision criterion should follow the following two fundamental principles i.e. (1) the
Bigger and Better principle; (2) A Bird in Hand is Better than Two in the Bush principle. The first principle
suggests that bigger benefits are preferable to smaller ones; whereas the second one suggests that early
benefits are preferable to later benefits.
Both the above principles are based on the assumption other things being equal which is a rare reality. But in
practice the decision process very much adheres to these principles particularly in the areas of capital budgeting
decisions and determining the cost of capital in project financing proposals.
Decision criteria in financial management can be studied under two separate heads viz. The criteria for investment
decisions; and the criteria for the financing decisions.
Criteria for investment decisions are mainly concerned with planning and control of capital expenditure through
budgeting process following the tools of analysis viz. ? pay back period, accounting rate of return, discounted
cash flow methods e.g., net present value method, etc. We shall discuss these methods for evaluating investment
decisions in detail in the study relating to capital budgeting. However, the essence and the inherent spirit in
these techniques is based on logic which helps in the decision making process.
As a matter of fact, these techniques have been founded on the following decision criteria:
1. Urgency: The use of urgency is treated as criterion for selection of investment projects in many corporate
units/business enterprises/government set up. Urgency is assessed on the following basis:
(a) it provides sufficient justification for undertaking a project;
(b) it provides immediate contribution for attainment of objectives of the project; and
(c) it maximises profits.
Although urgency as criterion lacks objectivity, being non-quantifiable, yet it definitely provides a ordinal ranking
scale for selection of projects on preferential pre-exemption basis.
2. Pay back: Time is of essence while selecting this criterion for investment decisions. The decision is taken on
the basis of quickness in pay off of the investments. Pay back simply measures the time required for cash flows
from the project to return the initial investment to the firms account. Projects, on the basis of this criterion,
having quicker pay backs are preferred.
Pay back decision criterion does not follow the principles laid down above viz. the bigger and better and bird
in hand. It ignores the first principle completely as it does not take into account the cash flows after investment
has been recovered. It also does not satisfy entirely the second principle as it assigns zero value to the receipts,
subsequent to recovery of the amount.
3. Rates of return: It provides another decision criterion based on accounting records or projected statements
to measure profitability as annual percentage of capital employed. Rate of return is arrived at following two
different methods for treating income in the analysis which give different results. In the first case, average
income generated from investment is taken after deduction of depreciation charge. In second case, the original
cost is taken as denominator rather than average investment. This gives the simple yearly rate of return. This is
based on bigger and better principle. This criterion can be applied either against average investment in the
year selected for study or simply against initial cost.
6 PP-FT&FM
4. Undiscounted benefit-cost ratio: It is the ratio between the aggregate benefits and the cost of project.
Benefits are taken at face value. The ratio may be gross or net. It is gross when calculated with benefits
without deducting depreciation. In the net version, depreciation is deducted from benefits before computing the
results. Both ratios give identical ranking. Net ratio equals the gross ratio minus 1.0. This relationship makes it
simple to calculate gross ratio and then to arrive at net ratio.
This criterion is compatible with the bigger and better principle. But it does not follow the second principle of
bird in hand as early receipts are given identical weights to later receipts in the projects life.
5. Discounted benefit-cost ratio: This ratio is more reliable as it is based on present value of future benefits
and costs. It may also be gross or net like the one discussed earlier. It takes into account all incomes whenever
received and to this extent complies with bigger and better principle. Early receipts are given more weight than
late receipts on account of introduction of discount factor.
This ratio satisfies the requirements of both the principles and is a good criterion for decision making.
6. Present value method: This concept is useful as a decision criterion because it reveals the fact that the
value of money is constantly declining as a rupee received today is more in value than the rupee at the end of a
year. Besides, if the rupee is invested today it will fetch a return on investment and accumulate to Re. 1 (1+i) at
the end of n period. Hence a rupee received at the end of n period is worth 1/(1+i)n now. Investment decisions
require comparison of present value with the cost of assets, and if the present value exceeds the cost, the
investment is rendered acceptable.
Another off-shoot of this criterion is net present value method which is closely related to cost-benefit ratio. It
takes into account all income and its timing with appropriate weights. Here difference of present value of benefits
and costs is considered as against the ratio in cost-benefit analysis. This criterion is useful for acceptance of
projects showing positive net present value at the companys cost of capital rate. It can be used for choosing
between mutually exclusive projects by considering whether incremental investment yields a positive net present
value.
7. Internal rate of return: It is a widely used criterion for investment decisions. It takes interest factor into
account. It is known as marginal efficiency of capital or rate of return over cost. It stipulates rate of discount
which will equate the present value of the net benefits with the cost of the project. This method satisfies both
these principles.
The criteria used in financing decisions, with particular reference to capital structure of a corporate unit can be
discussed here precisely.
The capital structure of a corporate unit contains two important parameters viz., the owners capital known as
equity and the debt which represents interest of debentureholders in the assets of the company. The factors
responsible for inclusion of debt in the capital structure of a company are tax-savings, easier to sell, lower cost
of floatation and services, lower cost of capital, the advantage of leverage, no dilution of equity and probable
loss of control, logical to consolidate and fund short-term indebtedness by a bond issue, advantageous in the
inflationary trends of rising interest rates and improvement in financial ratios.
There is no alternative for a company to equity financing to meet its requirement for funds. Debt can be raised
by a company only on an adequate equity base which serves as a cushion for debt financing. The study of
effect of leverage is the main focus point to determine the best mix of debt and equity sources of funds. It is,
therefore, desired to consider this criterion for financing decision making in relation to leverage and cost of
capital.
OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management of any business firm has to set goals for itself and to interpret them in relation to the
objective of the firm. Broadly, there are only two alternative objectives a business firm can pursue viz.
Lesson 1
(a) Profit maximisation;

(b) Wealth maximisation.
(a) Profit Maximisation

Profit maximisation is considered as an important goal in financial decision-making in an organisation. It ensures
that firm utilizes its available resources most efficiently under conditions of competitive markets. But in recent
years, under the changed corporate environment, profit maximisation is regarded as unrealistic, difficult,
unappropriate and socially not much preferred goal for business organisation. Profit maximisation as corporate
goal is criticised by scholars mainly on the following grounds:
(i) It is vague conceptually.
(ii) It ignores timing of returns.
(iii) It ignores the risk factor.
(iv) It may tempt to make such decisions which may in the long run prove disastrous.
(v) Its emphasis is generally on short run projects.
(vi) It may cause decreasing share prices.
(vii) The profit is only one of the many objectives and variables that a firm considers.
(b) Wealth Maximisation

Presently, maximisation of present value (or wealth) of a course of action is considered appropriate operationally
flexible goal for financial decision-making in an organisation. The net present value or wealth can be defined
more explicitly in the following way:
A3
A1
A2
A1
An
A1
...
Co
CO
t
1 K1 1 K 2 1 K 3 1 K1
1 K n
1 K
Where A1A2 represent the stream of benefits expected to occur if a course of action is adopted. Co is the
cost of that action and K is the appropriate discount rate, and W is the Net present worth or wealth which is the
difference between the present worth or wealth of the stream of benefits and the initial cost.
The management of an organisation maximises the present value not only for shareholders but for all including
employees, customers, suppliers and community at large. This goal for the maximum present value is generally
justified on the following grounds:
(i) It is consistent with the object of maximising owners economic welfare.
(ii) It focuses on the long run picture.
(iii) It considers risk.
(iv) It recognises the value of regular dividend payments.
(v) It takes into account time value of money.
(vi) It maintains market price of its shares.
(vii) It seeks growth in sales and earnings.
However, profit maximisation can be part of a wealth maximisation strategy. Quite often two objectives can be
pursued simultaneously but the maximisation of profit should never be permitted to overshadow the objectives
of wealth maximisation.
8 PP-FT&FM
The objective of the firm provides a framework for optimal decision making in the area of business management.
The term objective should be used in the sense of decision criteria for taking decisions involved in financial
management. It means that what is relevant is not overall objective of the business but operationally useful
criterion against which the investment, financing and dividend policy decisions are to be judged. Another point to
note in this context is that objective provide a normative framework. In other words, it implies that the focus is
on what a firm should try to achieve and on policies that it should follow if the objectives are to be achieved.
PROFIT MAXIMIZATION VERSUS SHAREHOLDER WEALTH MAXIMIZATION

Profit maximization is basically a single-period or, at the most, a short-term goal. It is usually interpreted to mean
the maximization of profits within a given period of time. A firm may maximize its short-term profits at the expense
of its long-term profitability and still realize this goal. In contrast, shareholder wealth maximization is a long-term
goal shareholders are interested in future as well as present profits. Wealth maximization is generally preferred
because it considers (1) wealth for the long-term, (2) risk or uncertainty, (3) the timing of returns, and (4) the
shareholders return. The following table provides a summary of the advantages and disadvantages of these
two often conflicting goals.
Profit Maximization Vs. Shareholder Wealth Maximization
Goal
Objective
Advantages
Disadvantages
Profit maximisation
Large amount
of profits
1. Easy to calculate profits
1. Emphasizes the short term
2. Easy to determine the

link between financial
decisions and profits
2. Ignores risk or uncertainty
3. Ignores the timing of returns

4. Requires immediate resources
Shareholder wealth
maximisation
Highest market
value of
common stock
1. Emphasizes the long term
1. Offers no clear relationship

between financial decisions
and stock price
2. Recognizes risk or
uncertainty
2. Can lead to management

anxiety and frustration
3. Recognizes the timing

of returns
4. Considers return
Economic Value-Added (EVA)

Economic value added (EVA) is the after tax cash flow generated by a business minus the cost of the capital it
has deployed to generate that cash flow. Representing real profit versus paper profit, EVA underlines shareholder
value, increasingly the main target of leading companies strategies. Shareholders are the players who provide
the firm with its capital; they invest to gain a return on that capital.
The concept of EVA is well established in financial theory, buy only recently has the term moved into the mainstream
of corporate finance, as more and more firms adopt it as the base for business planning and performance
monitoring. There is growing evidence that EVA, not earnings, determines the value of a firm. There is difference
between EVA, earnings per share, return on assets, and discounted cash flow, as a measure of performance.
Earnings per share tells nothing about the cost of generating those profits. If the cost of capital (loans, bonds,
Lesson 1
equity) as say, 15 per cent, then a 14 per cent earning is actually a reduction, not a gain, in economic value.
Profits also increase taxes, thereby reducing cash flow.
Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital. Leading
firms can obtain capital at low costs, via favourable interest rates and high stock prices, which they can then
invest in their operations at decent rates of return on assets. That tempts them to expand without paying attention
to the real return, economic value-added.
Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital.
There are two key components to EVA. The net operating profit after tax (NOPAT) and the capital charge, which
is the amount of capital times the cost of capital. In other words, it is the total pool of profits available to provide
cash return to those who provided capital to the firm. The capital charge is the product of the cost of capital times
the capital tied up in the investment. In other words, the capital charge is the cash flow required to compensate
investors for the riskiness of the business given the amount of capital invested. On the one hand, the cost of
capital is the minimum rate of return on capital required to compensate debt and equity investors for bearing
risk-a cut-off rate to create value and capital is the amount of cash invested in the business, net of depreciation
(Dierks and Patel, 1997). In formula form,
EVA = (Operating Profit) (A Capital Charge)
EVA = NOPAT (Cost of Capital x Capital)
However, in practical situations there are adjustments to both NOPAT and the capital employed to reduce noneconomic accounting and financing conventions on the income statement and balance sheet.
These are adjustments that turn a firm's accounting book value into an economic book value, which is more
accurate measure of the cash that investors have put at risk in the firm and upon which they expect to accrue
some returns. These adjustments turn capital-related items into more accurate measures of capital and include
revenue- and expense-related items in NOPAT, thus better reflecting the financial base upon which investors
expect to accrue their returns. Furthermore these adjustments are made to address the distortions suffered by
traditional measures, such as return on equity, earnings per share and earnings growth, that change depending
upon the generally accepted accounting principles adopted or the mix of financing employed.
Implementing EVA in a company is more than just patting one additional row in the income statement. It is of
course some kind of change process which should be given some management effort. However, if right actions
are taken straight from the beginning then implementing EVA should be one of the easiest change process that
a company goes through. The actions might include e.g.:
Gaining the understanding and commitment of all the members of the management group through
training and discussing and using this support prominently during the process.
Training of the other employees, especially all the key persons.
Adopting EVA in all levels of organization.
However, there are a few common mistakes that are often taken in implementing or using EVA. Most of them are
bound up with either misunderstanding and thus misusing the concept at upper levels or not training all the
employees to use EVA and thus not using the full capacity of the concept. These common mistakes include
defining capital costs intentionally wrongly (usually too high for some reason), using EVA only in the upper
management level and investing too little in training of employees.
Although EVA is a value based measure, and it gives in valuations exactly same answer as discounted cash
flow, the periodic EVA values still have some accounting distortions.
That is because EVA is after all an accounting-based concept and suffers from the same problems of accounting
rate of returns (ROI etc.). In other words, the historical asset values that distort ROI distort EVA values also.
10 PP-FT&FM
In EVA valuations, the historical asset values (book value) are irrelevant and only the cash flows are left to give
the end result.
VALUE OF FIRM-RISK AND RETURN

The financial manager tries to achieve the proper balance between the considerations of risk and return
associated with various financial management decisions to maximise the market value of the firm.
It is well known that higher the return, other things being equal, higher the market value; higher the risk, other
things being equal, lower the market value. In fact, risk and return go together. This implies that a decision
alternative with high risk tends to promise higher return and the reverse is also true. The figure demonstrates the
relationship between market value of the firm, return and risk, on the one hand and financial management
decisions on the other.
Investment
Decisions
Return
Financing
Decisions
Dividend
Decisions
Trade-off
Market Value
of the Firm
Risk
LIQUIDITY
It is an important concept in financial management and is defined as ability of the business to meet short-term
obligations. It shows the quickness with which a business/company can convert its assets into cash to pay what
it owes in the near future. According to Ezra Soloman, it measures a companys ability to meet expected as well
as unexpected requirements of cash to expand its assets, reduce its liabilities and cover up any operating
losses. Liquidity, as a decision criterion, is widely used in financial management. It is used for managing liquid
resources or current assets or near cash assets so as to enhance the effectiveness with which they are utilised
with a view to minimising costs. It also focuses attention on the availability of funds. Enhancement of liquidity
enables a corporate body to have more funds from the market.
While using liquidity as a decision criterion, the management makes use of ratios. They give a birds eye view of
the current liquidity position or shortages thereof. A company will like to have liquid resources for transaction
purposes, as a precautionary measure and for speculative opportunities. The managements attitude towards
these i.e., transaction motive, precautionary motive and speculative motive (taking advantage of lower prices of
raw materials etc., in the market) is an important determinant of a companys liquidity position.
Liquidity is assessed through the use of ratio analysis. Liquidity ratios provide an insight into the present cash
solvency of a firm and its ability to remain solvent in the event of calamities.
Current Ratio which is the ratio of current assets to current liabilities, is widely used by corporate units to judge
the ability to discharge short-term liabilities covering the period upto one year. The interpretation of the current
ratio is that 'higher the ratio, greater is the ability of the firm to pay off its bills'.
Nevertheless, it is a crude ratio and does not take into account the difference amongst different categories of
assets. For example, inventory may not be turned into cash as quickly as Account Receivables. The main
Lesson 1
11
difficulty that arises in treating inventory as a quick item is that unless one has ensured about the quality,
condition and marketability of the inventory it may be impossible to turn it into cash immediately at the estimated
value. Therefore, to assess quick liquidity position, inventory is excluded while calculating Quick Ratio. The
ingredients of current assets while computing the Quick Ratio are cash, marketable securities and receivables.
Besides cash, the other two items are near cash and at very short notice can easily be converted into cash.
Therefore, for taking financial decisions particularly for assessing cash position of the company and its ability to
discharge current obligations, Quick Ratio is frequently relied upon. Nevertheless, the main shortcoming of the
Quick Ratio is that it ignores inventories and concentrates on cash, marketable securities and receivables in
relation to current obligations although inventory is also a basic input in current ratio without which companys
decision process cannot be complete.
Liquidity ratio enables a company to assess its Net Working Capital. Working Capital is denoted by the combination
of current assets or current liabilities of a company, and for calculation of net working capital we deduct current
liabilities from current assets. Having done so we are left with the ready money in our hands to meet day to day
needs of the business. If we still want to know as to how much is available with the company per rupee of sales
then Net Working Capital is divided by sales.
Tailor-made measurement can be devised for calculating liquidity ratio in different situations. For example, the
principle of liquidity can be extended to study liquidity of receivables (or inventories) separately to enable the
executives to take decisions about the collection period of bills.
Liquidity of receivables is assessed through Average Collection Period (ACP). ACP tells us the average number
of days receivables are outstanding i.e., the average time a bill takes to convert into cash. The inverse to this
ratio is Receivables Turnover Ratio (RTR). Either of the two ratios can be used as both depict the slowness of
recovery, but the readings are different. For financial decisions and to use liquidity as criterion the average
collection period ratio is used, and receivables turnover ratio is used to help in taking corrective steps for
maintaining the optimum liquid position for the company at any given time to avoid risk of losing goodwill and
chances of bankruptcy. The ratio, in short, reveals the following results:
(1) Too low an average collection period may suggest excessively restricted credit policy of a company.
(2) Too high an average collection period (ACP) may indicate too liberal a credit policy. A large number of
receivables may remain due and outstanding, resulting in less profits and more chances of bad debts.
Average collection period and receivables turnover ratio should be compared to the average age of accounts
payable or accounts payable turnover ratio. Though adequate liquidity could be maintained by accelerating
collections and deferring payments, yet this has its own limitations and drawbacks. It affects the credit standing
of the company in business and banking circles.
In the same spirit, decisions are made to maintain a proper inventory level in the company. For the purpose, it
becomes essential to assess the liquidity of inventory. Inventory Turnover Ratio i.e., cost of goods sold divided
by average annual inventory, shows the rapidity with which inventory is turned into receivables through sales.
The higher the ratio, the more efficient is the inventory management system of the company.
To conclude, liquidity, as a decision criterion is an important tool in financial management. Financial decisions
are affected by liquidity analysis of a company in the following areas:
1. Management of cash and marketable securities;
2. Credit policy of a firm and procedures for realisation;
3. Management and control of inventories;
4. Administration of fixed assets;
5. Taking decisions for efficient use of current assets at minimum cost; and
12 PP-FT&FM
6. Decisions to keep the companys position on sound basis to avoid eventualities.
The above analysis of liquidity suggests evaluation of current assets of a company. On liabilities side also,
liquidity position is analysed and managed through assessment of long and medium term debts of the company,
and the arrangements for their repayments. This is done purely from the precautionary point of view so that the
company could be saved from the risk of bankruptcy for non-payment of its debt to the lenders.
PROFITABILITY
Profitability as a decision criterion is another important tool in financial management for taking decisions from
different angles after evaluating the performance of the company in different spheres. For example, if it becomes
essential for the company to examine profit per unit of sale then it is done by estimating profitability per rupee of
sales. It is used as a measure of comparison and standard of performance. Similarly, there could be other ratios.
Because different users look at the profitability of a company from different angles, they use different ratios.
Short-term creditors, long-term lenders, equity shareholders, investors, etc. all are interested in profitable
operations of a concern. They use the ratios which best suit their requirements. Profitability can be related to
sales or to total capital employed or to net worth of the company. But then different figures for profits are taken
into account.
Profitability to sales ratio, reflects the companys ability to generate profits per unit of sales. If sales lack sufficient
margin of profit, it is difficult for the business enterprise to cover its fixed cost, including fixed charges on debt,
and to earn profit for shareholders. From investors point of view profits are compared by the investors as
percentage to the capital employed in the business enterprise. Absence of adequate profitability ratio on sales
reflects the companys inability to utilise assets effectively. This is analysed through the asset turnover ratio.
One of the important profitability ratios is profits on equity profit figure after interest, before dividend and taxes,
drawn from the profit and loss account is related to the equity of the shareholders as shown in balance sheet.
This is an indicator of profits earned on funds invested by the owners. It is an indicator of actual returns received
by them. This ratio may assume two forms:
(1)
Earning available to common shareholders

Total Equity
(2)
Net income after tax

Total Equity
[The ratio at (2) is used where the company has no preference shareholders].
Profit margin is another measure of viewing profitability. The revenue bearing property of sales can be easily
assessed from the profit margin. It is derived by dividing operating income from business by sales. This ratio
indicates the efficiency of operations as well as how products are priced. Inadequacy of profit margin is an
evidence of companys inability to achieve satisfactory results. Pricing decisions are made by financial executives
in consultation with the marketing departments of the company. Policy decisions relating to increase or decrease
in price are taken in respect of different products keeping in view the competitiveness of the market. Profit
margin ratio is constantly used by business executives for this purpose. To look into the cash generating capacity
of sales, gross profit margin is used by deducting the cost of goods sold from sales and dividing by sales.
The gross profit margin ratio indicates the profits relative to sales after deduction of direct production cost. It
indicates efficiency of production operations and the relationship between production costs and selling price.
The difference between the above two ratios i.e. gross profit margin and net profit margin ratios is that general
and administrative expenses are excluded while computing gross margin. Thus net profit margin ratio is calculated
as under:
Lesson 1
Net Profit Margin (NPM) =
13
Net Profit after Taxes

Sales
NPM ratio is an indicator of companys ability to generate profits after paying all taxes and expenses. Decline in
this ratio reflects the presence of either higher expenses relative to sales or higher tax burden on the company,
affecting its profitability adversely. For assessment of profitability as a decision criterion return on investment
(ROI) is a frequently used ratio.
Return on Investment: This is an important profitability ratio from the angle of shareholders and reflects on the
ability of management to earn a return on resources put in by the shareholders. The beauty of the ROI ratio is
that earning of the company can be viewed from different angles so as to take decisions on different causes
responsible, to reduce or to enhance the profitability of the company. One way of finding out rate of return on
assets employed in the company is to find the ratio of earnings before interest and taxes (EBIT) to capital
employed. This ratio indicates operating income to the assets used to produce income.
Another way of computing the ratio of return is through the assets turnover ratio and margin of profit which gives
the same results, as EBIT to capital employed. It may be seen from the following:
EBIT
Sales
Sales
Assets
EBIT
Assets
A high ratio indicates efficient use of assets and low ratio reflects inefficient use of assets by a company.
Another off-shoot of profitability ratio is the times interest earned ratio, which gives a clue to the interest bearing
capacity of the income character of business operations. This ratio relates operating profits to fixed charges
created by the companys borrowings, and provides an indication of margin of safety between financial obligations
and Net income after tax. A company may earn profits but may find it difficult to make payments of excess
interest charges or may face inability to meet such obligations. EBIT should be 5 to 6 times interest charges as
a satisfactory guideline for this ratio. Lenders, particularly banks and financial institutions, greatly rely on this
ratio particularly in profitability assessment through projections of income of the borrower in the coming years
after investment of borrowed funds.
In this way we find that profitability as decision making criterion in financial management, is crucial for business
managers. Business works as a system comprised of sub-systems. Different criteria assess different aspects
and assist in viewing different situations which have an aggregate impact on business activity, and therefore
form the basis of financial management.
COSTING AND RISK

In financial management, costing relates to the system adopted for assessing cost of capital from various sources
viz., equity and preference shares, debentures/bonds, long-term borrowings from financial institutions, etc.
Equity capital is owners money employed in the business whereas borrowed funds are creditors funds carrying
an interest obligation and repayment schedule. There are thus, risks involved if interest is not paid or on account
of default in repayment of principal. It is ordinarily expected that every rupee obtained on loan enhances the
chances of increasing the returns on owners capital and the net worth. The rate of interest on borrowed funds
is usually lower than the returns expected by the investors or risk-takers in the business. Moreover, interest paid
is deductible for tax purposes. The following illustration gives an idea of the phenomenon stated above:
Company A
Company B
Total Capital
` 100
` 100
Owners capital
` 100
` 50
NIL
` 50
Borrowed capital
14 PP-FT&FM
Rate of earnings
20%
20%
15%
` 20
` 20
` 7.50
Earnings before taxes
` 20
` 12.50
Taxes at 50%
` 10
` 6.25
Earnings after taxes
` 10
` 6.25
Percentage of earnings on owners funds
10%
12.5%
Rate of interest
Earnings before interest and taxes
Interest paid
But if the company is not able to earn sufficient returns, the returns on owners funds are reduced and risk
increases. Using borrowed funds or fixed cost funds in the capital structure of a company is called financial
gearing. High financial gearing will increase the earnings per share of a company if earnings before interest and
taxes are rising, as compared to the earnings per share of a company with low or no financial gearing. It may be
understood that leverage and gearing are used interchangeably. (The former is used in the USA and the latter in
U.K.). So at times when the economy is doing well, the shareholders of a highly geared company will do better
than the shareholders of a low geared company. However, if the company is not doing well, when its profits
before interest and taxes are falling, the earnings per share of highly geared company will fall faster than those
of the low geared company. The higher this level of financial gearing, the greater the risk. Those who take risk
should appreciate that in difficult times their reward will be below average but in good times they will receive
above average rewards. The lower the levels of financial gearing, the more conservative are the financial policies
of the company and the less will be deviations over time to earnings per share.
Risk is associated with fixed charges in the shape of interest on debt capital. Higher the fixed charges, the
greater the chance that it will not be covered by earnings and so greater the risk. Large companies financed by
heavy borrowings, need to continue to produce and search for new markets for their output. Any internal
disturbance or external constraint that may hamper the companys production and sales will reduce inflow of
funds but fixed interest charges have to be paid. A study of the effects of capital gearing on cost of capital is quite
important for financial decisions. Given that a company has to minimise the cost of capital, it should fix up a level
of gearing where is costs of capital is minimum.
As against the traditional theory of capital structure suggesting that the average cost of capital does depends on
the level of gearing, the alternative theory on cost of capital as propounded by Modigliani and Miller argues that
the cost of capital is independent of the capital structure. The essence of the Modigliani and Miller argument is
the arbitrage process. Should the value of two firms with identical incomes and the same risk class ratios vary
(which would be possible under the traditional theory) the investors would arbitrage so as to make the market
value of the two firms equal. A key assumption of the model is that the investors can arbitrage between companies,
and between loan and equity capital, without increasing the risk of their individual investment portfolios.
Despite all the above theoretical explanations the fact remains that debt is associated with risk which enhances
with increase in the leverage. There are two major reasons for this increased risk viz., (1) interest is a fixed
charge and is required to be paid by the company whether or not it earns profits; and (2) a substantial decrease
in liquidity or increased demands from creditors for payment if the company has higher proportion of debt capital
in its capital structure. For these reasons, the risk of a company not being able to meet its obligations is greater
than in the case of a company in which the proportion of borrowed sum is substantially smaller.
Distinction may be made between different types of risk to which an enterprise is exposed in the business
environment.
The risk which we have discussed is financial risk that arises in relation to owners return created by the utilization
Lesson 1
15
of funds in the enterprise particularly fixed cost securities i.e. debt and preference shares. Financial risk is
distinguished from business risks which is associated with the chance of loss due to variability of return, in
general, created by the enterprise and as such it is known as operating risk. It is concerned with EBIT (earning
before interest and taxes) whereas financial risk is concerned with EAIT (earning after interest and taxes). If
there is preference capital then the financial risk is concerned with earnings available to ordinary (equity)
shareholders after dividends have been paid to preference shareholders. Financial risk encompasses the risk
of possible insolvency and the variability in the earnings on equity. In case the enterprise does not employ debt
or preference capital there will be no financial risk and over all risk for the firm will be low. It is only because of
application of debt financing, that overall risk increases and originates into financial risk to equity holders.
Besides, there are other types of risk which are related to investment decisions and not cost of financial sources
viz., purchasing power risk, market risk, interest rate risk, social or regulatory risk and other risks. Purchasing
power risk affects all investors. The risk is associated with changes in the price level on account of inflation.
Under inflationary conditions, the purchasing power of money decreases over time, and the investor is faced
with the possibility of loss on account of investments made to the extent of inflation. Under inflationary conditions,
therefore, the real rate of return would vary from the nominal rate of return (viz., the percent return on the face
value of investment made). Interest rate risk is concerned with holders of the bonds due to changes in interest
rates. These bonds are high quality bonds not subject to business or financial risk but their prices are determined
by there prevailing level of interest rates in the market. As a result, if interest rate falls, the price of these bonds
will rise and vice versa. The risk is more in case of long-term bonds because the rate of interest may fluctuate,
over a wider range as compared to a short-term bond. As regards social and regulatory risks, they arise due to
harsh regulatory measures like licensing, nationalisation, price controls limiting profits, etc. Other types of risks
may depend upon the nature of investment. Detailed discussion is not required at this stage.
FINANCIAL DISTRESS AND INSOLVENCY

Generally the affairs of a firm should be managed in such a way that the total risk business as well as financial
borne by equity holders is minimised and is manageable, otherwise, the firm would obviously face difficulties.
In managing business risk, the firm has to cope with the variability of the demand for its products, their prices,
input prices, etc. It has also to keep a tab on fixed costs. As regards financial risk, high proportion of debt in the
capital structure entails a high level of interest payments. If cash inflow is inadequate, the firm will face difficulties
in payment of interest and repayment of principal. If the situation continues long enough, a time will come when
the firm would face pressure from creditors. Failure of sales can also cause difficulties in carrying out production
operations. The firm would find itself in a tight spot. Investors would not invest further. Creditors would recall
their loans. Capital market would heavily discount its securities. Thus, the firm would find itself in a situation
called distress. It may have to sell its assets to discharge its obligations to outsiders at prices below their
economic values i.e. resort to distress sale. So when the sale proceeds is inadequate to meet outside liabilities,
the firm is said to have failed or become bankrupt or (after due processes of law are gone through) insolvent.
Failure of a firm is technical if it is unable to meet its current obligations. The failure could be temporary and
might be remediable. When liabilities exceed assets i.e. the net worth becomes negative, bankruptcy, as commonly
understood, arises. Technical bankruptcy can be ascertained by comparing current assets and current liabilities
i.e. working out current ratio or quick ratio. On the other hand, solvency ratios indicate long term liquidity i.e. the
ability of the firm to discharge its term-liabilities. Examples of solvency ratios are Debt to Equity ratio, Debt to
total Funds Ratios, and Interest coverage ratio. Trend analysis should be made for the past three to five years to
pick up signals of bankruptcy, if any.
FINANCIAL MANAGEMENT AS SCIENCE OR ART

Financial Management is a subject within the compass of social science as it deals with people. Its
nature is nearer to applied sciences as it envisages use of classified and tested knowledge as a help in
practical affairs and solving business.
16 PP-FT&FM
Theory of financial management is based on certain systematic principles, some of which can be tested in
mathematical equations like the law of physics and chemistry. Financial management contains a much larger
body of rules or tendencies that hold true in general and on the average. The use of computers, operations
research, statistical techniques and econometric models find wide application in financial management as tools
for solving corporate financial problems like budgeting, choice of investments, acquisition or mergers etc. This
takes the financial management nearer to treatment as a subject of science. Nevertheless, there remains a wide
scope for application of value judgement in financial decisions making. Most practical problems of finance have
no hard and fast answers that can be worked out mathematically or programmed on a computer. They must be
solved by judgement, intuition and the feel of experience. Thus, despite its frequent acceptance as an applied
science, finance remains largely an art. Because, according to George A. Christy and Peyton Foster Roden
(Finance: Environment and Decisions) knowledge of facts, principles and concepts is necessary for making
decisions but personal involvement of the manager through his intuitive capacities and power of judgement
becomes essential. This makes financial management and managing a companys finance both an art and a
science. It requires a feel for the situation and analytical skills alongwith a thorough knowledge of the techniques
and tools of financial analysis and the know-how to apply them and interpret the results.
A very interesting presentation has been made by Weston in his book Methodology in Finance. The finance
functions are mainly three viz., planning, organisation and financial control. In each of these finance functions
elements of science and art can be observed. Wherever methodology is to be applied in decision making in all
these areas, the subject matter becomes a science confronted with the framework of techniques and tools. On
the other hand, when the question of choice to make selection out of the alternative results arises the subject
matter becomes an art requiring human skills for value judgement. For example, in planning function there are
certain goals, which may be short-term goals or long-term goals. Each falls within the area of art. Another
parameter of planning is estimating funds, which may again be short-term or long-term involving techniques and
skills. When involvement to techniques is there the subject matter remains science and when the skills are
required to be interpreted, the subject matter becomes an art. It so happens in all aspects of planning, organisation
and control.
Thus, in the entire study of financial management whether it is related to investment decision, financing decisions
i.e. deciding about the sources of financing, or dividend decision, there is a mixture of science as well as art.
When techniques for analytical purposes are used it is science and when choice in appreciation of the results is
made it is an art. Thus, people will like to call financial management as science as well as art. But it is better if we
say that the discipline of financial management has both the aspects of science as well as art; where there is
theory of systematic knowledge it is science and where there is application it is art.
FUNCTIONS OF FINANCIAL EXECUTIVES

To achieve the objective of the financial management i.e. to maximise the owners wealth, the financial executives
have to perform variety of tasks to discharge their responsibilities. With the evolution of finance from being mere
a descriptive study to the one that is highly developed discipline, the role of financial managers has also undergone
a sea change. His areas of responsibilities now extend far beyond keeping records, reports, the firms cash
position, paying bills and obtaining funds, and he is now concerned with and is fully involved in the decision
making processes to decide investment of funds in assets, determining the best mix of financing and dividends
in relation to overall valuation of the firm. The responsibilities of the financial manager are linked to the goal of
ensuring liquidity, profitability or both and is also related to the management of assets and funds of any business
enterprise. When the Financial Manager is involved in management of asset, he is performing the role of the
decision-maker and when he is managing funds, he is performing the staff function. In the light of different
responsibilities of the financial manager, he performs mainly the following duties:
1. Forecasting of Cash Flow: This is necessary for the successful day to day operations of the business so that
it can discharge its obligations as and when they arise. In fact, it involves matching of cash inflows against
Lesson 1
17
outflows and the manager must forecast the sources and timing of inflows from customers and use them to pay
the liability.
2. Raising Funds: The Financial Manager has to plan for mobilising funds from different sources so that the
requisite amount of funds are made available to the business enterprise to meet its requirements for short term,
medium term and long term.
3. Managing the Flow of Internal Funds: Here the Manager has to keep a track of the surplus in various bank
accounts of the organisation and ensure that they are properly utilised to meet the requirements of the business.
This will ensure that liquidity position of the company is maintained intact with the minimum amount of external
borrowings.
4. To Facilitate Cost Control: The Financial Manager is generally the first person to recognise when the costs
for the supplies or production processes are exceeding the standard costs/budgeted figures. Consequently, he
can make recommendations to the top management for controlling the costs.
5. To Facilitate Pricing of Product, Product Lines and Services: The Financial Manager can supply important
information about cost changes and cost at varying levels of production and the profit margins needed to carry
on the business successfully. In fact, financial manager provides tools of analysis of information in pricing
decisions and contribute to the formulation of pricing policies jointly with the marketing manager.
6. Forecasting Profits: The Financial manager is usually responsible for collecting the relevant data to make
forecasts of profit levels in future.
7. Measuring Required Return: The acceptance or rejection of an investment proposal depends on whether
the expected return from the proposed investment is equal to or more than the required return. An investment
project is accepted if the expected return is equal or more than the required return. Determination of required
rate of return is the responsibility of the financial manager and is a part of the financing decision.
8. Managing Assets: The function of asset management focuses on the decision-making role of the financial
manager. Finance personnel meet with other officers of the firm and participate in making decisions affecting the
current and future utilisation of the firms resources. As an example, managers may discuss the total amount of
assets needed by the firm to carry out its operations. They will determine the composition or a mix of assets that
will help the firm best achieve its goals. They will identify ways to use existing assets more effectively and reduce
waste and unwarranted expenses.
The decision-making role crosses liquidity and profitability lines. Converting the idle equipment into cash improves
liquidity. Reducing costs improves profitability.
9. Managing Funds: Funds may be viewed as the liquid assets of the firm. In the management of funds, the
financial manager acts as a specialised staff officer to the Chief Executive of the company. The manager is
responsible for having sufficient funds for the firm to conduct its business and to pay its bills. Money must be
located to finance receivables and inventories, to make arrangements for the purchase of assets, and to identify
the sources of long-term financing. Cash must be available to pay dividends declared by the board of directors.
The management of funds has therefore, both liquidity and profitability aspects. If the firms funds are inadequate,
the firm may default on the payment of liabilities and may have to pay higher interest. If the firm does not
carefully choose its financing methods, it may pay excessive interest costs with a subsequent decline in profits.
FINANCIAL SECTOR ROLE AND FUNCTIONS

In any economy, the financial sector plays a major role in the mobilisation and allocation of savings. Financial
institutions, instruments and markets which constitute the financial sector act as conduit for the transfer of
financial resources from net savers to net borrowers, i.e., from those who spend less than they earn to those
who spend more than they earn.
18 PP-FT&FM
The financial sector performs this basic economic function of intermediation essentially through four transformation
mechanisms:
(i) Liability-asset transformation (i.e., accepting deposits as a liability and converting them into assets
such as loans);
(ii) Size-transformation (i.e., providing large loans on the basis of numerous small deposits);
(iii) Maturity transformation (i.e., offering savers alternate forms of deposits according to their liquidity
preferences while providing borrowers with loans of desired maturities); and
(iv) Risk transformation (i.e., distributing risks through diversification which substantially reduces risks for
savers which would prevail while directly in the absence of financial intermediation).
The process of financial intermediation supports increasing capital accumulation through the institutionalisation
of savings and investments and as such, fosters economic growth. The gains to the real sector of the economy,
therefore, depend on how efficiently the financial sector performs this basic function of financial intermediation.
A distinction is often made in the literature between operational efficiency and allocational efficiency; while the
former relates to transaction costs, the latter deals with the distribution of mobilised funds among competing
demands. Sustained improvements in economic activity and growth are greatly enhanced by the existence of a
financial system developed in terms of both operational and allocational efficiency in mobilising savings and in
channelling them among competing demands. In addition, functional efficiency of a financial system must be
judged in terms of (a) the soundness of the appraisals as measured by the level of overdues, (b) the resource
cost of specific operations, and (c) the quality and speed of delivery of services. Both operational and allocational
efficiency, to a large extent, are influenced by market structure and the regulatory framework, and on both
grounds the Central Bank has an important role to play in developing economy like India.
Financial Sector Reforms in India Background

The financial sector reforms (initiated in 1991) currently underway in India must be seen as a component, of the
overall scheme of structural reforms. The overall package is aimed at enhancing the productivity and efficiency
of the economy as a whole and also increasing international competitiveness. The reforms are comprehensive
in scope covering besides financial sector reforms, several other components of economic policy including,
liberalisation and deregulation of domestic investment, opening up to key infrastructure areas hitherto reserved
for the public sector for private sector participation, opening up the economy to foreign competition by reducing
protective barriers such as import controls and high tariff, encouraging direct foreign investment as source of
technology upgradation and also as a source of non-debt finance for investment, reform of the public sector to
impart greater efficiency of operations and reform of the tax system to create a structure with moderate rates of
tax, broader base of taxation and greater ease of administration. All these reforms are closely inter-related, and
progress in one area helps to achieve objectives in others. Since the reforms are being introduced in a phased
manner the extent of progress differs from area to area. Importance of the financial sector reforms such as
structured package needs to be delineated clearly. Structural reforms in areas such as industrial and trade
policy can succeed only if resources are redeployed towards more efficient producers which are encouraged to
expand under the new policies. This reallocation is possible only if the financial system plays a crucial supportive
role. The reforms in the banking sector and in the capital markets are aimed precisely at achieving this primary
objective.
The Indian financial system comprises an impressive network of banks and financial institutions and a wide
range of financial instruments. There is no doubt that there has been a considerable widening and deepening of
the Indian financial system in the last decade.
Financial Sector Reforms in India: Philosophy and Strategy

The ongoing financial sector reforms aim at promoting a diversified, efficient and competitive financial sector
Lesson 1
19
with the ultimate objective of improving the allocative efficiency of available resources, increasing the return on
investments and promoting an accelerated growth of the real sector of the economy.
According to Economic Development Institute of the World Bank while dealing with structure reforms and
development of financial system has specified the following key areas of reforms:
Reforms of structure of financial systems;
Policies and Regulations to deal with insolvency and illiquidity of financial intermediaries;
The development of markets for short and long term financial instruments;
The role of institutional elements in development of financial systems;
The links between financial sector and the real sectors, particularly in the case of restructuring financial
and industrial institutions or enterprises.
The dynamics of financial systems management in terms of stabilisation and adjustment, and
Access to International Markets.
More specifically, the financial sector reform in India seeks to achieve the following:
(i) suitable modifications in the policy framework within which various components of the financial system
operate, such as rationalisation of interest rates, reduction in the levels of resources, pre-emptions and
improving the effectiveness of directed credit programmes.
(ii) improvement in the financial health and competitive capabilities by means of prescription of prudential
norms, recapitalisation of banks, restructuring of weaker banks, allowing freer entry of new banks and
generally improving the incentive system under which banks function;
(iii) building financial infrastructure relating to supervision, audit, technology and legal framework; and
(iv) upgradation of the level of managerial competence and the quality of human resource of banks by
reviewing relating to recruitment, training, and placement.
Pre-requisites for Reforms in Financial Sector

There are certain commandments for pre-requisites for systemic reform of the financial sector. First and foremost,
macroeconomic stabilisation is a must during the reform process. Fiscal and external policies must support
monetary policy in maintaining the overall macro-economic balance. Secondly, during the reform period, prudential
regulation must be introduced and adhered to in order to help safeguard against a financial crisis and prevent
the undermining of monetary control and macro-economic adjustment. Thirdly, the Government must
simultaneously implement wide-ranging reforms in other sectors, specially those which require support from the
financial system to get the best results.
SALIENT FEATURES OF FINANCIAL SECTOR REFORMS IN INDIA

In conformity with the broad philosophy and strategy for reforms, salient features of the financial sector reforms
in India could be analysed under three broad categories:
(a) Policy framework,
(b) Improvement in financial health, and
(c) Institutional strengthening.
(a) Policy Framework

The external factors bearing on the profitability of the banking system related to the administered structure of
20 PP-FT&FM
interest rates, high levels of pre-emptions in the form of reserve requirements and credit allocation to certain
sectors. Easing of these external constraint constitutes a major part of the reform agenda.
(i) Interest Rate Policy
The reform of the interest rate regime constitutes an integral part of the financial sector reforms. For long, an
administered structure of interest rates was in vogue. The purpose behind this structure was largely to direct
implicit subsidy to certain sectors and enable them to obtain funds at concessional rates of interest. An element
of cross subsidisation automatically got built into a system where concessional rates of interest provided to
some sectors were compensated by higher rates charged to other non-concessional borrowers. The regulation
of lending rates, ipso factor, led to the regulation of the deposit rates mainly to keep the cost of funds to banks in
reasonable relation to the rates at which they are required to lend. This systems of setting the interest rates
through administrative fiat became extremely complex and was characterised by detailed prescriptions on the
lending as well as the deposit side.
In recognition of the problems arising from administrative control over the interest rates, such as, market
fragmentation, inefficient allocation of resources, and the like. Several attempts were made since the mid-1980s
to rationalise the level and structure of interest rates in the country. Initially, steps were taken to develop the
domestic money market and freeing of the money market rates. The rates of interest offered on Government
securities were progressively raised so that the government securities were progressively raised so that the
Government borrowing could be carried out a market-related rates. The rates at which the corporate entities
could borrow from the capital market were also freed.
In respect of banks, a major effort was undertaken to simplify the administered structure of interest rates. In
September 1990, a process of simplification was undertaken by reducing the number of slabs for which lending
rates had hitherto been prescribed. Until some time ago, the Reserve Bank was prescribing a minimum lending
rate, two concessional rates of lending for small borrowers and a maximum deposit rate. The rationalisation in
the structure of interest rates culminated in the Reserve Bank abolishing and minimum lending rate in October
1994 and leaving banks to determine their prime lending rates. On the deposit side, since July, 1996 the Reserve
Bank prescribes only a maximum rate for deposits upto one year.
A gradual approach has thus far been adopted in reforming the interest rates structure in India. Care has been
taken to ensure that banks and financial intermediaries do not have incentives which tempt them to lend at high
rates of interest assuming higher risks. A major safeguard in this regard has been the prescription of prudential
norms relating to provisioning and capital adequacy. These combined with higher standards of operational
accountability and appraisal of credit risks would ensure that banks lend prudently and with care.
(ii) Pre-emption of Deposits
In the past, the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) had to be maintained at high
levels because of rising fiscal and monetised deficits. Reduction in these deficits is now the stated goal of fiscal
policy and several steps have already been taken in this direction. As the containment of deficits occurs, reductions
in the reserve requirements are being effected. These measures will help to increase the lendable resources
available with the banking industry. It must be noted, however, that being an instrument of monetary control,
CRR will continue to be used flexibly, depending on the monetary situation.
(iii) Directed Credit
In respect of directed lending, it is prescribed that 40 per cent of the net bank credit should go to certain
sectors?the priority sector?such as agriculture, small scale industry and small businesses and the programmes
for poverty alleviation. Give the imperfections of the credit market, credit allocation for certain sectors becomes
necessary in the Indian context. The prescription of 40 per cent of net bank credit to the priority sector as well as
prescription of two concessional rates of interest applicable for small loans have been retained. Since the bulk
of borrowers with such credit needs fall within the priority sector, they will continue to obtain bank finance at
Lesson 1
21
concessional rates. Priority sector borrowers with credit needs of higher amounts will however, be governed by
the general interest rate prescriptions. This will ensure that a certain proportion of bank credit goes to the
designated sector and to the needy borrowers, without unduly affecting the viability and profitability of banks.
(b) Improvement in Financial Health

Another major element of the financial sector reforms has been the introduction of prudential norms and regulations
aimed at ensuring the safety and soundness of the financial system, imparting greater transparency and accountability
in operations and restoring the credibility of and confidence in the Indian financial system. Prudential norms serve
two primary purposes? first, they bring out the true position of a banks loan portfolio and secondly, they help to
arrest its deterioration. In the absence of an effective prudential framework, the reform process can run into difficulties.
Introduction of prudential regulations as part of the reform process is therefore a must. Prudential reforms introduced
in India relate to income recognition, asset classification, provisioning for bad and doubtful debts and capital
adequacy. A proper definition of income is essential in order to ensure that banks take into account income which
is actually realised. Banks have now been given a clear definition of what constitutes a non-performing asset and
instructions have been issued that no interest should be charged and taken to income account on any nonperforming asset. The definition of non-performing asset is also being tightened over a time. Banks are now
required to make provisions on advances depending on the classification of assets into the four broad groups: (i)
standard assets, (ii) sub-standard assets, (iii) doubtful assets, and (iv) loss assets. The provisioning requirement
ranges from 10 per cent to 100 per cent depending on the category of the asset. Banks have now fully met with the
new provisioning requirements.
(c) Institutional Strengthening

Along with relaxing the external constraints and introducing the prudential norms, a major effort has been to
strengthen the banking system in general, and public sector banks, in particular, through appropriate institution
building measures of (i) recapitalisation, (ii) improving the quality of loan portfolio, (iii) instilling a greater element
of competition and (iv) strengthening the supervisory process.
A more competitive environment is also being created. Banks are already facing competition from non-bank
finance companies primarily on the lending side and from mutual funds and other similar institutions on the
deposit side. They, therefore, need to gear themselves up to meet this challenge. But significantly, banks are
also facing competition from within their industry. New banks are now being set up in the private sector, although
the challenge from these new banks will for some time be minimal. The improvement in the efficiency of the
public sector banks will have to come from within and from the need to improve their profitability. Banks with
strong balance sheets are now going to the capital market and raising funds. This will also make them accountable
to a wider base of shareholders resulting in better performance.
A strong system of supervision is essential for a sound banking system. There has to be an alert mechanism for
monitoring compliance with prudential regulation and directives of the Reserve Bank and other regulatory agencies.
The system of external supervision of banks has been revamped with the setting up of a separate Board for
Financial Supervision (BFS) within Reserve Bank, concentrating exclusively on supervisory issues. The Board will
ensure compliance with regulations and guidelines in the areas of credit management, asset classifications, income
recognition, capital adequacy, provisioning and treasury operations. Supervision, however, can at best be a second
line of defence; the main mechanism of compliance and control must operate within the financial institutions.
Financial Sector Reforms Present Scenario

Financial Sector Regulations
With increasing financial sector liberalisation and emergence of financial conglomerates, financial sector
stability has emerged as a key objective of the Reserve Bank. In this context, the recent emphasis in the
regulatory framework in India on ensuring good governance through fit and proper owners, directors and
22 PP-FT&FM
senior managers of the banks infuses a qualitative dimension to the conventional discharge of financial
regulation through prescribing prudential norms and encouraging market discipline. In totality, however, these
measures interact to produce a positive impact on the overall efficiency and stability of the banking system in
India.
The thrust of the Reserve Banks financial sector policies is on strengthening the health of financial institutions
as well as on improving the efficiency of financial markets. Policy initiatives encompassed the adoption of
international standards and codes in the banking system, strengthening urban cooperative banks (UCBs) and
non-banking financial companies (NBFCs) and improvement in customer services. The Reserve Bank undertook
several initiatives to improve corporate governance in the banking system.
The Reserve Bank continued to stress the need to improve customer services by banks to ensure that the
benefits of financial liberalization percolate to the widest sections of society. Several measures were undertaken
to further improve the functioning of the money, the debt and the foreign exchange markets. Internal technical
groups on the money market, the Government securities market and the foreign exchange market were set up
to chart a medium-term framework for the future course of market development in the context of the ongoing
changes in the institutional framework and market dynamics.
In the capital market, policy initiatives are directed towards further broadening and deepening the markets,
achieving better investor protection and making the market investor friendly.
In regard to capital flows, India has adopted a policy of active management of the capital account. The compositional
shifts in the capital account towards non-debt flows since the early 1990s have been consistent with the policy
framework, imparting stability to the balance of payments. The substitution of debt by non-debt flows also gives
room for manoeuvre since debt levels, particularly external commercial borrowings, have been moderate. There is
also the cushion available from the foreign exchange reserves. Since non-debt creating flows are dominating, the
emphasis is on encouraging inflows through foreign direct investment and enhancing the quality of portfolio flows
by strict adherence to what may be described as Know Your Investor principle. Prudential regulations over financial
intermediaries, especially over banks, in respect of their foreign exchange exposures and transactions are a
dynamic component of management of the capital account as well as financial supervision.
India has made significant progress in financial liberalization since the institution of financial sector reforms in
1992 and this has been recognized internationally. India has chosen to proceed cautiously and in a gradual
manner, calibrating the pace of capital account liberalization with underlying macroeconomic developments, the
state of readiness of the domestic financial system and the dynamics of international financial markets. Unlike in
the case of trade integration, where benefits to all countries are demonstrable, in the case of financial integration,
a threshold in terms of preparedness and resilience of the economy is important for a country to get full
benefits. A judgmental view needs to be taken whether and when a country has reached the threshold and
financial integration should be approached cautiously, preferably within the framework of a plausible roadmap
that is drawn up by embodying the country-specific context and institutional features. The experience so far has
shown that the Indian approach to financial integration has stood the test of time.
The optimism generated by the recent gains in microeconomic performance warrants a balanced consideration
of further financial liberalisation. At this stage, the optimism generated by impressive microeconomic performance
accompanied with stability has given rise to pressures for significantly accelerating the pace of external financial
liberalization. It is essential to take into account the risks associated with it while resetting an accelerated pace
of a gradualist approach. The recent experience in many countries shows that periods of impressive
macroeconomics performance generate pressures for speedier financial liberalization since everyone appears
to be a gainer from further liberalization, but the costs of instability that may be generated in the process are
borne by the country, the government and the poorer sections. Avoiding crisis is ultimately a national responsibility.
The approach to managing the external sector, the choice of instruments and the timing and sequencing of
policies are matters of informed judgment, given the imponderables.
Lesson 1
23
The overall approach to the management of Indias foreign exchange reserves in recent years reflects the
changing composition of the balance of payments and the liquidity risks associated with different types of flows
and other requirements. The policy for reserve management is thus judiciously built upon a host of identifiable
factors and other contingencies. Taking these factors into account, Indias foreign exchange reserves continue
to be at a comfortable level and consistent with the rate of growth, the share of external sector in the economy
and the size of risk-adjusted capital flows.
The financial system in India, through a measured, gradual, cautious, and steady process, has undergone
substantial transformation. It has been transformed into a reasonably sophisticated, diverse and resilient system
through well-sequenced and coordinated policy measures aimed at making the Indian financial sector more
competitive, efficient, and stable. Concomitantly, effective monetary management has enabled price stability
while ensuring availability of credit to support investment demand and growth in the economy. Finally, the multipronged approach towards managing capital account in conjunction with prudential and cautious approach to
financial liberalization has ensured financial stability in contrast to the experience of many developing and
emerging economies. This is despite the fact that we faced a large number of shocks, both global and domestic.
Monetary policy and financial sector reforms in India had to be fine tuned to meet the challenges emanating
from all these shocks. Viewed in this light, the success in maintaining price and financial stability is all the more
creditworthy.
As the economy ascends a higher growth path, and as it is subjected to greater opening and financial integration
with the rest of the world, the financial sector in all its aspects will need further considerable development, along
with corresponding measures to continue regulatory modernization and strengthening. The overall objective of
maintaining price stability in the context of economic growth and financial stability will remain.
Indias financial system holds one of the keys, if not the key, to the countrys future growth trajectory. A growing
and increasingly complex market-oriented economy, and its rising integration with global trade and finance,
require deeper, more efficient and well-regulated financial markets.
The Government of India Constituted a High Level Committee on Financial Sector Reforms on 17th August
2007, under the Chairmanship of Shri Raghuram Rajan, Professor, Graduate School of Business, University of
Chicago, with a view to outlining a comprehensive agenda for the evolution of financial sector indicating especially
the priorities and sequencing decisions. The terms of Reference of the Committee were as under:
(i) To identify emerging challenges in meeting the financing needs of the Indian economy in the coming
decade and to identify real sector reforms that would allow those needs to be more easily met by the
financial sector;
(ii) To examine the performance of various segments of the financial sector and identify changes that will
allow it to meet the needs of the real sector;
(iii) To identify changes in the regulatory and supervisory infrastructure that can better allow the financial
sector to play its role, while ensuring that risk are contained; and
(iv) To identify changes in the other areas of the economy-including in the conduct of monetary and fiscal
policy, and the operation of legal system and the education system-that could help the financial sector
function more effectively.
The Committee on Financial Sector Reforms delivered its Draft report to Indias Planning Commission in April
2008. The report shows that recognizing the deep linkages among different reforms, including broader reforms
to monetary and fiscal policies, is essential to achieve real progress.
The report has three main conclusions. First, the financial system is not providing adequate services to the
majority of Indian retail customers, small and medium-sized enterprises, or large corporations. Government
ownership of 70% of the banking system and hindrances to the development of corporate debt and derivatives
markets have stunted financial development. This will inevitably become a barrier to high growth. Second, the
24 PP-FT&FM
financial sector if properly regulated, but unleashed from government strictures that have stifled the development
of certain markets and kept others from becoming competitive and efficienthas the potential to generate
millions of much-needed jobs and, more important, have an enormous multiplier effect on economic growth.
Third, in these uncertain times, financial stability is more important than ever to keep growth from being derailed
by shocks, especially from abroad.
FINANCIAL SECTOR LEGISLATIVE REFORMS COMMISSION, 2011

The Finance Minister in his Budget speech of 2011-2012 announced the formation of FSLRC to rewrite and
harmonise financial sector legislations, rules and regulations. The resolution notifying the FSLRC was issued by
the government in March 2011.
Chaired by Justice BN Srikrishna, the Commission has a diverse mix of expert members drawn from the fields
of finance, economics, public administration, law, etc.
Purpose of formation
FSLRC was formed as most legal and institutional structures of the financial sector in India had been created
over a century. Many financial sector laws date back several decades, when the financial landscape was very
different from that seen today.
There are over 61 Acts and multiple rules and regulations that govern the financial sector. For example, the
SEBI (Securities and Exchange Board of India) Act does not give the regulator powers to arrest anyone but
tasks it with penalising all market related crimes stiffly. The Reserve Bank of India (RBI) Act and the Insurance
Act are of 1934 and 1938 period, respectively.
The Commission was formed to review and recast these old laws in tune with the modern requirements of the
financial sector. FSLRC plans to eliminate 25 of the current 61 laws that currently govern the financial sector and
amend many others.
FSLRC moots single regulator

The FSLRC submitted its report in March 2013.It came up with its recommendation spread over two volumes
and 439 pages. The Commission has proposed an Indian Financial Code Bill 2013 to create a Unified Financial
Authority (UFA) and bring about reforms in financial sector regulations. The panel suggested that SEBI, IRDA,
PFRDA (Pension Fund Regulatory and Development Authority) and the Forward Markets Commission (FMC)
be merged under one regulatorUFA.
However, RBI (Reserve Bank of India) will continue to be the banking regulator. The new UFA would subsume
watchdogs for insurance, capital markets, pension and commodities while letting the RBI continue its supervisory
role over the banking industry.
Consumer protection
According to FSLRC, all financial laws and regulators are intended to protect the interest of consumers. Hence,
a dedicated forum for relief to consumers and detailed provisions for protection of unwary customers against
mis-selling and defrauding by smaller print etc has been recommended.
The FSLRC report proposes certain basic rights for all financial consumers. For lay investors, the report proposes
additional set of protections. The Commission has recommended some amendments to existing laws and new
legislations. These changes will have to be carefully brought about accordingly.
Some basic protections consumers would expect include that financial service providers must act with due
diligence. It is essential to protect investors against unfair contract terms, unjust conduct and protection of
personal information. The FSLRC report also recommends fair disclosure and redressal of investor complaints
by financial service providers.
Lesson 1
25
Financial Regulatory Architecture Act

The proposed regulatory structure will be governed by the Financial Regulatory Architecture Act that will ensure
a uniform legal process for the financial regulators. The finance ministry will unify the regulatory structure before
tweaking the legislative structure. It may take two years for the report to be implemented in a phased manner.
Judicial review
The panel has recommended judicial review of regulations. The report has suggested a sunset clause of 10
years. In other words, the laws would be reviewed every 10 years. The committee also recommended giving
required attention to debt management and setting up a financial redressal agency and a financial stability and
development council.
FINANCIAL SECTOR REFORMS: SOME CRITICISMS

It is not surprising that the sweeping nature of the financial sector reforms has evoked some criticism. While the
banking community and the customer in general have welcomed the changes that have been ushered in,
criticisms mainly emanated from those who are enchored to certain ideological moorings. Internationally, a
trenchant critic of financial sector reforms has bee Joseph Stighlita, who has argued that financial markets are
vulnerable to market failure more than any other market and therefore, government intervention in financial
market is imperative. He writes, that there exists form of government intervention that will not only make these
(financial) markets function better but will also improve the performance of the economy. The need for intervention
in financial markets is not denied by any one. All advocates of financial sector reforms have pleaded that deregulation should be accompanied if not preceded by putting in place a rigorous set of prudential standards to
be meet by financial institutions. As John Crow Former Governor of the Bank of Canada said, deregulation
does not mean desupervision. Internationally accepted common standards for income recognition, provision
and capital adequacy have come into force in almost all countries.
Financial Sector reforms in India is basically criticised on the grounds of slow pace of reforms and nonimplementation of capital account convertibility. In this context eminent Ford Economist Paul Krugman has
recently rightly pointed out, India had avoided the worst of the Asian crisis because existing restrictions
discouraged inflows and out flows of short term capital. India should close down its weak banks, impose
serious capital requirements on the strong one, and leave the currency convertibility programme where it
is. Thus, India which has been slow to open up for right things, has fortunately also been slow to open up to
the wrong things. Reforms are premised on two critical factors. Krugman emphasised, education and
infrastructure both left much to be desired in India. Having introduced liberalisation, it was incumbent on
India to address these two areas of failure. The failure presents the country with greater opportunities,
provided the right lessons were learnt. Recently eminent economist Prof. Amartya Sen, a noble laureate
while supporting the programme of reforms in India has suggested to concentrate on two issues i.e. primary
education.
FINANCIAL MANAGEMENT A NEW LOOK

Financial management in India has also changed substantially in scope and complexity in view of recent
government policy. Some of the changes include introduction of new financial instruments and transactions like
options and future contracts, foreign currency swaps, and interest rate swaps, GDR (Global Depository Receipts),
Euro Issues, globalization of capital markets, finance mix, liberalisation measures taken by government etc. All
these have emphasised the need for effective and efficient use of corporate financial resources.
Under the changed circumstances, financial management covers the following:
(a) Raising the funds: Apart from Indian Public and Financial Institutions, companies have started raising
funds etc. in the international markets by way of Euro Issues and from International Financial Institutions
26 PP-FT&FM
etc. Foreign currency loans are availed from foreign banks due to globalization. Foreign Institutional
Investors (FII) have also started participation in Indias equity market due to liberalisation of the
economy.
(b) Investment Decisions: Presently, investment decisions of firms are not confined to Indian territory
but spread over globally. Foreign investors are encouraged. Hence the competitions in India as well
as from abroad have made the financial management more complex and foreign exchange
management has become highly specialised area in financial management. The time value of money
coupled with exchange rate fluctuations make the decision making exercise more complex and
compelled the decision makers to make the use of various sophisticated management techniques
like probability theory, capital rationing, linear programming, goal programming and sensitivity analysis
to overcome the problems.
(c) Dividend Decisions: In view of wealth maximisation of firm, the internal generation of funds are not
paid out by way of dividend or issue of bonus shares. They are utilised by companies in portfolio
management by floating mutual funds etc. In order to avoid scams, the Government has established
new institutions like SEBI, NSE, Stock Holding Corporation of India etc. It further increases the scope of
financial management and makes it more complex.
However, in true sense, as such there is no change in scope of financial management in India because it still
aims at maximising value of shares. Basically, it is extension in earlier coverage.
LESSON ROUND-UP
Financial Management deals with procurement of funds and their effective utilizations in the business
and concerned with investment, financing and dividend decisions in relation to objectives of the company.
Investment decisions are essentially made after evaluating the different proposals with reference to
growth and profitability projections of the company.
Financing decisions are concerned with the determination of how much funds to procure from amongst
the various avenues available i.e. the financing mix or capital structure.
Dividend decision is to decide whether the firm should distribute all profits or retain them or distribute
a portion and retain the balance.
Profit maximization ensures that firm utilizes its available resources most efficiently under conditions
of competitive markets.
Wealth maximization means the management of an organization maximizes the present value not
only for shareholders but for all including employees, customers, suppliers and community at large.
Economy value added is the after cash flow generated by a business minus the cost of capital it has
deployed to generate that cash flow.
Liquidity means ability of the business to meet short-term obligations. It shows the quickness with
which a business/company can convert its assets into cash to pay what it owes in the near future.
Profitability ratio reflects on the ability of management to earn a return on resources put in by the
shareholders evaluating the performance of the company in different spheres
Financial reform in India is aimed at enhancing the productivity and efficiency of the economy as a
whole and also increasing international competitiveness
Lesson 1
27
SELF-TEST QUESTIONS
(These are meant for re-capitulation only. Answers to these questions are not to be submitted for evaluation)
1. Discuss the nature and scope of Financial Management.
2. What is justification for the goal of maximising the wealth of shareholders?
3. Critically examine the goals of maximisation of profit and maximisation of return on equity.
4. The goal of profit maximisation does not provide us with an operationally useful criterion. Comment.
5. Financial management has changed substantially in scope and complexity in recent decades. How do
you account for this trend? In what directions has emphasis in the field been shifted?
6. Investment, financing and dividend decisions are interrelated. Comment.
7. What criteria should you adopt in making financial decisions in your company? Discuss with reference
to the costing of funds decisions.
8. Write short notes on:
(a) Liquidity;
(b) Profitability;
(c) Costing and risk;
(d) Financial distress.
9. Discuss the responsibilities of a financial executive in a corporation.
28 PP-FT&FM
Lesson 2
Lesson 2
Capital Budgeting
LESSON OUTLINE
Capital Budgeting
29
LEARNING OBJECTIVES
Time Value of Money
Capital Budgeting is one of core and most

difficult task of a finance manager. In capital
budgeting cum investment appraisal decision,
a finance manager is to co-ordinate with project
managers, bankers and promoters to get
different data for his analysis. Capital budgeting
requires use of various techniques including
statistical techniques.
Planning and Control of Capital

Expenditure
Techniques of Capital BudgetingDiscounted and Non- Discounted Cash
Flow Methods,
The object of the study lesson is to enable the

students to understand:
Choice of Methods
Capital Rationing;
Need and importance of Capital

Budgeting
Risk Evaluation and Sensitivity Analysis,
Factors Including Investment Decision
Kinds of Capital Budgeting Decisions
Linear Programming and Capital

Budgeting Decisions under Constraints
and with Multiple Objectives using
Mathematical Programming Models,
Planning of Capital Expenditure

Capital Expenditure Control
Capital Rationing
Inflation, Uncertainty and Evaluation using

Statistical Decision Theory
Analysis of Capital Budgeting, DecisionsSome Case Studies
Risk Evaluation and Sensitivity Analysis
Various methods of Capital Budgeting.
LESSON ROUND UP
Cost of Capital and its implications in

Capital Budgeting decisions.
SELF TEST QUESTIONS
29
30 PP-FT&FM
TIME VALUE OF MONEY

Introduction
One of the most fundamental concepts in finance is that money has a time value. That is to say that money in
hand today is worth more than money that is expected to be received in the future. The reason is straightforward:
A rupee that you receive today can be invested such that you will have more than a rupee at some future time.
Suppose A win a Prize in a contest and he has got two options.
A. Receive `10,000 now
OR
B. Receive `10,000 in three years
Which option should A choose?
If A is a rational person he would choose to receive `10,000 now. After all, three years is a long time to wait. Why
would any rational person defer payment into the future when he or she could have the same amount of money
now? For most of us, taking the money in the present is just natural. So at the most basic level, the time value of
money demonstrates the concept of time value:
A rupee today is worth more than a rupee tomorrow.
The time value of money serves as the foundation for all other notions in finance. It impacts business finance,
consumer finance, and government finance. Time value of money results from the concept of interest.
Why ` 1 received today worth more than 1 ` Received after a time period
There are four primary reasons why a rupees to be received in the future is worth less than a rupees to be
received immediately.
1. Presence of positive rates of inflation which reduce the purchasing power of rupees through time.
Suppose Rate of petrol about one year back was ` 65 per litter and now it is 76 per litter. This may be
observed that in this example purchase power of rupee in terms of petrol purchased has decreased
from 1/65 to 1/76.
2. A rupee today is worth more today than in the future because of the opportunity cost of lost earnings
that is, it could have been invested and earned a return between today and a point in time in the future.
3. Thirdly, all future values are in some sense only promises, and contain some uncertainty about their
occurrence. As a result of the risk of default or non-performance of an investment, a rupee in hand today
is worth more than an expected rupee in the future.
4. Finally, human preferences typically involve impatience, or the preference to consume goods and services
now rather than in the future.
Use of Time Value of Money

Some standard calculations based on the time value of money are:
Present Value: Present value refers to the current worth of a future sum of money or stream of cash flows given
a specified rate of return. Present Value of a cash flow is calculated on the basis of formula as given below
PV = Cash Flow/ (1+r) t
Here r refers to required rate of return and t refers to the period.
Lesson 2
Capital Budgeting
31
Example
Find Present Value of ` 80,000 to be received after five years when required rate of return is 10%
Present Value = 80000/ (1+0.10)5
= ` 49,674
Assume in the same example, the rate of return is 15%,
Present Value will be
= 80000/ (1+0.15)5
= 39,774
The above calculation shows, higher the discount rate, the lower the present value of the future cash flows.
Future Value of a lump sum

Future value of a lump sum refers to the value after a certain period of time at the given rate of interest.
It may be calculated by under given formula
FVt = CF0 * (1+r)t OR FVt = PV * (1+r)t
Where FVt = Future Value after a period t
R = Rate of return
PV= Present Value
Example. Find present value of maturity value of ` 10,000 which has been given on 15% interest for five years
while required rate of return is 10%.
FV of ` 10,000 @ 15% after five years = ` 10,000 (1+0.15)5 = ` 20,113.57
Present Value of ` 20,113.57 which is to be received after 5 years =
`20,113.57/ (1+0.10)5 = ` 12,488.94
Present Value of a cash flow stream

It refers to the present value of a series of cash flows occurred in different years.
Example
Find Present Value of cash flows to be accrued as given below when required rate of return is 10%
Period
Cash Flow in `
80,000
70,000
50,000
30,000
Present Value = ` 80,000/(1+0.10)1+ ` 70,000/(1+0.10)2 + ` 50,000/(1+0.10)3 + ` 30,000/(1+0.10)4 = ` 1,88,635
Net Present Value

Net Present Value is the difference between the sum total of present values of all the future cash inflows and outflows:
Algebraically:
NPV =
R1
(1 K)1
R2
(1 K)2
...
Rn
(1 k)n
Wn
(1 k)n
Sn
(1 k)n
If cash outflow is also expected to occur at some time other than initial investment (non-conventional cash flows)
then formula would be
32 PP-FT&FM
R
Rn
Sn
Wn
C1
Cn
1
C 0
NPV
...
...
n
n
n
t
n
(1 k )1
(
1
k
)
(
1
k
)
(
1
k
)
(
1
k
)
(
1
k
)
NPV
= Net Present Value
R = Cash inflow at different time period

K = Rate of discount or cost capital
t = 1 = first period in the sum
N = The last period in the sum
Sn = Salvage value
W n = Working capital
C = Cost of investment plus Working Capital
Example
A Company has Invested ` 8,00,000 in a business and expected a series of cash flow as per under given details
Year
Cash Flow in `
Additional Cash outflow
2,50,000
Nil
4,20,000
1,05,000
3,50,000
Nil
2,50,000
10,000
At the end of fourth year company made a sale of scrap for ` 2,40,000 and realized ` 30,000 from working
capital. Find Net Present Value (NPV) if required rate of return is 10%
Present Value of Cash Flows = ` {(2,50,000/ (1+0.10)1+ 4,20,000/(1+0.10)2 + 3,50,000/(1+0.10)3 + 2,50,000/
(1+0.10)4 + 2,40,000(1+0.10)4+ 30,000(1+0.10)4} = ` 11,92,507
Present Value of Cash Out Flows = ` {(8,00,000/ + 1,05,000 / (1+0.10)2 + 10,000(1+0.10)4} = ` 8,93,607
Net Present Value = Present Value of Cash Inflow- Present value of Cash Outflows
= ` 11,92,507- ` 8,93,507= ` 2, 98,900.
CAPITAL BUDGETING- PLANNING AND CONTROL OF CAPITAL EXPENSES

In modern times, the efficient allocation of capital resources is a most crucial function of financial management.
This function involves organisations decision to invest its resources in long-term assets like land, building
facilities, equipment, vehicles, etc. All these assets are extremely important to the firm because, in general, all
the organisational profits are derived from the use of its capital in investment in assets which represent a very
large commitment of financial resources, and these funds usually remain invested over a long period of time.
The future development of a firm hinges on the capital investment projects, the replacement of existing capital
assets, and/or the decision to abandon previously accepted undertakings which turns out to be less attractive to
the organisation than was originally thought, and divesting the resources to the contemplation of new ideas and
planning. For new projects such as investment decisions of a firm fall within the definition of capital budgeting or
capital expenditure decisions.
Capital budgeting refers to long-term planning for proposed capital outlays and their financing. Thus, it includes
Lesson 2
Capital Budgeting
33
both raising of long-term funds as well as their utilisation. It may, thus, be defined as the firms formal process
for acquisition and investment of capital. To be more precise, capital budgeting decision may be defined as the
firms decision to invest its current fund more efficiently in long-term activities in anticipation of an expected flow
of future benefit over a series of years. The long-term activities are those activities which affect firms operation
beyond the one year period. Capital budgeting is a many sided activity. It contains searching for new and more
profitable investment proposals, investigating, engineering and marketing considerations to predict the
consequences of accepting the investment and making economic analaysis to determine the profit potential of
investment proposal. The basic feature of capital budgeting decisions are:
(1) current funds are exchanged for future benefits;
(2) there is an investment in long-term activities; and
(3) the future benefits will occur to the firm over series of years.
NEED FOR CAPITAL INVESTMENT

This is the logical question and the answer to that is rather easy. The following factors give rise to the need for
capital investments:
(a) Wear and tear of old equipments.
(b) Obsolescence.
(c) Variation in product demand necessitating change in volume of production.
(d) Product improvement requiring capital additions.
(e) Learning-curve effect.
(f) Expansion.
(g) Change of plant site.
(h) Diversification.
(i) Productivity improvement.
Some of these factors are self-explanatory. However, we add a few explanatory lines on a few of these factors.
Obsolescence occurs when alternative methods of equipments for performing a function become available
which are significantly better either in terms of quality of newness of the product or plant safety. In a high
consumption economy like U.S.A. this problem is acute. In an economy like India, the problem of obsolescence
is still rare. Only in certain investments for manufacturing export products (e.g. garments, jute goods, cotton
textiles), this problem exists. Product improvements require changes in equipments and this problem is also not
an important factor in influencing capital investment decisions in India, expecting changes special product qualities
like radios, transistors, televisions etc. Learning curve consideration influences capital decisions in the sense
that new equipments might be such as to cut down learning time and effect considerable saving on training
expenses. For reasons such as expansion, new sources of raw materials, new markets, labour conditions,
transportation or termination of a lease, an entire plant may have to be relocated. The cost of removing a plant
is enormous and management may decide to undertake modernisation through a complete new layout and
equipment purchases. Many progressive companies seek out new markets and new products. They may even
like to acquire another company for purpose of diversification. All these require major capital investments. In
some industries, wage escalation may force management to acquire labour-saving equipment machinery to
effect saving on wages and at the same time improve productivity.
INVESTMENT DECISIONS MANAGEMENT PERSPECTIVE

Usually, in investment problems, much attention is focussed on how to choose among alternative projects, so
34 PP-FT&FM
that one is tempted to believe that this constitutes the only problem in capital decisions. However, if we examine
carefully, it is easy to realise that choice among alternatives is only one facet albeit the important facet of the
problem from the top management perspective. The other facets are implementation and control as applied to
all phases of capital investment, and these are important aspects because in the ultimate analysis, the top
management is accountable to Board of directors and owners for the success or failure of investment plans.
Let us examine in brief how investment decisions are influenced by management perspective. Obviously, we
have to start with the company objectives which provide the broad guidelines to policies, plans and operations.
A possible objective might be to maximise return on investment in which case the management might seek to
minimise investment by selecting only a few capital projects that yield the highest returns. On the other hand, the
objective may be to maximise sales volume and in that case all capital investment that yield a net profit (may be
small) would be made without undue concern. If the management is guided by a growth objective, expansionary
investment involving high capital cost would be undertaken.
Within the board company objectives, top management also reviews the competitive position of the company
and if the competition is sharper, the management looks out continuously to evaluate and upgrade the equipments
to achieve greater efficiency at least cost. In big companies, the management sets out policies to guide lower
levels of management in the search for evaluation of and initiation of capital projects.
Top management has also to keep watch on company funds which finance investments. It cannot allow funds to
lie idle just because suitable project is not at hand. The cost of idle funds is substantial and hence the need for
looking out for suitable investment opportunities. If such opportunities exist then the management must spare
funds and if existing funds are inadequate it should raise funds externally. It should be remembered that if there
is no profitable investment opportunity with in the company, the dividend policy of the company should be liberal.
Funds for capital investment must be arranged on a long-term basis otherwise borrowings short and investing
long can lead to lack of liquidity and consequent troubles. The major sources of long-term funds are long-term
borrowing, new equity capital (sale of stock) and retained earnings. Sometimes, a change in the inventory
system also releases funds by effecting reduction in inventory to be carried. The selection of the right source of
funds is again influenced by managements own belief and value judgement and such other factors like outsider
control, dilution of equity, price earnings ratio, cost of funds etc.
And finally, the top management is usually concerned with implementation and control aspects of investment
projects. Specific responsibilities are to be assigned to specific individuals or cells and progress reports have to
be carefully studied. In big projects, improved methods like programme evaluation review technique (PERT) or
critical path method (CPM) may be used.
IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting decisions are of paramount importance in financial decision. So it needs special care on
account of the following reasons:
(1) Long-term Implications: A capital budgeting decision has its effect over a long time span and inevitably
affects the companys future cost structure and growth. A wrong decision can prove disastrous for the
long-term survival of firm. It leads unwanted expansion of assets, which results in heavy operating cost
to the firm. On the other hand, lack of investment in asset would influence the competitive position of the
firm. So the capital budgeting decisions determine the future destiny of the company.
(2) Involvement of large amount of funds: Capital budgeting decisions need substantial amount of capital
outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision
would not only result in losses but also prevent the firm from earning profit from other investments which
could not be undertaken.
(3) Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible because it is
Lesson 2
Capital Budgeting
35
difficult to find a market for such assets. The only way out will be to scrap the capital assets so acquired
and incur heavy losses.
(4) Risk and uncertainty: Capital budgeting decision is surrounded by great number of uncertainties.
Investment is present and investment is future. The future is uncertain and full of risks. Longer the
period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and
profits may not come true.
(5) Difficult to make: Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events which are uncertain. It is
really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to
the uncertainties caused by economic-political social and technological factors.
FACTORS INFLUENCING INVESTMENT DECISION

We shall now study the factors, which have specific or general relevance to capital investment decisions. We
have realised already that capital investment decisions are not governed by one or two factors, because the
investment problem is not simply one of replacing an old equipment by a new one, but is concerned with
replacing an existing process in a system with another process which makes the entire system more effective.
We discuss below some of the relevant factors that affects investment decisions:
(i) Management outlook: If the management is progressive and has an aggressive marketing and growth
outlook, it will encourage innovation and favour capital proposals which ensure better productivity or
quality or both. In some industries where the product being manufactured is a simple standardised one,
innovation is difficult and management would be extremely cost conscious. In contrast, in industries
such as chemicals and electronics, a firm cannot survive, if it follows a policy of make-do with its
existing equipment. The management has to be progressive and innovation must be encouraged in
such cases.
(ii) Competitors Strategy: The competitors strategy regarding capital investment exerts significant influence
on the investment decision of a company. If competitors continue to install more equipment and succeed
in turning out better products, the existence of the company not following suit would be seriously
threatened. This reaction to a rivals policy regarding capital investment often forces decision on a
company.
(iii) Opportunities created by technological change: Technological changes create new equipment
which may represent a major change in process, so that there emerges the need for re-evaluation of
existing capital equipment in a company. Such changes may justify new investments. Sometimes the
old equipment which has to be replaced by new equipment as a result of technical innovation may be
downgraded to some other applications. A proper evaluation of this aspect is necessary, but is often not
given due consideration. In this connection, we may note that the cost of new equipment is a major
factor in investment decisions. However, the management should think in terms of incremental cost, not
the full accounting cost of the new equipment because cost of new equipment is partly offset by the
salvage value of the replaced equipment. In such analysis an index called the disposal ratio becomes
relevant.
Disposal ratio =
Salvage value / Alternative use value

Installed cost
(iv) Market forecast: Both short and long run market forecasts are influential factors in capital investment
decisions. In order to participate in long-run forecast for market potential critical decisions on capital
investment have to be taken.
(v) Fiscal incentives: Tax concessions either on new investment incomes or investment allowance allowed
36 PP-FT&FM
on new investment decisions, the method for allowing depreciation deduction allowance also influence
new investment decisions.
(vi) Cash flow Budget: The analysis of cash-flow budget which shows the flow of funds into and out of the
company, may affect capital investment decision in two ways. First, the analysis may indicate that a
company may acquire necessary cash to purchase the equipment not immediately but after say, one
year, or it may show that the purchase of capital assets now may generate the demand for major capital
additions after two years and such expenditure might clash with anticipated other expenditures which
cannot be postponed. Secondly, the cash flow budget shows the timing of cash flows for alternative
investments and thus help management in selecting the desired investment project.
(vii) Non-economic factors: A new equipment may make the workshop a pleasant place and permit more
socialising on the job. The effect would be reduced absenteeism and increased productivity. It may be
difficult to evaluate the benefits in monetary terms and as such we call this as non-economic factor. Let
us take one more example. Suppose the installation of a new machine ensures greater safety in operation.
It is difficult to measure the resulting monetary saving through avoidance of an unknown number of
injuries. Even then, these factors give tangible results and do influence investment decisions.
RATIONALE OF CAPITAL BUDGETING DECISIONS

The rationale behind the capital budgeting decisions is efficiency. A firm has to continuously invest in new plant
or machinery for expansion of its operations or replace worn out machinery for maintaining and improving
efficiency. The main objective of the firm is to maximise profit either by way of increased revenue or by cost
reduction. Broadly, there are two types of capital budgeting decisions which expand revenue or reduce cost.
1. Investment decisions affecting revenue: It includes all those investment decisions which are expected
to bring an additional revenue by raising the size of firms total revenue. It is possible either by expansion
of present operations or the development of new product in line. In both the cases fixed assets are
required.
2. Investment decisions reducing costs: It includes all those decisions of the firms which reduces the
total costs and leads to increase in its total earnings i.e. when an asset is worn out or becomes outdated,
the firm has to decide whether to continue with it or replace it by new machine. For this, the firm evaluates
the benefit in the form of reduction in operating costs and outlays that would be needed to replace old
machine by new one. A firm will replace an asset only when it finds it beneficial to do so. The above
decision could be followed decisions following alternative courses: i.e. Tactical investment decisions to
strategic investment decisions, as briefly defined below.
3. Tactical investment decisions: It includes those investment decisions which generally involves a
relatively small amount of funds and does not constitute a major departure from what the firm has been
doing in the past.
4. Strategic investment decisions: Such decisions involve large sum of money and envisage major
departure from what the company has been doing in the past. Acceptance of strategic investment will
involve significant change in the companys expected profits and the risk to which these profits will be
subject. These changes are likely to lead stock-holders and creditors to revise their evaluation of the
company.
KINDS OF CAPITAL BUDGETING DECISIONS

Generally the business firms are confronted with three types of capital budgeting decisions (i) the accept-reject
decisions; (ii) mutually exclusive decisions; and (iii) capital rationing decisions.
(i) Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the proposal
Lesson 2
Capital Budgeting
37
is accepted, the firm incur the investment and not otherwise. Broadly, all those investment proposals which yield
a rate of return greater than cost of capital are accepted and the others are rejected. Under this criterion, all the
independent prospects are accepted.
(ii) Mutually exclusive decisions: It includes all those projects which compete with each other in a way that
acceptance of one precludes the acceptance of other or others. Thus, some technique has to be used for
selecting the best among all and eliminates other alternatives.
(iii) Capital rationing decisions: Capital budgeting decision is a simple process in those firms where fund is
not the constraint, but in majority of the cases, firms have fixed capital budget. So large number of projects
compete for these limited budget. So the firm ration them in a manner so as to maximise the long run returns.
Thus, capital rationing refers to the situations where the firm have more acceptable investments requiring greater
amount of finance than is available with the firm. It is concerned with the selection of a group of investment out
of many investment proposals ranked in the descending order of the rate of return.
PLANNING OF CAPITAL EXPENDITURE

From the above discussion, it is evident that capital budgeting is concerned with activities ranging from planning
the availability, allocation and control of expenditure of long-term as well as short-term investment funds.
Planning of capital expenditure could be done to finance the capital expenditure plans of the company for shortterm or long-term periods and hence the long-term plan budget and short-term plan budget.
A. As regards long-term plan budget, the period covered under the planning is three to five or more years.
The planning for such expenditure assumes a composite form involving all aspects of economic forecasts for
the outlook of entire industry in which the company performs with its unit and forecast for the company with
probable or expected coverage of market share. On the basis of this forecast plant managers estimate their
prospective capital expenditure, the marketing managers plan their market shares, the personnel managers
assess the requirements for manpower and technical hands to achieve targeted production results, and the
finance mangers plans, for the funds to be made available for investment taking into consideration the above
requirements. The long-range capital budget is continually revised with changing economic conditions, the
marketing environment, structure of wages and the inflationary pressures in the economy. It is flexible in nature
and oriented towards a long-range growth planning for the company.
B. As regards short-period Capital budgeting, involving short-range planning for funds, it covers expenditure
for a short duration involving the period covered within one or two years. It does not involve large capital expenditure
but covers temporary need for funds for different departments within the company depending upon the degree
of urgency, profitability and savings to be achieved with reference to the capital costs to be incurred. Short run
capital expenditure plans get converted into long-term plans of capital expenditure. Short-term capital expenditure
plan is known as operating budget and is concerned with revenues and expenses related to firms daily operations.
Significance of planning for capital expenditure is derived only with major investment proposals and the use of
funds over a long period. The most important factor affecting the planning horizon is the rate of change in
technology in the industry. The advancement in technology may warrant capital investment for short as well as
long period depending upon the changing pace of technology and technological obsolescence: long-term plan,
however, helps the company to analyse its need and directions into the distant future involving a technological
change.
CAPITAL EXPENDITURE CONTROL

Planning and control are inter-linked and consecutive steps for the successful implementation of any programme.
Planning done for incurring capital expenditure is followed by control devices to assess the divergencies between
the expected and achieved results. Control for capital expenditure is expressed keeping in view the above
objective.
38 PP-FT&FM
It may be recalled that capital expenditure is classified into three main forms viz.:
(1) expenditure made to reduce costs;
(2) expenditure made to increase revenue;
(3) expenditure which is justified on non-economic grounds.
Which exercise control over capital expenditure in any of the above categories, the capital expenditure analysis
should concentrate on three types of outlays viz.: (1) Major projects, (2) Routine expenditure, and (3) Replacement.
As regards major projects, strategic investment may be made for expansion of productive capacity or achieving
product innovation or preparing barriers against capital fluctuations. In the second type of outlay, routine
expenditure may be working condition improvement, maintenance expenditure, competition oriented expenditure
etc. Thirdly, replacement need may arise to avoid capital wastage for existing equipment to check its disposal
value or it may be obsolescence replacement. In all circumstances, proper attention is to be devoted in analysing
the need for the capital expenditure so that it would be curtailed to the minimum required.
One important aspect of control device is to match the demand schedule for the capital for the company and the
supply of capital from different sources. Demand comes for capital from all departments and it is at this level
control could be exercised to keep the demand at the bare minimum required for the objective inherent in capital
investment decisions. Supply of capital, on the other hand, is a scarce commodity and the company has to incur
expenditure for availing it. This necessitates for the finance manager to exercise economy in capital expenditure
so that optimum benefit could be obtained with the use of scarce capital sources. This establishes the need for
capital rationing to impose constraints on capital expenditure under prevailing market conditions and place selfimposed constraints to check the funds being raised from outside agencies like borrowings. Thus, the device of
capital rationing is adopted to control capital expenditure.
CAPITAL RATIONING
The firm may put a limit to the maximum amount that can be invested during a given period of time, such as a
year. Such a firm is then said to be resorting to capital rationing. A firm with capital rationing constraint attempts
to select the combination of investment projects that will be within the specified limits of investments to be made
during a given period of time and at the same time provide greatest profitability.
Capital rationing may be effected through budget ceiling. A firm may resort to capital rationing when it follows the
policy of financing investment proposals only by ploughing back its retained earnings. In that case, capital
expenditure in a given period cannot exceed the amount of retained earnings available for reinvestment.
Management may also introduce capital rationing when a department is authorised to make investments upto a
limit beyond which investment decisions will be made by higher level management.
Capital rationing may result in accepting several small investment proposals then accepting a few large investment
proposals so that there may be full utilisation of budget ceiling. This may result in accepting relatively less
profitable investment proposals if full utilization of budget is a primary consideration. Similarly, capital rationing
also means that the firm foregoes the next most profitable investment falling after the budget ceiling even though
it is estimated to yield a rate of return much higher than the required rate of return. Thus, capital rationing does
not lead optimum results.
CAPITAL BUDGETING PROCESS

It is a complex process which may be divided in the following phases:
I. Identification of Potential Opportunities: Mere identification or possible alternatives is not all that is required
in any search for investment proposals. The best proposal needs to be discovered and considered. Capital
expenditure proposals should come from different segments of the enterprise. Personnel working at different
Lesson 2
Capital Budgeting
39
levels in the organisation should be encouraged to participate in the discovery of best available proposals for
capital outlays within the limits of their authority, knowledge and experience. It is better if management establishes
well-defined guidelines for searching investment proposals so that no useful idea remains uncommunicated
and no redundant proposal pass through the processing stage.
Proposals regarding capital expenditure do not originate at the level of the controller or the budget committee.
The requirements for fixed-assets expenditure are forwarded by the managers of different operating units or
departments. It is, however, better if such proposals are accompanied by commercial and technical assumptions
on which these are based and duly supported with details relating to the following matters;
(a) Market potential for the product and yearly sales forecasts for different years.
(b) Raw material requirements and their supply position.
(c) Technical details relating to physical facilities and flow diagrams.
(d) Financial implications.
Capital expenditure proposals may also originate at the top management level of the company. The Chief
Executive may carry out survey relating to physical facilities, new market, development of new products, stage
of technology and the like. Such efforts may lead to discovery of certain useful alternatives which should be
screened and evaluated in the same way as originating at lower levels.
II. Establishing the Criteria: Economic performance like return on investment as calculated in a number of
ways under different methods furnishes the most important criterion used for evaluating fixed assets investment
proposals. But here also the technique to be used for evaluating economic performance should be clearly
defined and communicated. There are also occasions when non-economic criteria like competition, risk, legal
requirements, and social responsibilities become the over-riding considerations in evaluating different investment
proposals. But it does not mean that criteria once established holds good under all circumstances and for all
times to come. Relevance and reliability of criteria should be continuously reviewed.
III. Screening and co-ordination: At this stage, all those proposals which are conflicting and do not deserve
further consideration are rejected so that only useful alternatives are analysed in detail. Economic evaluation
generally plays an important role in the screening process. Along with screening, there is also the need for
blending together and unifying different capital projects under the total capital expenditure programme. In this
way, conflicting and duplicate proposals would be eliminated and taken together all of them contribute to the
accomplishment of some higher objectives. Co-ordination will be greatly facilitated in different proposals for
capital outlays are related to each other.
IV. Evaluating Investment Proposals: It would be useful if different proposals are properly classified and
diagnosed before their evaluation. Investment proposals may be classified on the basis of the degree of risk
involved or the extent to which they are postponable. In terms of reasons for the expenditure, the proposals may
be classified whether they result in replacements, betterments or additions to assets. In the process, certain
mutually exclusive and conflicting proposals will be eliminated. If the firm enjoys sufficient resources to finance
all the remaining projects which are profitable, ranking them in order of preference is not a serious problem. But
in reality, the number of proposals are generally larger than the amount of funds available with the firm, and the
controller wants to recommend only the most desirable of them. As a matter of fact, some of the good proposals
are also rejected even when they are profitable.
Return on investment in the underlying consideration for economic evaluation and techniques dealing with this
kind of appraisal have received wide publicity in the literature covering planning and control of fixed assets
expenditures. However, a number of non-economic criteria like social responsibilities and emergencies should
be accorded with due consideration while appraising different investment projects. At the same time, certain
appraisal technique should not be accepted blindly, simply because they are more sophisticated and are expressed
numerically. The underlying assumption of different techniques should be adequately looked into and their
reliability and suitability under a given situation thoroughly tested.
40 PP-FT&FM
V. Budgeting Capital Expenditure: Capital budgeting refers to the process of planning the investment of funds
in long-term assets of the enterprise. Its purpose is to help management control capital expenditure. With the
help of capital budgeting, management is able not only to reject poor investment decisions but also to select, in
order of priority the projects which are most profitable and consistent with the objectives and targets set.
Additions, replacement and betterments require additional funds to be committed to long-term assets, and are
thus included in the capital budget which is typically prepared for a year. Capital budget is a snapshot of the plan
and projects for the coming year for which approval is sought. Capital budget should be flexible so as to eliminate
some of the projects already included but allow addition of new projects that deserve consideration. Inclusion of
certain projects in the capital budget and its approval by the management does not mean that actual expenditure
has been authorised. Rather, it offers an opportunity to look at each project even from the view point of the total
organisation. There is also the need of reconcile capital budget with other budgeting activities of the enterprise
for example, cash revenue and expense budgets.
VI. Controlling Projects in Process: Another important aspect of planning and control of capital outlays is to
devise a procedure to exercise control over projects while in process. Controlling of projects in process generally
falls within the purview of the financial manager. He is concerned with laying down the procedure to ensure that
completion satisfies the norms with respect to cost, time and purpose of expenditure. Variations from approved
plans together with reasons should promptly be reported to responsible authorities for deviations. The observations
and up-to-date progress report provide sufficient information to the management about the exact stage and
status of all major projects. Programme Evaluation and Review Technique (PERT) and Critical Path Scheduling
(CPS) are the newly developed and sophisticated techniques often used by large undertakings to plan and
control the firm and cost of construction.
VII. Follow-up and Performance Report: The project manager or the manager originating the investment
proposal, is responsible for submitting its completion report on the basis of which management normally proceeds
to carry out the post completion audit. Follow up implies comparing and reporting actual results with the projected
result of investment proposal so as to evaluate the performance and outcome in proper perspective. It is required,
however, that procedures and format of follow-up should be clearly defined and communicated. Frequency and
duration of audit should also be clearly indicated. Audit personnel should also be provided with broad guidelines
as to the extent of economic and non-economic evaluation they are expected to carry out.
A project below a certain size may be audited locally by the staff of the departmental manager. But projects
involving a number of departments or above a certain size should be audited by a certain group. The latter
approach claims uniformity, efficiency and detailed review of the project as its main advantages. The postcompletion audit helps managemnt in a number of ways:
(a) to validate the existing capital expenditure, planning and control procedures and methods;
(b) to evaluate results;
(c) to highlight reasons for projects failure; and
(d) to judge soundness of proposals originating at different levels in the organisaiton.
INVESTMENT CRITERIA
A sound and systematic investment criteria is absolutely necessary to appraise the economic worth of an
investment proposal. It is because of the fact that huge sums of scarce financial and other resources are to be
sunk almost irrevocably within a limited span of time for which returns and rewards are uncertain and expected
to accrue over a long period of time in the future. A sound investment criteria at least should provide the
following:
1. a means of distinguishing between acceptable and non-acceptable projects;
2. ranking of projects in order of their desirability;
Lesson 2
Capital Budgeting
41
3. choice among several alternatives;

4. a criteria which is applicable to any conceivable investment project independent of others;
5. recognising the fact that the bigger benefits are preferable to smaller one and early benefits are preferable
to later benefits;
6. helping to choose among mutually exclusive projects, one which maximises the shareholders wealth.
A wide variety of techniques are used for evaluating investment proposals. The most commonly used techniques
are as follows:
The Payback Method
The Average Rate of Return Method
Discount Cash Flow Method
(A) Net Present Value Method (NPV)
(B) Internal Rate of Return Method (IRR)
(C) Profitability Index (PI) or Benefit Cost Ratio (BC).
Every method is designated with some purpose in view and as such different methods are not equally useful to
every firm and under all circumstances. However, proper understanding of these techniques will help the
management to determine the most suitable technique to be used and thus make better investment decisions
keeping in view the business situation, particular requirements of the firm and nature of investment proposals.
The Payback Method

This technique estimates the time required by the project to recover, through cash inflows, the firms initial outlay.
Beginning with the project with the shortest payout period, different projects are arranged in order of time required
to recapture their respective estimated initial outlays. The payback period for each investment proposal is
compared with the maximum period acceptable to management and proposals are then ranked and selected in
order of those having minimum payout period.
While estimating net cash inflows for each investment proposal, the following considerations should be borne in
mind:
(i) Cash inflows should be estimated on incremental basis so that only the difference between cash inflows
of the firm with and without the proposed investment project is considered.
(ii) Cash inflows for a project should be estimated on an after-tax basis.
(iii) Since non-cash expenses like depreciation do not involve any cash outflows, estimated cash inflows
form a project should be adjusted for such items.
Let us consider an example. Say, a project requires ` 25,000 as initial investment, and it will generate an annual
cash inflow of ` 5,000 for ten years then pay back period will be five years, calculated as follows:
Pay back period =
Initial Investment
Annual cash inflows
Rs. 25,000
= 5 years
Rs. 5,000
The annual cash inflow is calculated by taking into account the amount of net income on account of the asset (or
project) before depreciation but after taxation.
Sometimes there are projects where the cash inflows are not uniform. In such a case cumulative cash inflows
will be calculated and by interpolation exact payback period can be calculated. For example if the project need
42 PP-FT&FM
an initial investment of ` 25,000 and the annual cash inflow for five years are ` 6,000, ` 9,000, ` 7,000, ` 6,000
and ` 4,000 respectively. The pay back period will be calculated as follows:
Year
Cash inflow `
Cumulative cash-inflow `
1.
6,000
6,000
2.
9,000
15,000
3.
7,000
22,000
4.
6,000
28,000
5.
4,000
32,000
It is evident form the above table that in 3 years ` 22,000 has been recovered and ` 3,000 is left of initial
investment of ` 25,000. It indicates that payback period is between 3 to 4 years calculated as follows:
Pay back period = 3 years +
3,000
6,000
= 3.5 years.
Decision Rule for Payback Method:
Accept the project if the payback period calculated for it is less than the maximum set by the management.
Reject the project if it is otherwise. In case of multiple projects, the project with shorter payback period will be
selected. In essence, payback period shows break-even point where cash inflows are equal to cash out flows.
Any inflows beyond this period are surplus inflows.
Advantages of Payback Method:
1. It is easy to calculate and investment proposals can be ranked quickly.
2. For a firm experiencing shortage of cash, the payback technique may be used with advantage to select
investments involving minimum time to recapture the original investment.
3. The payout method permits the firm to determine the length of time required to recapture through cash
flows, the capital expenditure incurred on a given project and thus helps it to determine the degree of
risk involved in each investment proposal.
4. This is ideal in deciding cash investment in a foreign country with volatile political position and a longterm projection of political stability is difficult.
5. This is, likewise, more preferred in case of industries where technological obsolescence comes within
short period; say electronic industries.
Disadvantages of Payback Method:
1. The payback method ignores the time value of money and treats all cash flows at par. Thus, projects A
and B with the following cash flows are treated equally:
Years
Cash Flows
Project A `
Project B `
1.
5,000
2,000
2.
4,000
3,000
3.
3,000
4,000
4.
2,000
5,000
Investment
14,000
14,000
Lesson 2
Capital Budgeting
43
Although Pay Back period is 4 years for both the projects, project A is preferable since it recovers larger
amount of money during the initial years.
The pay back method, therefore, ignores the fact that amount of cash received today is more important
than the same amount received after say, 2 years.
2. The payback method does not consider cash flows and income that may be earned beyond the payout
period.
3. Moreover, it does not take into account the salvage or residual value, if any, of the long-term asset.
4. The payback technique ignores the cost of capital as the cut-off factor affecting selection of investment
proposals.
Suitability of using Paybck Period of Medhod :
Payback period method may be successfully applied in the following circumstances:
(i) where the firms suffers from liquidity problem and is interested in quick recovery of fund than profitability;
(ii) high external financing cost of the project;
(iii) for projects involving very uncertain return; and
(iv) political and economic pressures.
It may, therefore, be said that payback period is defined as the measure of projects liquidity and capital recovery
rather than its profitability.
The Average Accounting Rate of Return (ARR) Method

This method is designated to consider the relative profitability of different capital investment proposals as the
basis for ranking them the fact neglected by the payout period technique. Since this method uses accounting
rate of return, it is sometimes described as the financial statement method. Rate of return is calculated by
dividing earnings by capital invested. The numerator, i.e., earnings can be interpreted in a number of ways. It
might mean income after taxes and depreciation, income before taxes and depreciation, or income after taxes
but before depreciation. Since both numerator and denominator carry different meanings. It is not surprising if
one comes across a number of variations of the average rate of return method. However, the two common
variations are:
(a) Average Rate of Return in Original Investment:
=
Net earnings after Depreciation and Taxes

Original Investment
No. of years project will last
(b) Average Rate of Return on Average Investment:

=

Average Investment
No. of years project will last
Average investment is estimated by dividing the total of original investment and investment in the project at the end
of its economic life by 2. The approach of dividing average annual after-tax earnings of the project by its original
investment makes no attempt to incorporate the fact of gradual recovery of investment over time, hence tends to
undertake the average rate of return. The average investment approach on the other hand, gives best result when
original investment is evenly recovered over the economic life of the project which may not always be the case.
Decision Rule for Average of Rate of Return Method:
Normally business firm determine rate of return. So accept the proposal if
44 PP-FT&FM
ARR > Minimum rate of return (cut off rate)
and Reject the project if
ARR < Minimum rate of return (cut off rate)
In case of more than one project, where a choice has to be made, the different projects may be ranked in
descending or ascending order of their rate of return. Project below the minimum rate will be dropped. In case of
project yielding rate of return higher than minimum rate, it is obvious that project yielding a higher rate of return
will be preferred to all.
Advantages of Average Rate of Return Method:
(i) Earnings over the entire life of the project are considered.
(ii) This method is easy to understand, simple to follow. Accounting concept of income after taxes is known
to every student of accountancy.
Disadvantages of Average Rate of Return Method:
(i) Like the payback technique, the average return on investment method also ignore the time value of
funds. Consideration to distribution of earnings over time is important. It is to be accepted that current
income is more valuable than income received at a later date.
(ii) The method ignores the shrinkage of original investment through the process of charging depreciation
allowances against earnings. Even the assumption of regular recovery of capital over time as implied in
average investment approach is not well founded.
(iii) The average rate of return on original investment approach cannot be applied to a situation where part
of the investment is to be made after the beginning of the project.
Suitability of using ARR Method:
If the project life is not long, then the method can be used to have a rough assessment of the internal rate of
return. The present method is generally used as supplementary tool only.
Comparison between Average Rate of Return and Payback Method:
The average rate of return method and its comparison with payback method may be illustrated as follows:
Suppose there are two investment proposals A and B each with capital investment of ` 20,000 and depreciable
life of 4 years. Assume that following are the estimated profit and cash inflows when annual straight line
depreciation charged is ` 5,000.
Period
Project A
Project B
Book Profits
`
Net Cash Inflows

`
1.
4,000
9,000
1,000
6,000
2.
3,000
8,000
2,000
7,000
3.
2,000
7,000
3,000
8,000
4.
1,000
6,000
4,000
9,000
Total
10,000
30,000
10,000
30,000
Average rate
of return on
original
investment
12.5%
Book Profits
`
Net Cash Inflows

`
12.5%
Lesson 2
Capital Budgeting
45
If evaluated in terms of average rate of return method, the two projects are equally favourable. However, project
A is more favourable than project B since it provides larger cash inflows in the initial period (i.e. Quicker Payback).
Discounted Cash Flow (DCF) Method

The traditional techniques like the Payback period or Accounting rate of return takes no account of the time
value of the money. But money received today is much more valuable than the some money received later.
Present inflationary conditions magnify the difference. This is the principal fact that modern analysis technique
like Discounted Cash flow have incorporated to improve on the past procedures. Under this method, the cash
flow discounted at the projects discount rate to the present time, is a present value. Analysis concentrate on the
incremental cash flow of a project. Discounted cash flow method involves following steps:
1. Computation of cash flows i.e. both inflows and out flows (preferably after tax) over the life of the project.
2. Applying the discount factor to the cash flows.
3. Totalling discounted cash-inflows and comparing it with discounted cash outflows.
Broadly, there are three discounted cash flow methods for evaluating capital investment proposals i.e.
A. Net Present Value Method
B. Internal Rate of Return Method
C. Profitability Index or Benefit Cost (B/C) Ratio Method.
A. Net Present Value Method
The net present value method is understood to be the best available method for evaluating the capital investment
proposals. Under this method, the cash outflows and inflows associated with each project are ascertained first.
Cash inflows are worked out by adding depreciation to profit after tax arising to each project*. Since the cash
outflows and inflows arise at different point of time and cannot be compared, so both are reduced to the present
values at the rate of return acceptable to the management. The rate of return is either cost of capital of the firm
or the opportunity cost of capital to be invested in the project. The assumption under this method remain that
cash inflows are reinvested at the same discount rate.
In essence, Net Present Value is the difference between the sum total of present values of all the future cash
inflows and outflows:
Algebrically:
NPV =
R1
R2
Rn
Wn
Sn
...
C
(1 K)1 (1 K)2
(1 k)n (1 k)n (1 k)n
N
Rt
S Wn
NPV =
n
C
t
(1 k)n
t = 1(1 k)
If cash outflow is also expected to occur at some time other than initial investment (non-conventional cash flows)
then formula would be
R
Rn
Sn
Wn
C1
Cn
1
C 0
NPV
...
...
n
n
n
t
n
(1 k )1
(1 k )
(1 k )
(1 k )
(1 k )
(1 k )
Sn Wn N C t
C0
t
(1 k)n t=1(1 k)t
t=1(1 k)
N
NPV =
Rt
46 PP-FT&FM
NPV = Net Present Value
R=Cash inflow at different time period
K=Rate of discount or cost capital
t=1 = first period in the sum
N=The last period in the sum
Sn=Salvage value
W n=Working capital
C=Cost of investment plus Working Capital
Decision Rule of using DCF Method:
If
NPV > Zero : Accept the project

NPV < Zero : Reject the project
NPV = Zero : Firm is indifferent to accept or reject the project.
Advantages of DCF Method:

(i) Income over the entire life of the project is considered.
(ii) The method takes into account time value of money.
(iii) The method provides clear acceptance so interpretation is easy.
(iv) When projects involves different amount of investment, the method may not provide satisfactory answers.
Disadvantages of DCF Method:
(i) As compared with the first two methods, the present value approach is certainly more difficult to understand
and apply.
(ii) An additional difficulty in this approach is encountered when projects with unequal lives are to be
evaluated.
(iii) It is difficult to determine the firm cost of capital or appropriate rate of discount.
Suitability of DCF Method:
Net present value is the most suitable method in those circumstances where availability of resources is not a
constraint. The management authority can accept all those projects having Net Present Value either Zero or
positive. This method shall maximise shareholders wealth and market value of share which is the sole aim of
any business enterprise.
B. Internal Rate of Return (IRR)
The internal rate of return refers to the rate which equates the present value of cash inflows and present value
of cash outflows. In other words, it is the rate at which net present value of the investment is zero. If the Net
Present Value is positive, a higher discount rate may be used to bring it down to equalise the discount cash
inflows and vice versa. That is why Internal Rate of Return is defined as the break even financing rate for the
project.
The necessary steps to be followed in applying this method are:
(i) Project the net cash benefit of an investment during the whole of its economic life. Future cash flows
should be estimated after taxes, but before depreciation and interest.
Lesson 2
Capital Budgeting
47
(ii) Determine the rate of discount that equates the present value of its future cash benefits to its present
investment. The rate of discount is determined by the method of trial and error.
(iii) Compare the rate of discount as determined above with the cost of capital or any other cut-off rate, and
select proposals with the highest rate of return as long as the rate is higher than the cost of capital or cut
off rate.
Assuming conventional cash flows, mathematically the Internal Rate of Return is represented by that rate of,
such that
C
CF1
1
(1 r)
n
CFt
t 1(1 r)
n
CF2
(1 r)
(1 r)
CF
(1 rt) t
CFn
...
Sn
t 1
(1 r)
Sn
n
(1 r)
Wn
(1 r)n
Wn
(1 r)n
Sn Wn
(1 r )n
S Wn
n
C
(1 r)n
t 1(1 r)
n
CFt
For non-conventional cash flows the equation would be

C
S Wn n
C1
n
n
t
(1 r)
t 1(1 r)
t 1 (1 k)
n
CFt
r = the internal rate of return

CFt = cash inflows at different time periods
Sn = salvage value
W n = working capital adjustment
C = cash outlays at different time periods
k = cut off rate, the rate below which a project will not be accepted, which is normally the cost of capital
Decision Rule:
If Internal Rate of Return i.e.
r > k (cut off rate) Accept the investment proposal
r < k Reject the investment proposal
r = k Indifferent
In case of several investment proposals the projects may be ranked according to their Internal Rate of Return,
the project with highest Internal Rate of Return, is ranked first and so on. Acceptance of more than one project
may follow in order of priority.
Computation of Internal Rate of Return:
The computation of Internal Rate of Return is relatively complicated and difficult compared to Net Present Value. One
has to follow trial and error exercise to ascertain Internal Rate of Return (r) which equates the cash inflows and
outflows of the investment proposals. Under net present value, k is known, but under this method it is worked out.
Initially the Internal rate of return (r) may give
48 PP-FT&FM
NPV > 0 r > k (higher rate will be tried)
NPV = 0 r = k
NPV < 0 r < k (lower rate will be tried)
To calculate the exact figure, we use the method of interpolation i.e.
PVC
PV
IRR(r ) rL CFAT
Dr
DPV
or
PV PVCFAT
rH C
Dr
DPV
rL = The lower rate of discount.

PVCFAT = Calculated present value of cash inflow.
PVC = Present value of cash outlay.
DPV = Difference in calculated present value.
Dr = Difference in rate of interest.
rH = The higher rate of discount.
Let us illustrate the method in two different situations:
(i) Uniform cash inflows
(ii) Non-uniform cash inflows.
Example
Let us consider a project where initial investment is ` 18,000. The annual cash flow will be ` 5,600 for a period
of 5 years. The internal rate of return can be computed by computing the factor as under
F = I/C
where,
F = Factor to be located
I = Initial investment
C = Average cash inflow
18,000
=
3.214
5600
After the factor is calculated as above, it is located in the different Annuity table on the line representing the
number of years corresponding to the economic life of the project.
In above example, according to annuity table, factor closest to 3.21 for five years are 3.2 (16% discount rate)
and 3.199 (17% discount rate). Net Present Value for both the rates are as follows:
Rate of Discount
16%
17%
Total Present Value
` 5,600 x 3.274 = ` 18,334.40
` 5,600 x 3.199 = ` 17,914.40
Less: initial outlay
` 18,000.00
` 18,000.00
NPV
+ ` 334.40
() ` 85.60
Lesson 2
Capital Budgeting
49
Since Net Present Value is greater than zero i.e. ` 334.40 at 16% rate of discount, we need a higher rate of
discount to equalise Net Present Value with total outlay. On other hand, Net Present Value is less than zero i.e.
() ` 85.60 at 17% rate of discount we need lower rate. So the above exercise shows that internal Rate of Return
lies between 16% and 17%. To find out the exact figure, the interpolation can be used i.e.
IRR rL
PVCFAT PVc
Dr
PV
rL = 16
PVCFAT = + ` 18,334.40
PVC = ` 18,000
DPV = ` 420
Dr = 1
334
IRR 16 `
1 16.8
`420
= 16.8
Alternatively it can be worked out by using higher rate of return.
Under uneven cash inflow, the calculation of internal rate of return is a tedious job. The process of Internal Rate
of Return can be understood with the help of following illustration i.e. Company A is proposed to instal a new
machine costing ` 16,200 having an economic life of 3 years. The annual Cash inflow shall be ` 8,000, 7,000
and 6,000 in the respective 3 years. Calculate Internal Rate of Return.
To compute internal rate of return, the trial and error method has been followed.
Average cash inflow =
F
Rs. 8,000 + `7,000 +`6,000

= ` 7,000
3
I `16,200
2.314
C `7,000
According to annuity table factor closest to 2.314 for 3 years are 2.322 (14%) and 2.246 (16%). Broad results
are given in the following table:
Year
Cash
in flow
`
Rate of
Discount
(14%)
PV
`
Rate of
Discount
(16%)
PV
`
Rate of
Discount
PV
`
(15%)
1.
8,000
0.877
7,016
.862
6.896.08
.870
6,960
2.
7,000
0.769
5,383
.743
5,201.00
.756
5,292
3.
6,000
0.675
4,050
.641
3,846.00
.658
3,948
16,449
15,943
16,200
Less: Cash outlay
16,200
16,200
16,200
NPV
+249
-257
From the above table, it is quite clear that net present value is zero with 15% rate of discount, so it is the true
internal rate of return.
50 PP-FT&FM
Advantages of IRR Method:
(i) The discounted cash flow (IRR) takes into account the time value of money.
(ii) It considers cash benefits, i.e. profitability of the project for the whole of its economic life.
(iii) The rate of discount at which the present value of cash flows is equated to capital outlay on a project is
shown as a percentage figure. Evidently, this method provides for uniform ranking and quick comparison
of relative efficiency of different projects.
(iv) This method is considered to be a sophisticated and more reliable technique of evaluating capital
investment proposals.
(v) The objective of maximising of owners welfare is met.
Disadvantages of IRR Method:
(i) The discounted cash flow is the most difficult of all the methods of project evaluation discussed above.
(ii) An important assumption implied in this method is that incomes are reinvested (compounding) over the
projects economic life at the rate earned by the investment. This assumption is correct and justified only
when the internal rate of return is very close to the average rate of return earned by the company on its
total investments. To the extent internal rate of return departs from the typical rate of earnings of the
company, results of this method, will be misleading. Thus, when the internal rate of return on a project is
computed to be 30% while companys average rate of return is 15%, the assumption of earning income
on income at the rate of 30% is highly unrealistic. From this point of view the assumption of the net
present value method that incomes are reinvested at the rate of discount (cost of capital) seems to be
more reasonable.
(iii) The rate may be negative or one or may be multiple rate as per calculations. When a project has a
sequence of changes in sign of cash flow, there may be more than one internal rate of return.
C. Profitability Index (PI)
Profitability Index is defined as the rate of present value of the future cash benefits at the required rate of return
to the initial cash outflow of the investment. Symbolically, Profitability Index is expressed as
n
PI
At
t 1(1 k)
At = Present value of cash inflows.

K = rate of return
C = initial cash outlay
t = time period.
The above ratio is an indicator of the profitability of the project. If the ratio is equal to or greater than one, it shows
that project has an expected yield equal to or greater than the discount rate. If the index is less than one, it
indicates that project has an expected yield less than the discount rate.
Decision Rule:
If PI > 1 Accept the Project, PI = 1 indifferent, PI < 1 Reject the project.
In the event of more than one alternatives, projects may be ranked according to their ratio the project with the
highest ratio should be ranked first and vice versa.
Lesson 2
Capital Budgeting
51
Advantages of PI Method:
(1) Profitability Index method gives due consideration to the time value of money.
(2) Profitability Index method satisfies almost all the requirements of a sound investment criterion.
(3) This method can be successfully employed to rank projects of varying cash and benefits in order of their
profitability.
Disadvantages of PI Method:
(1) This method is more difficult to understand and compute.
(2) This method does not take into account the size of investment.
(3) When cash outflows occur beyond the cement period Profitability Index Ratio criterion is unsuitable as
a selection criterion.
COMPARISON OF NET PRESENT VALUE AND INTERNAL RATE OF RETURN APPROACH

The net present value and internal rate of return, two widely used methods are the species of the same genus
i.e. Discount cash flow method, yet they are different from each other on various points.
The broad points of difference between the two are as follows:
Points of Differences
1. Interest Rate: Under the net present value method rate of interest is assumed as the known factor whereas
it is unknown in case of internal rate of return method.
2. Reinvestment Axiom: Under both the methods, it is assumed that cash inflows can be re-invested at the
discount rate in the new projects. However, reinvestment of funds, at cut-off rate is more possible than internal
rate of return. So net present value method is more reliable than internal rate of return method for ranking two or
more projects.
3. Objective: The net present value method took to ascertain the amount which can be invested in a project so
that its expected yields will exactly match to repay this amount with interest at the market rate. On the other
hand, internal rate of return method attempts to find out the rate of interest which is maximum to repay the
invested fund out of the cash inflows.
Points of Similarities
IRR will give the same results as NPV in terms of acceptance or rejection of investment proposals in the following
circumstances:
1. Projects having conventional cash flows i.e. a situation where initial investment (outlay or cash outflow)
is followed by series of cash inflows.
2. Independent Investment Proposals: Such proposal, the acceptance of which does not exclude the
acceptance of others.
The reasons for the consistent results under net present value and internal rate of return method in above two
cases are simple and logical. According to the net present value method the rule is that an investment proposal
will be accepted if it has positive net present value (NPV > 0) which is possible only when actual rate of ret urn
is more than cut off rate. It is supported by internal rate of return method. In those case internal rate of return is
more than required rate of return (r > k). When the net present value is = 0 or internal rate of return r = k the
project may be accepted or rejected. So the proposal which have positive net present value will also have a
higher than required rate of return.
52 PP-FT&FM
The following diagram depict NPV as 0 corresponding to IRR (r) k
NPV
IRR
r1
r2
r3
IRR
If NPV is positive, it indicates r > k (cost of capital) and vice versa.

Points of conflict between net present value and internal rate of return cannot avoid certain situations where the
results given by both the methods are in conflict to each other. This is so in the case of mutually exclusive
investment proposals which result in non-acceptance of others. There are two types of mutually exclusive
proposals:
1. Technical: It refers to proposals having different profitabilities and selection of that which is most profitable.
2. Financial: It is the exclusiveness due to limited fund. A firm will select only those proposal which is most
profitable rather than accepting all proposals yielding more than minimum acceptable level. The conflict
of results under two methods may be due to following reasons:
1. Size-disparity problem
2. Time-disparity problem
3. Unequal expected lives.
Comparative Study of results under alternative Discounted Cash Flow Method
We can summarise the relationship among net present value, internal rate of return and profitability index
methods regarding decision rules as follows:
Proposal
Net Present Value
Internal rate of return (r)
Profitable Index(PI)
Accept
(1) Positive
>k
>1
Indifferent
(2) Zero
=k
=1
Reject
(3) Negative
<k
<1
Given the above relationship, any discounted cash flow criterion may be employed where investment proposals
are independent and there is no capital budget constraints. In such a situation, the set of projects selected by all
the criterion would be the same though there may be differences in internal ranking. In the real world, however,
firms are faced with mutually exclusive proposals and limited availability of funds. On account of the imperfections,
all the projects with (NPV) > 0, (IRR) > k, and (PI > 1) can be accepted.
Lesson 2
Capital Budgeting
53
CHOICE OF METHODS
The business enterprise is confronted with large number of investment criteria for selection of investment
proposals. It should like to choose the best among all. Specially, it is the choice between Net Present Value and
Internal Rate of Return Method because these are the two methods which are widely used by the firms. If a
choice must be made, the Net Present Value Method generally is considered to be superior theoretically because:
(i) It is simple to operate as compared to internal rate of return method;
(ii) It does not suffer from the limitations of multiple rates;
(iii) The reinvestment assumption of the Net Present Value Method is more realistic than internal rate of
return method.
On the other hand, some scholars have advocated for internal rate of return method on the following grounds:
1. It is easier to visualise and to interpret as compared to Net Present Value Method.
2. It suggests the maximum rate of return and even in the absence of cost of capital, it gives fairly good
idea of the projects profitability. On the other hand, Net Present Value Method may yield incorrect
results if the firms cost of capital is not calculated with accuracy.
3. The internal rate of return method is preferable over Net Present Value Method in the evaluation of risky
projects.
Limits on Investment
The evaluation techniques discussed above help management to appraise and rank different capital
investment proposals in terms of their economic benefits. But does it mean that management will accept all
projects promising some economic benefit? The most probable answer seems to be in negative. For one
thing, no firm enjoys infinite capital supply at a point of time when investment decisions have to be made.
Ability to generate funds internally and to raise them externally is not without limits. Next, there are also
occasions when quantitative factors of economic evaluation need to be supplemented with a number of
qualitative considerations like employee relations, competitive position, environmental and social
responsibility and public relations. Moreover, there are some valid reasons for establishing some minimum
acceptable rate of return below which management will not accept any investment proposal even if resources
would remain unutilised for sometime. The rate of return below which no investment should ordinarily be
accepted is known as the cut off rate or the hurdle rate. Establishing the levels of hurdle rate enables the
organisation to make investment decisions and maintain consistency in the actions of different people in
the organisation. Further, by indicating the hurdle rate management communicates throughout the
organisation its expectation as to the minimum rate of return.
The cut off rate may be established by any of the following methods:
1. By the method of intuition;
2. By the historical rate of return;
3. By the weighted average cost of capital;
4. By the cost of funds to be used to finance a given project.
The method used to establish a hurdle rate should be carefully selected keeping in view the overall objectives of
the enterprise, its environment and opportunity cost of funds required to be invested in a given project.
54 PP-FT&FM
RISK EVALUATION AND SENSITIVITY ANALYSIS

Risk Evaluation
Risk analysis gives management better information about the possible outcomes that may occur so that
management can use their judgement and experience to accept an investment or reject it. Since risk analysis is
costly, it should be used relatively in costly and important projects.
Risk and uncertainty are quite inherent in capital budgeting decisions. This is so because investment decisions
and capital budgeting are actions of today which bear fruits in future which is unforeseen. Future is uncertain
and involve risk. The projection of probability of cash inflows made today are not certain to be achieved in
the course of future. Seasonal fluctuations and business cycles both deliver heavy impact upon the cash
inflows and outflows projected for different project proposals. The cost of capital which offers cut-off rates
may also be inflated or deflated under business cycle conditions. Inflation and deflation are bound to effect
the investment decision in future period rendering the degree of uncertainty more severe and enhancing
the scope of risk. Technological developments are other factors that enhance the degree of risk and
uncertainty by rendering the plants or equipments obsolete and the product out of date. Tie up in the
procurement in quantity and/or the marketing of products may at times fail and frustrate a business unless
possible alternative strategies are kept in view. The case of Kudermukh Iron Ores Ltd. which had a firm tieup with the Govt. of Iran is an example. All these circumstances combined together affect capital budgeting
decisions.
It is therefore necessary to allow discounting factor to cover risk. One way to compare risk in alternative proposals
is the use of Standard Deviation. Lower standard deviation indicates lower risk. However, wherever returns are
expressed in revenue terms the co-efficient of variation gives better measurement for risk evaluation. Both
Standard Deviation and co-efficient of variation can be arrived at by using following formula:
Standard Deviation
Co - efficient of Variation =
f(x x)2
f
Standard Deviation
100
Mean
Both standard deviation and co-efficient of variation require to be adjusted with the discount rate with which the
project investments are evaluated. According to the degree of standard deviation or co-efficient of variation, the
investment proposals shall be termed as highly risky or less risky investments. Less risky projects shall be
afforded highest priority in investment or capital budgeting decisions.
Risk adjusted discount rates are used in investment and budgeting decisions to cover time value of money and
the risk. According to new thinking, discounting and risk considerations are treated separately. The method
which is used for this purpose is known as Certainty Equivalent Method (CE). The riskness of the project is
handled by adjusting the expected cash flow and not the discount rate. The certainty equivalent in a year
represent the cash-flows that investors would be satisfied to receive for certain period i.e. certainty equivalent
converts the projects expected cash flow for this year into a certain amount investors consider equivalent to the
project calculated cash flow for the year. Net Present Value of these cash flows is calculated with risk free
interest rate as the discounting factor. Both the methods i.e. Risk adjusted discount rate and certainty equivalent
methods are good for Risk Evaluation. The essential difference in the two methods is that the risk adjusted
discount rate method account for risk by adjusting the discount rate in the denominator of the expected net
present value formula, while the certainty equivalent method accounts for risk by adjusting the expected cash
flow in the numerator of the expected net present value formula.
For evaluating risk, payback method provide crude account for risk differences by altering payback
Lesson 2
Capital Budgeting
55
requirements i.e. instead of four year payback requirements, the firm may require three year payback for a
proposed new product line that the firm feels is riskier investment. Shortening payback is similar to raising
the discount rate.
Decision tree technique is another method which many corporate units use to evaluate risky proposals. A
decision tree shows the sequential outcome of a risky decision. A capital budgeting decision tree shows the
cash flows and net present value of the project under differing possible circumstances.
For example, a company X has an opportunity to invest in equivalent schemes that will last for two years and
will cost ` 1,00,000 initially and has the following estimated possible cash flow after tax (CFAT)
Year
One:
30% chance that (CFAT) will be ` 40,000/40% chance that (CFAT) will be ` 60,000/30% chance that (CFAT) will be ` 80,000
Two:
CFAT are conditional to those of year one.
The estimated conditional CFATs and probabilities are as under:

If 1st year CFAT = ` 40,000
2nd year CFAT
Probability
2nd year CFAT
Probability
2nd year CFAT
Probability
20,000
0.2
70,000
0.3
80,000
0.1
50,000
0.6
80,000
0.4
1,00,000
0.8
80,000
0.2
90,000
0.3
1,20,000
0.1
From the above data we may plan the decision as under:

Decision Tree
Probability
CFAT
Year 1
Probability
(`)
.3
40,000
Cash outlay
1,00,000
.4
.3
60,000
80,000
CFAT
Year 2
CFAT at
15%
(` )
(a) NPV
at 15%
Expected
(b) Joint
Probability
NPV a x b
(` )
0.2
20,000
49,920
- 50,080
0.06
- 3,005
0.6
50,000
72,600
- 27,400
0.18
- 4,932
0.2
80,000
95,280
- 4,720
0.06
- 283
0.3
70,000
1,05,120
5,120
0.12
614
0.4
80,000
1,12,680
12,680
0.16
2,029
0.3
90,000
1,20,240
20,240
0.12
2,428
0.1
80,000
1,30,080
30,080
0.03
902
0.8
1,00,000
1,45,200
45,200
0.24
10,848
0.1
1,20,000
1,60,320
60,320
0.03
1,810
1.00
10,411
Note: Present value of cash inflows are worked out on the basis of three decimal points.
The above decision tree shows possible CFAT outcomes in each year and the probabilities associated with
these outcomes. The decision tree shows nine distinct paths, or combinations of outcomes that the project
56 PP-FT&FM
would take if accepted. One possibility is that one years CFAT is ` 40,000 and the second years CFAT is `
20,000. This is worst combination of outcomes that could occur. The company X would have paid ` 1,00,000 for
a CFAT stream of ` 40,000 and ` 20,000 in years one and two respectively. If the company X determined that an
appropriate discount rate for this project is 15%, the NPV of the worst path is ` 50,080. By looking at the
decision tree figure, the best path for the firm is CFAT1 = ` 80,000 and CFAT2 = ` 1,20,000. The NPV at 15% of
that path is ` 60,320. The decision tree shows NPV of each of the nine possible CFAT paths in the tree at
discount rate of 15%. The expected net present value (NAP) of the problem depicted by the decision tree is the
weighted average of net present values of all the paths:
N
NPV (Prob j ) (NPVj )
J0
Where NPVj = net present value of the jth path

Probj = the probability of the jth path occurring
N = number of possible paths
The probability of a path occurring is called its joint probability. It is equal to the product of the probabilities along
with the path.
In the decision tree calculations the last column shows the calculation of expected NPV which is the weighted
average of individual path NPVs where the weights are the path probabilities. NPV for example is ` 10,411 and
project should be accepted.
For short period projects the above technique is good but for long period projects it becomes more complicated
with the multiplication of paths, for the number of possibilities. In the above case, there had been 9 paths for 2
years, but for the 3 years these could be (3 3 3) = 27 paths and like wise the increase of path complicates the
diagram and calculations.
Sensitivity Analysis
Capital budgeting remain unrealistic in the circumstances when despite a set of reliable estimates of return,
outlays, discount rate and project life time uncertainty surrounds some of all of these figures. Sensitivity analysis
is helpful in such circumstances.
It is a computer based device. Sensitivity analysis has been evolved to treat risk and uncertainty in capital budgeting
decisions. The analysis is comprised of the following steps: (1) Identification of variables; (2) Evaluation of possibilities
for these variables; (3) Selection and combination of variables to calculate NPV or rate of return of the project; (4)
substituting different values for each variables in turn while holding all other constant to discover the effect on the
rate of return; (5) Comparison of original rate of return with this adjusted rate to indicate the degree of sensitivity of
the rate to change in variables; (6) subjective evaluation of the risk involved in the project.
The purpose of sensitivity analysis is to determine how varying assumptions will effect the measures of investment
worth. Ordinarily, the assumptions are varied one at a time i.e. cash flows may be held constant with rate of
discount used to vary; or discount rate is assumed constant and cash flow may vary with assumed outlay; or the
level of initial outlay may change with discount rate and annual proceeds remaining the same.
In the context of NPV, sensitivity analysis provides information regarding the sensitivity of the calculated NPV to
possible estimation errors in expected cash flows, the required rate of return and project life.
Suppose, a proposed project has an initial estimated cost (after tax) of ` 75,000 and an estimated expected
cash flow (after tax) stream of ` 20,000 per year for seven years. The estimated k is 15%.
NPV = - ` 75,000 + (` 20,000) (Annuity at 15% for 7 years)
Lesson 2
Capital Budgeting
57
= - ` 75,000 + (` 20,000) (4.160)

= ` 8,200
The project should be accepted.
The project would show different results with expected annual cash flow (after tax) being ` 17,000 per year
instead of ` 20,000 as stated above, then:
NPV = - ` 75,000 + (` 17,000) (4.160)
= - ` 4,280 (negative value)

This giving an indication to give a second thought to the project acceptance.
Samuel and Wilkies in Management of Company Finance opine that sensitivity analysis does not make any
decisions of itself. It is a practicable procedure that presents derived information in particularly revealing way.
The method is usually applied to each possible project as it arises. It could be used for the total company
activities existing investments plus new proposals, but such a grand exercise would detract from the essential
simplicity of the method and not be warranted for all the largest projects. When all the sensitivity data have been
assembled a judgement has then to be made as to whether the picture presented is acceptable or not. In this
decision the management may subjectively estimate the likelihood of each scenario, or they may play safe and
consider only the worst possibilities. It is unlikely that the market as a whole would have access to the same
volume and quality of information as that given by the sensitivity analysis and this would have to be done by
intelligent guess too.
A sensitivity analysis is particularly helpful in large projects that would have a substantial impact on the companys
operations.
SIMULATION FOR RISK EVALUATION

Simulation is known as simulated sampling or more fully Monte-Carlo simulation is as much an art as a technique.
It has been described as what to do when all else fails. Some investment projects may depend on so many
stochastic variables that analytical results are unobtainable. In simulation a mathematical model is constructed
and artificial data is fed. The desired parameters of the system are then determined from the output of the mode.
Simulation like sensitivity analysis is not an optimising technique. It merely provides a convenient representation
of reality in some more advanced work than can be used to improve NPV by adjusting certain variables under
the decision makers control (like advertising expenditure). There are two important things in simulation viz. the
construction of the model and the judgement of changes to be made to controllable variables. This method
involves use of computers to determine the distribution of the internal rate of return or net present value. Suppose
the company has estimated project probability distribution for initial investment, annual sales and operating
costs, life and salvage value, the simulation proceeds as follows:
1. Randomly select a value of each variable from its distribution;
2. Take these values and other given information (tax rates, type of depreciation used and so on) and
calculate the projects IRR or NPV;
3. Repeat steps one and two many times; and
4. Prepare the IRR or NPV distribution.
This is the result of the simulation. From the information used to prepare the distribution the analyst can determine
the standard deviation of the projects IRR which is used in determining the project risk.
Simulation is an expensive device and suits only to those projects involving heavy capital expenditure. Simulation
is advantageous to corporate project proposal selections for the reason that it shows all possible outcomes
58 PP-FT&FM
associated with the project including identification of possible extremely bad outcomes which might happen if
the project is accepted.
LINEAR PROGRAMMING AND CAPITAL BUDGETING DECISIONS

Linear programming is a mathematical technique concerned with optimal solution to problems of business
world. The areas of frequent use of this technique are product lines and production processes, transportation,
routing, and meeting product specifications. Most profitable use of scarce resources could be planned through
the technique in production lines and processes. Similarly, substantial savings can be affected by using the
technique in movement of goods and planning the routes which entail minimum payments towards cost. In
meeting product specifications least cost combinations could easily be sorted out through this technique. Business
firms have been constantly using the technique for solving such like problems. The application of the programming
technique is now being frequently tried in capital budgeting problems and investment allocation processes. The
technique is useful in sorting out allocation problems as the resources are limited and cannot be used beyond a
fixed quantity. Choice is to be made for allocation for best use to maximise contribution or to minimise cost.
The area of application of programming techniques in investment decision making is that of capital rationing
where the approach has been fixed for seeking solution to the problem when there are more desirable investments
than there are funds available for such investment and a solution of the best choice is involved. Efforts are made
to find the set of investments through time that maximises the present value of future dividends. Feasible solution
could be reached at for making joint investment in certain projects for yielding higher returns by taking into
consideration the opportunity cost of funds.
APPLICATION OF LINEAR PROGRAMMING MODEL

Primal
Presuming that the company is to maximise the present value of the dividends of the company and that there is
no adjustment of risk, the capital budgeting problem can be solved by maximising the present value of the
dividends generated by the investments. Assuming further that there are no limitations set on dividend policy
other than that dividends should be non-negative and the rate of interest is to be used for discounting the
dividends to be default-free market rate. Subsequently, a risk adjustment would be added to or subtracted from
the resulting present value of the investment and the condition for investing the funds in short-term securities will
be relaxed. It is assumed that all investments are continuous and the IRRs of all investments considered are
larger than the cost of new funds. To maximise the present value of the dividend we present the notation in
matrix as under:
Maximise
Z = a D
Subject to
Cx D M
X,D 0
where:
a = time-value-factors vectors (a is a row vector)
D = dividend vector
C = matrix of cash flows (outlays are positive and inflow are negative), the rows are the cash flows of
each period and the columns are the cash flows of each investment.
M = column vector of cash available from outside sources.
X = column vector indicating the number of units invested in each investment.
Lesson 2
Capital Budgeting
59
The above is the primal model and can be presented in summation notation as under assuming different
investments and a planning horizon of T periods:
Maximise Z
a tD t
t 0
Subject to
j
C jt x j D t Mt
J1
t = 0, 1..T
X j ,D t 0
The above formula can be tested in a problem where a company has a capital budget limited to ` 10,000 and
has following investment opportunities X1 and X2 in period 1 and 2 with time value of money as 0.5 and internal
rate of return for opportunity X1, as 10% and for opportunity X2 as 14% generating cash flow as under:
X1
X2
Period 1
` 11,400
Period 2
12,100
There is possibility that the cash flow generated in period 1 are re-employed in period 2 in another opportunity
X3. The above facts can be presented as under:
Period
Cash flows
Investments
In Rupee
x1
x2
X3
-10,000
-10,000
11,400
-11,400
12,100
12,540
Assuming risk free rate of interest being 5% then

a1 = (a0, a1, a2)
= (1.050 1.051 1.052)
D1 = (D0 D1 D2)
10,000
C
0
12,000
10,000
11,400
0
11,400
12,540
Since x1 is equal to 1 then one unit or ` 10,000 is invested J = 1; and financing of ` 10,000 is available only at
time 0, so M (10,000 0 0)
This leads to the primal model as under:
D0
Maximize Z = aD = (1.05 1.05 1.05 ) D1
D2
0
Subject to
60 PP-FT&FM
10,000
0
12,000
10,000
11,400
0
11,400
12,540
X1 D0 10,000
X 2 D1 0
X D 0
3 2
X j, Dt 0
Completing the matrix multiplication,

2
2
Maximize Z a tD t (1.05) t D t
t0
t0
Subject to
10,000x1 10,000x 2 0x 3 D 0 10,000
0x1 11,400x 2 11,400x 3 D1 0
12,100x1 0x 2 12,540x 3 D 2 0
If
x1 D0 D1 0
x2 1
x3 1
D 2 12,540
the value of objective function is Z = 1.05-2 12,540 = ` 11,347, with the above, the constraints are satisfied. No
other solution is better.
Dual Problems
The above explanation is devoted to primal linear programming problem, a maximization case but it could be the
minimization case also. Such pairs of problems with maximization and minimization problems are called dual
linear programming problems.
Dual linear programming has become important because of certain reasons, according to Baumol, these reasons
are viz. (1) Duality yield a number of powerful theorems which add substantially to our understanding of linear
programming. (2) Duality analysis has been very helpful in the solution of programming problems. Indeed as we
shall see, it is frequently easier to find the solution of a programming problem by first solving its associated dual
problem. (3) The dual problem turns out to have an extremely illuminating economic interpretations which
incidentally shows that old fashioned marginal analysis is always implicitly involved in the search for an optimal
solutions of a linear programming problems.
With the given problem to maximise the results as under, we can go to solve a minimisation problem covering
opposite aspects of the problems. Suppose maximisation problems with given constraints is as under:
Maximize Z = P1Q1 P2 Q 2 ..........PnQn
Subject to = a11Q1 a12Q2 ..........a1nQn C1
..
a m1Q1 a m2 Q 2 .......... a mnQ n Cm
Q1 0,..........Qn 0
The above is the primal problem and it has its dual as under:
Lesson 2
Capital Budgeting
61
Minimize a = C1V1 C 2 V2 ..........CmVm

Subject to = a11V1 a21V2 .......... am1vm p1
..
a1nv1 a2nv 2 ..........amnvm pn

V1 0,V2 0..........Vm 0
From the above, one thing is obviously clear that we have changed the word maximize to minimize and
substituted symbol to . For unit profits P1, P2Pn we took the capacity figure C1, C2Cn. Original variables Q1,
Q2,Qn has been substituted by a new set of variables V1, V2Vm. The order in which the constant appears in
inequalities has been reversed and instead of reading them across we would read now down. Where a12 was
formerly the second constant in the first inequality, would now make it first constant in the second inequality and
so on. These steps of converting a primal into dual are summarized below by Baumol:
(1) If the primal problem involves maximization, the dual involves minimization, and vice versa;
(2) If the primal involves > signs, the dual involves < signs and vice versa;
(3) The profit constraints Pj in the primal model replace the capacity constraints Cj, and vice versa;
(4) In the constraint inequalities the co-efficients which were found by going left to right are positioned in the
dual from top to bottom, and vice versa;
(5) A new set of variables appears in dual;
(6) Neglecting the number of non-negativity conditions, if there are n variables and m inequalities in the
primal model, in the dual there will be m variables and n inequalities.
The dual of the problem is the original linear programming problem itself. So, the problem which was primal
could be dual and vice versa.
To illustrate the above discussion, we take a simplified illustration in an advertising budgeting problem which
aims to minimize the cost of reaching 30 million potential customers of whom 23 million are required to have an
income of over ` 5,000 per year. Suppose the relevant data are those shown in the following table:
Cost per Ad.
(` 000)
Audience
(000)
Audience with income

over ` 5,000
(000)
Newspaper
28
0.6
T.V.
400
Radio
20
0.8
0.7
Newspaper advertisement reaches 1 million readers where as T.V. programme covers 9 million viewers. Let the
N, T and R respectively represent the newspaper, television, and radio advertisements budgeted, our programme
is then:
Minimize Ad. Cost = 28N + 400T + 20R
Subject to :
N + 9T + 0.8R 30 Required Audience size
0.6N + 2T + 0.7R 23 (required income)
N 0, T 0, R 0
62 PP-FT&FM
The above primal is converted into dual problem as under:
Minimize
30v1 23v 2
Subject to
v1 0.6v 2 28
9v1 2v 2 400
0.8v1 0.7v 2 20
v1 0,v 2 0
From the above, it is evident that primal involved 3 variables and 2 ordinary constraints whereas the dual
involved 2 variables and 3 constraints. No change has occurred in inequalities on non-negativity conditions i.e.
both in the primal and in the dual problems each variable is required to be greater than or equal to zero.
If we turn the above ordinary constraints into equations, we have to rewrite the problem with slack variables in
the same shape as discussed in the beginning of this section.
From the literature available on financial management evidence can be gathered whether the linear programming
technique are being widely used for capital budgeting decisions. However, for academicians interest remain
widely recognised for a keen desire to use the techniques of linear programming in budgeting decisions. With
the use of computers, the multinational companies and American giant business enterprises are making use of
these techniques.
Capital budgeting Techniques under uncertainty:
Risk can be defined as the chance that the actual outcome will differ from the expected outcome. Uncertainty
relates to the situation where a range of differing outcome is possible, but it is not possible to assign probabilities
to this range of outcomes. The two terms are generally used interchangeably in finance literature. In investment
appraisal, managers are concerned with evaluating the riskiness of a projects future cash flows. Here, they
evaluate the chance that the cash flows will differ from expected cash flows, NPV will be negative or the IRR will
be less than the cost of capital. In the context of risk assessment, the decision-maker does not know exactly
what the outcome will be but it is possible to assign probability weightage to the various potential outcomes. The
most common measures of risk are standard deviation and coefficient of variations. There are three different
types of project risk to be considered:
1. Stand-alone risk: This is the risk of the project itself as measured in isolation from any effect it may
have on the firms overall corporate risk.
2. Corporate or within-firm risk: This is the total or overall risk of the firm when it is viewed as a collection
or portfolio of investment projects.
3. Market or systematic risk: This defines the view taken from a well-diversified shareholders and investors.
Market risk is essentially the stock markets assessment of a firms risk, its beta, and this will affect its
share price.
Due to practical difficulties of measuring corporate and market risk, the stand-alone risk has been accepted as
a suitable substitute for corporate and market risk. There are following techniques one can use to deal with risk
in investment appraisal.
Statistical Techniques for Risk Analysis:
(a) Probability Assignment
(b) Expected Net Present Value
Lesson 2
Capital Budgeting
63
(c) Standard Deviation

(d) Coefficient of Variation
(e) Probability Distribution Approach
(f) Normal Probability Distribution
(a) Probability Assignment:
The concept of probability is fundamental to the use of the risk analysis techniques. It may be defined as the
likelihood of occurrence of an event. If an event is certain to occur, the probability of its occurrence is one but if
an event is certain not to occur, the probability of its occurrence is zero. Thus, probability of all events to occur
lies between zero and one.
The classical view of probability holds that one can talk about probability in a very large number of times under
independent identical conditions. Thus, the probability estimate, which is based on a large number of observations,
is known as an objective probability. But this is of little use in analyzing investment decisions because these
decisions are non-repetitive in nature and hardly made under independent identical conditions over time. The
another view of probability holds that it makes a great deal of sense to talk about the probability of a single event
without reference to the repeatability long run frequency concept. Therefore, it is perfectly valid to talk about the
probability of sales growth will reach to 4%, the probability of rain tomorrow or fifteen days hence. Such probability
assignments that reflect the state of belief of a person rather than the objective evidence of a large number of
trials are called personal or subjective probabilities.
(b) Expected Net Present Value:
Once the probability assignments have been made to the future cash flows, the next step is to find out the
expected net present value. It can be found out by multiplying the monetary values of the possible events by
their probabilities. The following equation describes the expected net present value.
n
ENPV
i 0
ENCFt
1 k t
Where ENPV is the expected net present value, ENCFt expected net cash flows in period t and k is the discount
rate. The expected net cash flow can be calculated as follows:
ENCFt = NCFjt Pjt
Where NCFjt is net cash flow for jth event in period t and Pjt probability of net cash flow for jth event in period t21.
For example, A company is considering an investment proposal costing ` 7,000 and has an estimated life of
three years. The possible cash flows are given below:
Expected net present value
All amount in `
Cash flow
In Year 1
Prob.
Expected
Value
Cash flow
in Year 2
Prob.
Expected
Value
Cash flow Prob.

in Year 3
Expected
Value
2000
0.2
400
3000
0.4
1200
4000
0.3
1200
3000
0.5
1500
4000
0.3
1200
5000
0.5
2500
4000
0.3
1200
5000
0.3
1500
6000
0.2
1200
3100
3900
4900
64 PP-FT&FM
If we assume a risk free discount rate of 10%, the expected NPV for the project will be as follows:
Year
ENCF in `
PV@10%
PV in `
3100
0.909
2817.9
3900
0.826
3221.4
4900
0.751
3679.9
PV
9719.2
Less : NCO
7000
ENPV
2719.2
(c) Standard Deviation:

The assignment of probabilities and the calculation of the expected net present value include risk into the
investment decision, but a better insight into the risk analysis of capital budgeting decision is possible by calculating
standard deviation and coefficient of variation.
Standard deviation(s) is an absolute measure of risk analysis and it can be used when projects under consideration
are having same cash outlay. Statically, standard deviation is the square root of variance and variance measures
the deviation about expected cash flow of each of the possible cash flows. The formula for calculating standard
deviation will be as follows:
CF CF
i 1
Thus, it is the square root of the mean of the squared deviation, where deviation is the difference between an
outcome and the expected mean value of all outcomes and the weights to the square of each deviation is
provided by its probability of occurrence. For example, the standard deviation of following project X and Y is as
follows23:
Table 2.8
PROJECT-X (Standard deviation)
CF CFt CF
All Amount in in `
CF
CF CF
t
CF CF
CF CF
Pi
CF CF Pi
2
4000
6000
-2000
4000000
0.1
400000
5000
6000
-1000
1000000
0.2
200000
6000
6000
0.4
7000
6000
1000
1000000
0.2
200000
8000
6000
2000
4000000
0.1
400000
1200000
1095
Lesson 2
Capital Budgeting
65
PROJECT Y (Standard deviation)

All Amount in `
CF CF
CF
CF CF
t
CF CF
Pi
CF CF Pi
2
12000
8000
4000
16000000
0.1
1600000
10000
8000
2000
4000000
0.15
600000
8000
8000
0.5
6000
8000
-2000
4000000
0.15
600000
4000
8000
-4000
16000000
0.1
1600000
4400000
2098
In the above example, Project Y is riskier as standard deviation of project Y is higher than the standard deviation
of project X. However, the project Y has higher expected value also so the decision-maker is in a dilemma for
selecting project X or project Y.
(d) Coefficient of Variation:
If the projects to be compared involve different outlays/different expected value, the coefficient of variation is the
correct choice, being a relative measure. It can be calculated using following formula:
CV =
Standard deviation or
Expected Value CF
For example, the coefficient of variation for the above project X and project Y can be calculated as follows:
CV ( X ) = 1095 = 0.1825
6000
CV (Y ) = 2098 = 0.2623
8000
The higher the coefficient of variation, the riskier the project. Project Y is having higher coefficient so it is riskier
than the project X. It is a better measure of the uncertainty of cash flow returns than the standard deviation
because it adjusts for the size of the cash flow.
(e) Probability Distribution Approach:
The researcher has discussed the concept of probability for incorporating risk in capital budgeting proposals.
The concept of probability for incorporating risk in evaluating capital budgeting proposals. The probability
distribution of cash flows over time provides valuable information about the expected value of return and the
dispersion of the probability distribution of possible returns which helps in taking accept-reject decision of the
investment decision.
The application of this theory in analyzing risk in capital budgeting depends upon the behaviour of the cash flows,
being (i) independent, or (ii) dependent. The assumption that cash flows are independent over time signifies that
future cash flows are not affected by the cash flows in the preceding or following years. When the cash flows in one
period depend upon the cash flows in previous periods, they are referred to as dependent cash flows.
(i) Independent Cash Flows over Time: The mathematical formulation to determine the expected values
of the probability distribution of NPV for any project is as follows:
n
NPV
i 0
CF t
1 k t
CO
66 PP-FT&FM
where CF1 is the expected value of net CFAT in period t and I is the risk free rate of interest.
The standard deviation of the probability distribution of net present values is equal to ;
t2
1 k
i 0
21t
where t is the standard deviation of the probability distribution of expected cash flows for period t, t
would be calculated as follows:
CF
n CF t Pn
i 0
Thus, the above calculation of the standard deviation and the NPV will produce significant volume of information
for evaluating the risk of the investment proposal. For example, The standard deviation of the probability distribution
of net present
values under the assumption of the independence of cash flows over time for the above mentioned example of
expected net present values can be calculated as follows:
Probability distribution approach
Year 1
CF in `
CF CF in `
t
CF CF `
CF CF
in `
Pi
CF CF Pi in `
2
2000
3100
-1100
1210000
0.2
242000
3000
3100
-100
10000
0.5
5000
4000
3100
900
810000
0.3
243000
490000
700
Year 2
3000
3900
-900
810000
0.4
324000
4000
3900
100
10000
0.3
3000
5000
3900
1100
1210000
0.3
363000
690000
831
Year 3
4000
4900
-900
810000
0.3
243000
5000
4900
100
10000
0.5
5000
6000
4900
1100
1210000
0.2
242000
490000
700
Lesson 2
n
t2
1 i
i 0
2t
Capital Budgeting
67
7002 8312 7002

2
2
2
1.10 1.10 1.10
=` 1073.7
where s is the standard deviation of the probability distribution of possible net cash t 2 flows and is the variance
of each period.
(ii) Dependent Cash Flows: If cash flows are perfectly correlated, the behavior of cash flows in all periods is
alike. This means that if the actual cash flow in one year is a standard deviations to the left of its expected value,
cash flows in other years will also be a standard deviations to the left of their respective expected values. In
other words, cash flows of all years are linearly related to one another. The expected value and the standard
deviation of the net present value, when cash flows are perfectly correlated, are as follows:
n
NPV
i 0
CF t
NPV
1 t
i 1
1 i i
Where,
NPV = Expected Net Present Value
CFt = Expected Cash Flow for year"t"
I = Risk-free interest rate
NPV = S tan darddeviationofNet Pr esentValue
t = S tan darddeviationofthecashflowforyear"t"
For example, if we calculate NPV and sNPV for an investment project requiring a current outlay of Rs 10,000,
assuming a risk free interest rate of 6 per cent. The mean
and standard deviation of cash flows, which are perfectly correlated, are as follows:
Year
CFt (`)
5,000
1,500
4,000
1,000
5,000
2,000
3,000
1,200
NPV
5000
1.06
NPV
1, 500
1.06
4000
1.06
1, 000
1.06
3000
10, 000 Rs.3,121
1.063
2, 000
1.06
1, 200
1.06 4
Rs.3,121
(f) Normal Probability Distribution:

The normal probability distribution can be used to further analyze the risk in investment decision. It enable the
decision maker to have an idea of the probability of different expected values of NPV, that is, the probability of
NPV having the value of zero or less, greater than zero and within the range of two values for example, within
68 PP-FT&FM
the range of ` 2,000 and ` 3,000 etc. If the probability of having NPV zero or less is low, eg. .01, it means that the
risk in the project is negligible. Thus, the normal probability distribution is an important statistical technique in the
hands of decision makers for evaluating the riskiness of a project.
The area under the normal curve, representing the normal probability distribution, is equal to 1 (0.5 on either side
of the mean). The curve has its maximum height at its expected value i.e. its mean. The distribution theoretically
runs from minus infinity to plus infinity. The probability of occurrence beyond 3 s is very near to zero (0.26 per cent).
For any normal distribution, the probability of an outcome falling within plus or minus.
1 from the mean is 0.6826 or 68.26 per cent,
2 from the mean is 95.46 per cent,
3. from the mean is 99.74 per cent.
Figure 2.4
For example, If one needs to calculate for the above mentioned example the probability of the NPV being zero
or less, the probability of the NPV being greater than zero and the probability of NPV between the range of `
1500 and ` 3000, it can be calculated as follows using normal distribution.
Probability of the NPV being zero or less:
Z=
X - X 0-2719.2
=
-2.533
1073.7
According to Table Z, the probability of the NPV being zero is = 0.4943, therefore, the probability of the NPV
being zero or less would be 0.5-0.4943=0.0057 i.e. 0.57 per cent.
Probability of the NPV being greater than zero:
As the probability of the NPV being less than zero is 0.57 per cent, the probability of the NPV being greater than
zero would be 1-0.0057=0.9943 or 99.43 per cent.
Probability of NPV between the range of ` 1,500 and ` 3,000:
Z1
1, 500 2, 719.2
1.13
1, 073.7
Lesson 2
Z2
Capital Budgeting
69
3000 2719.2
0.26
1073.7
The area as per Table Z for the respective values of -1.13 and 0.26 is 0.3708 and
0.4803 respectively. Summing up, we have 0.8511 i.e., there is 85.11 per cent probability of NPV being within
the range of ` 1500 and ` 3000.
SOME CASE STUDIES

1. NPV and Payback Period Analysis
An Entrepreneur has approached you with an opportunity to lend ` 25,000 for his newly established home
healthcare business. Funds would be used to lease a delivery vehicle, purchase supplies, and provide working
capital. Terms of the proposal are that you would receive ` 5,000 at the end of each year in interest with the full
` 25,000 to be repaid at the end of a ten-year period.
A. Assuming a 10% required rate of return, calculate the present value of cash flows and the net present
value of the proposed investment.
B. Based on this same interest rate assumption, calculate the cumulative cash flow of the proposed
investment for each period in both nominal and present-value terms.
C. What is the payback period in both nominal and present-value terms?
D. What is the difference between the nominal and present-value payback period? Can the present-value
payback period ever be shorter than the nominal payback period??
Solution
A : The present value of cash flows and the net present value of the proposed investment can be calculated as
given below:
Present Value
Present Value
Year
Cash Flow in `
Interest Factor
Cash Flow `
(25,000)
1.0000
(25,000)
5,000
0.9091
4,545
5,000
0.8264
4,132
5,000
0.7513
3,757
5,000
0.6830
3,415
5,000
0.6209
3,105
5,000
0.5645
2,822
5,000
0.5132
2,566
5,000
0.4665
2,333
5,000
0.4241
2,120
10
5,000
0.3855
1,928
Cost of Capital
10.0%
70 PP-FT&FM
Present Value of Benefits
` 30,723
Present Value of Cost
` 25,000
Net Present Value
` 5,723
B. The cumulative cash flow of the proposed investment for each period in both nominal and present-value
terms is:
Year
Flow
Cash
Interest Factor
Present Value
Cash Flow
Present Value
Cash Flow
Cumulative
PV Cash Flow
Cumulative
(` 25,000)
1.0000
(`25,000)
(`25,000)
(`25,000)
5,000
0.9091
4,545
(20,000)
(20,455)
5,000
0.8264
4,132
(15,000)
(16,322)
5,000
0.7513
3,757
(10,000)
(12,566)
5,000
0.6830
3,415
(5,000)
(9,151)
5,000
0.6209
3,105
(6,046)
5,000
0.5645
2,822
5,000
(3,224)
5,000
0.5132
2,566
10,000
(658)
5,000
0.4665
2,333
15,000
1,675
5,000
0.4241
2,120
20,000
3,795
10
5,000
0.3855
1,928
25,000
5,723
Payback Period
5 years
Present Value Payback Period
8.28 years ( = 8 + ` 658/`2,333).
C. Based on the information provided in part B, it is clear that the cumulative cash flow in nominal rupees
reached `0 at the end of Year 5. This means that the nominal payback period is 5 years. The cumulative cash
flow in present-value rupees exceeds `0 when the Year 8 interest payment is received. This means that the
present-value payback period is roughly 8 years. If cash flows were received on a continuous basis, the presentvalue payback period would be 8.28 years ( = ` 658/` 2,333).
D. Assuming a positive rate of interest, the present-value payback period is always longer than the nominal
payback period. This stems from the fact that present-value dollars are always less than nominal dollars, and it
therefore takes longer to receive a fixed dollar amount back in terms of present-value dollars rather than in
nominal terms.
Qns No 2: Decision Rule Conflict. Balwinder has been retained as a management consultant by Square
Pants, Inc., a local specialty retailer, to analyze two proposed capital investment projects, projects X and Y.
Project X is a sophisticated working capital and inventory control system based upon a powerful personal
computer, called a system server, and PC software specifically designed for inventory processing and control in
the retailing business. Project Y is a similarly sophisticated working capital and inventory control system based
upon a powerful personal computer and general- purpose PC software. Each project has a cost of ` 10,000, and
the cost of capital for both projects is 12%. The projects = expected net cash flows are as follows
Lesson 2
Capital Budgeting
71
Solution:
Years
Expected Net Cash Flows in `

Project X
Project Y
(10,000)
(10,000)
6,500
3,500
3,000
3,500
3,000
3,500
1,000
3,500
A. Calculate each project = s nominal payback period, net present value (NPV), internal rate of return
(IRR), and profitability index (PI).
B. Should both projects be accepted if they are interdependent?
C. Which project should be accepted if they are mutually exclusive?
D. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of
these two projects? At what values of k would this conflict exist?
E. Why does a conflict exist between NPV and IRR rankings?
Solution
A. Payback:
To determine the nominal payback period, construct the cumulative cash flows for each project:
Cumulative Cash Flow in `
Year
Project X
Project Y
(10,000)
(10,000)
(3,500)
(6,500)
(500)
(3,000)
2,500
500
3,500
4,000
72 PP-FT&FM
Net Present Value
All amount in INR
Years
Expected Net Cash Flows

in `
Present Value
Factor @ 12%
Cash Flow
in `
Project X
Project Y
(10,000)
(10,000)
1.0000
6,500
3,500
0.8929
5,803.57
3,125.00
3,000
3,500
0.7972
2,391.58
2,790.18
3,000
3,500
0.7118
2,135.34
2,491.23
1,000
3,500
0.6355
635.52
2,224.31
Net Cash Flow 966.01
Project X
Project Y
(10,000)
(10,000)
630.72
Internal Rate of Return (IRR):

To solve for each project = s IRR, find the discount rates that set NPV to zero:
IRRX = 18.0%.
IRRY = 15.0%.
Profitability Index (PI):
B. Using all methods, project X is preferred over project Y. Because both projects are acceptable under the NPV,
IRR, and PI criteria, both projects should be accepted if they are interdependent.
C. Choose the project with the higher NPV at k = 12%, or project X.
D. To determine the effects of changing the cost of capital, plot the NPV profiles of each project. The crossover
rate occurs at about 6% to 7%. To find this rate exactly, create a project , which is the difference in cash flows
between projects X and Y:
Years
Differential Cash flow between Project X and Y (in ` )
3,000
(500)
(500)
(2,500)
Then find the IRR of Project

IRR = Crossover Rate = 6.2%.
Lesson 2
Capital Budgeting
73
Thus, if the firms cost of capital is less than 6.2%, a conflict exists, because
NPVY > NPVX but IRRX > IRRY.
E. The basic cause of conflict is the differing reinvestment rate assumptions between PV and IRR. The conflict
occurs in this situation because the projects differ in their cash flow timing.
Qns No 3: Decision Rule Criteria. The net present value (NPV), profitability index (PI), and internal rate of
return (IRR) methods are often employed in project valuation. Identify each of the following statements as true or
false, and explain your answers.
A. The IRR method can tend to understate the relative attractiveness of superior investment projects when
the opportunity cost of cash flows is below the IRR.
B. A PI = 1 describes a project with an NPV = 0.
C. Selection solely according to the NPV criterion will tend to favor larger rather than smaller investment
projects.
D. When NPV = 0, the IRR exceeds the cost of capital.
E. Use of the PI criterion is especially appropriate for larger firms with easy access to capital markets.
Solution
A. False. The IRR method implicitly assumes reinvestment of net cash flows during the life of the project at
the IRR and will overstate the relative attractiveness of superior investment projects when the opportunity
cost of cash flows is below the IRR. If, for example, a project has a projected IRR = 22%, but cash flows
thrown off during the life of the project can only be reinvested at, say, 15%, then the true IRR for the
project will be less than 22% and its relative attractiveness will be overstated using the IRR method.
B. True. The PI = PV Cash Flows/Cost, and NPV = PV Cash Flows -Cost. Therefore, when PV Cash Flows
= Cost, PI = 1 and NPV = 0.
C. True. Selection according to the NPV criterion will tend to favor larger as opposed to smaller investment
projects.
D. False. The IRR is the interest rate that equates the PV cash flows with the investment cost of a project.
NPV = PV Cash Flows - Cost, when cash flows are discounted at an appropriate risk-adjusted cost of
capital, k. Therefore, when IRR = k, NPV = 0.
E. False. Larger firms with easy access to capital markets maximize the value of the firm through the
process by selecting projects according to the NPV criterion. Smaller firms, which face capital budget
constraints forcing rejection of some NPV > 0 projects, can best employ scarce capital through use of
the PI criterion.
Question No 4:
Mr. Jagdish owns a Drug Store, located in Maliwara Ghaziabad. The drug store sells pharmaceuticals, cosmetics,
toiletries, magazines, and various novelties. The most recent annual net income statement of drug store is as
follows:
Amount in `
Sales revenue
1,800,000
Total costs
Cost of goods sold
Wages and salaries
1,260,000
200,000
74 PP-FT&FM
Rent
120,000
Depreciation
60,000
Utilities
40,000
Miscellaneous
30,000
Total
1,710,000
Net profit before tax
90,000
Drug Stores sales and expenses have remained relatively constant over the past few years and are expected to
continue unchanged in the near future. To increase sales, Drug Store is considering using some floor space for
a small soda fountain. Drug Store would operate the soda fountain for an initial three-year period and then would
reevaluate its profitability. The soda fountain would require an incremental investment of `20,000 to lease furniture,
equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the
end of that time, additional capital would be required to continue operating the soda fountain, and no capital
would be recovered if it were shut down. The soda fountain is expected to have annual sales of `100,000 and
food and materials expenses of `20,000 per year. The soda fountain is also expected to increase wage and
salary expenses by 8% and utility expenses by 5%. Because the soda fountain will reduce the floor space
available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.
A. Calculate net incremental cash flows for the soda fountain.
B. Assume that Drug Store has the capital necessary to install the soda fountain and that he places a 12%
opportunity cost on those funds. Should the soda fountain be installed? Why or why not?
Solution
A. The relevant annual cash flows from the proposed soda fountain are:
Amount in `
Incremental revenue (A)
100,000
Increment Cost
Food and materials
20,000
Wages and salaries (`200,000 x 0.08)
16,000
Utilities (`40,000 x 0.05)
2,000
Opportunity Cost: Profit contribution lost on regular sales

= 0.1(` 18,00,000 - `12,60,000)
54,000
Total incremental cost (B)
92,000
Net incremental annual cash flow (A B)

Incremental investment
8,000
20,000
B. No, the NPV for the proposed soda fountain should be calculated to determine the economic viability of
the project.
NPV = (Incremental annual cash flow)(PVIFA, N = 3, i = 12%) - `20,000
= `8,000(2.4018) - `20,000
= -`785.60 (A loss)
Because NPV < 0, Drug Store should not undertake the soda fountain investment project.
Lesson 2
Capital Budgeting
75
Question No 5: Cash Flow Analysis. The Future India Press is analyzing the potential profitability of three
printing jobs put up for bid by the Department of Revenue:
Job A
Job B
Job C
Projected winning bid (per unit)
` 5.00
` 8.00
` 7.50
Direct cost per unit
` 2.00
` 4.30
` 3.00
Annual unit sales volume
` 8,00,000
` 6,50,000
` 4,50,000
Annual distribution costs
` 90,000
` 75,000
` 55,000
` 50,00,000
` 52,00,000
` 40,00,000
Investment required to produce annual volume

Assume that
(1) The companys marginal city-plus-state-plus-Corporate tax rate is 50%;

(2) Each job is expected to have a six-year life; (3) the firm uses straight-line depreciation; (4) the average
cost of capital is 14%; (5) the jobs have the same risk as the firms other business; and (6) the company
has already spent `60,000 on developing the preceding data. This `60,000 has been capitalized and
will be amortized over the life of the project.
A. What is the expected net cash flow each year? (Hint: Cash flow equals net profit after taxes plus
depreciation and amortization charges.)
B. What is the net present value of each project? On which project, if any, should Future India Press
(FIP) bid?
C. Suppose that FIPs primary business is quite cyclical, improving and declining with the economy,
but that job A is expected to be countercyclical. Might this have any bearing on your decision?
Solution
A. The `60,000 spent on job cost development is a sunk cost. This cost must, however, be accounted for in
the tax calculation as a `10,000 per year non-cash expense. The annual net cash flow calculations are:
Amount in `
Job A
Job B
Job C
Projected winning bid (per unit)
5.00
8.00
7.50
Deduct direct cost per unit
2.00
4.30
3.00
Profit contribution per unit
3.00
3.70
4.50
8,00,000
6,50,000
4,50,000
24,00,000
24,05,000
20,25,000
90,000
75,000
55,000
23,10,000
23,30,000
19,70,000
10,000
10,000
10,000
23,00,000
23,20,000
19,60,000
8,33,333
8,66,667
6,66,667
14,66,667
14,53,333
12,93,333
Deduct taxes
7,33,333
7,26,667
6,46,667
Cash flow
7,33,333
7,26,667
6,46,667
Times annual unit sales volume

Profit contribution per year
Deduct annual distribution costs
Cash flow before amortization, depreciation and
taxes
Deduct amortization charges
Cash flow before depreciation and taxes
Deduct depreciation
Cash flow before taxes
76 PP-FT&FM
Add back depreciation plus amortization
8,43,333
8,76,667
6,76,667
Net annual cash flow
15,76,667
16,03,333
13,23,333
Investment required to produce annual volume
50,00,000
52,00,000
40,00,000
Job cost development
60,000
Job life (years)
Tax rate
B.
50%
The NPV calculations are:

Amount in `
Job A
Job B
Job C
15,76,667
16,03,333
13,23,333
3.8887
3.8887
3.8887
Present value of annual net cash flows
61,31,185
62,34,881
51,46,045
Deduct initial investment cost
50,00,000
52,00,000
40,00,000
Net present value (NPV)
11,31,185
10,34,881
11,46,045
Net annual cash flow

Times PVIFA
Relevant discount rate
14%
Job life (years)
Job C is the most profitable, and therefore is the most attractive because NPVC
> NPVA > NPVB. However, NPV > 0 for each job and each project is attractive.
C. Risk for the firm is reduced through diversification. If job A is counter-cylical, then it is least risky, other things
being equal, and could be attractive on the basis of both its risk and return characteristics.
LESSON ROUND-UP
Capital Budgeting refers to long-term planning for proposed capital outlays and their financing. Capital
Budgeting may also be defined as the firms decision to invest its current fund more efficiently in longterm activities in anticipation of an expected flow of future benefit over a series of years.
Capital Rationing helps the firm to select the combination of investment projects that will be within the
specified limits of investments to be made during a given period of time and at the same time provide
greatest profitability.
Pay Back technique estimates the time required by the project to recover, through cash inflows, the
firms initial outlay.
Pay back period =
Initial Investment
Annual cash inflows
Average Rate of Return method is designated to consider the relative profitability of different capital
investment proposals as the basis for ranking them the fact neglected by the payout period technique.
Average Rate of Return
=
No. of years project will last Investment
Original Investment of Average
Lesson 2
Capital Budgeting
77
Net Present Value: The cash outflows and inflows associated with each project are ascertained first and
both are reduced to the present values at the rate of return acceptable to the management. The rate of
return is either cost of capital of the firm or the opportunity cost of capital to be invested in the project.
Sn Wn N C t
C0
t
(1 k)n t=1(1 k)t
t=1(1 k)
N
Rt
NPV =
Internal Rate of Return: The internal rate of return refers to the rate which equates the present value of
cash inflows and present value of cash outflows.
C
Sn Wn n
C1
t
n
t
(1 r)
t 1(1 r)
t 1 (1 k)
n
CFt
Profitability Index (PI): Profitability Index is defined as the rate of present value of the future cash benefits
at the required rate of return to the initial cash outflow of the investment.
n
PI
At
t 1(1 k)
Sensitivity Analysis treats risk and uncertainty in capital budgeting decisions.

Cost of equity capital is the minimum return that the investors would like to get on their investments in
Companys Shares.
Composite cost of Capital is calculated as combined weighted average of the cost of all different sources
of capital
SELF-TEST QUESTIONS
1. Define capital budgeting and examine the need for capital budgeting.
2. Explain different methods of appraising project profitability. Which method is considered to be the
best?
3. Distinguish between Internal Rate of Return and Net Present Value techniques. Which method would
you recommend for evaluating investment? Explain.
4. (a) Capital Budgeting models are used to evaluate a wide variety of capital
expenditure
decisions. Comment on this statement and enunciate some of the important expenditure decisions to
which capital budgeting technique can be applied.
(b) The Susan Co. is contemplating either of two mutually exclusive projects. The data with respect to
each are given below. The initial investment for both is equal to their depreciable value. Both will be
depreciated straight line over a five-year life.
Project A (`)
Project B (`)
Initial Investment
1,00,000
1,40,000
Year
Profits after taxes
10,000
25,000
15,000
25,000
78 PP-FT&FM
3
20,000
25,000
25,000
25,000
35,000
25,000
(i) Calculate the net present value and benefit-cost ratio for each project.
(ii) Evaluate the acceptability of each project on the basis of above mentioned two techniques.
(iii) Select the best project, using NPV and benefit-cost ratios and comment on the resulting rankings.
(iv) Assume that the Susan Co. has an 11% cost of capital.
(v) The following data relates to discounting factor:
Year
Discounting factor at 11%
.901
.812
.731
.659
.593
and discounting factor for present value of an annuity discounted at 11% for five years is 3.696.
5. Define the concept of cost of capital. State how you would determine the weighted average cost of
capital of firm.
(1) Profitability Index
(2) Sensitivity Analysis
(3) Linear Programming and Capital Budgeting
(4) Capital Rationing.
7. Explain the various steps of capital budgeting process.
Lesson 2
Capital Budgeting
79
80 PP-FT&FM
Lesson 3
Capital Structure
LESSON OUTLINE
Lesson 3
Capital Structure
81
LEARNING OBJECTIVES
Meaning and Significance of Capital

Structure
Capital Structure of a company is very important

for company survival. If the capital structure of
a company is not optimized, then it becomes
difficult for a company to get sustain i.e.
sometime it have to face the lack of capital,
sometime it has to bear the high interest. So in
view of above, it becomes very important for a
finance manager to ensure that the firms capital
structure is as per the market and organisation
condition. The object of the Lesson is to enable
the students to understand:
Capital Structure vis--vis Financial

Structure
Planning and Designing
Optimal Capital Structure
Factors affecting Capital Structure of a
Company
Determinants of Capital Structure
Nature, scope and significance of capital

structure
Capital Structure and Valuation

Theories of Capital Structure
Factors influencing Capital Structure
EBIT - EPS Analysis
Capital structure vis a vis Financial

structure
EBITDA Analysis (Earnings before

Interest, Tax, Depreciation and
Amortization)
Planning and designing of capital

structure
Measures of Operating and Financial

Leverage
Optimal Capital Structure
Effects of Leverage on Shareholders

Returns
Capital Structure theories
Capital Structure & Valuation
Risk and Leverage
Leverage Operating leverage, financial

leverage, combined leverage
LESSON ROUND UP
EBIT-EPS Analysis
SELF TEST QUESTIONS
Effect of leverages on return on equity
The optimal capital structure indicates the best debt-to-equity ratio for a firm that maximizes its
value. Putting it simple, the optimal capital structure for a company is the one which proffers a
balance between the idyllic debt-to-equity ranges thus minimizing the firms cost of capital
81
82 PP-FT&FM
MEANING AND SIGNIFICANCE OF CAPITAL STRUCTURE

Meaning of Capital Structure
By the term capital structure we mean the structure or constitution or break-up of the capital employed by a firm.
The capital employed consists of both the owners capital and the debt capital provided by the lenders. Debt
capital is understood here to mean the long term debt which has been deployed to build long term assets. Apart
from the elements of equity and debt in the capital structure, a firm could have quasi equity in the form of
convertible debt.
Capital Structure of a firm is a reflection of the overall investment and financing strategy of the firm. It shows how
much reliance is being placed by the firm on external sources of finance and how much internal accruals are
being used to finance expansions etc. Capital structure can be of various kinds as described below:
1. Horizontal Capital Structure
In a Horizontal capital structure, the firm has zero debt components in the structure mix. The structure is quite
stable. Expansion of the firm takes in a lateral manner, i.e. through equity or retained earning only. The absence
of debt results in the lack of financial leverage. Probability of disturbance of the structure is remote.
2. Vertical Capital Structure
In a vertical capital structure, the base of the structure is formed by a small amount of equity share capital. This
base serves as the foundation on which the super structure of preference share capital and debt is built. The
incremental addition in the capital structure is almost entirely in the form of debt. Quantum of retained earnings
is low and the dividend pay-out ratio is quite high. In such a structure, the cost of equity capital is usually higher
than the cost of debt. The high component of debt in the capital structure increases the financial risk of the firm
and renders the structure unstable. The firm, because of the relatively lesser component of equity capital, is
vulnerable to hostile takeovers.
3. Pyramid shaped Capital structure
A pyramid shaped capital structure has a large proportion consisting of equity capital and retained earnings
which have been ploughed back into the firm over a considerably large period of time. The cost of share capital
and the retained earnings of the firm is usually lower than the cost of debt. This structure is indicative of risk
averse conservative firms.
4. Inverted Pyramid shaped Capital Structure
Such a capital structure has a small component of equity capital, reasonable level of retained earnings but an
ever increasing component of debt. All the increases in the capital structure in the recent past have been made
through debt only. Chances are that the retained earnings of the firm are shrinking due to accumulating losses.
Such a capital structure is highly vulnerable to collapse.
Significant of capital structure

Capital structure is significant for a firm because the long term profitability and solvency of the firm is sustained
by an optimal capital structure consisting of an appropriate mix of debt and equity. The capital structure also is
significant for the overall ranking of the firm in the industry group. The significance of the capital structure is
discussed below:
1. It reflects the firms strategy
The capital structure reflects the overall strategy of the firm. The strategy includes the pace of growth of the firm.
In case the firm wants to grow at a faster pace, it would be required to incorporate debt in its capital structure to
Lesson 3
Capital Structure
83
a greater extent. Further, in case of growth through acquisitions or the inorganic mode of growth as it is called,
the firm would find that financial leverage is an important tool in funding the acquisitions.
2. It is an indicator of the risk profile of the firm
One can get a reasonably accurate broad idea about the risk profile of the firm from its capital structure. If the
debt component in the capital structure is predominant, the fixed interest cost of the firm increases thereby
increasing its risk. If the firm has no long term debt in its capital structure, it means that either it is risk averse or
it has cost of equity capital or cost of retained earnings less than the cost of debt.
3. It acts as a tax management tool
The capital structure acts as a tax management tool also. Since the interest on borrowings is tax deductible, a
firm having healthy growth in operating profits would find it worthwhile to incorporate debt in the capital structure
in a greater measure.
4. It helps to brighten the image of the firm
A firm can build on the retained earnings component of the capital structure by issuing equity capital at a
premium to a spread out base of small investors. Such an act has two benefits. On the one hand, it helps the firm
to improve its image in the eyes of the investors. At the same time, it reduces chances of hostile take-over of the
firm.
CAPITAL STRUCTURE VIS-A-VIS FINANCIAL STRUCTURE

In engineering, structure refers to different parts of a building and thus in financial terms, financial structure
refers to all the components of finance in an organization. In simple terms, financial structure consists of all
assets, all liabilities and the capital. The manner in which an organizations assets are financed is referred to as
its financial structure. There are some similarities between capital structure and financial structure. However,
there are many differences also that will be highlighted in this article.
If you take a look at the balance sheet of a company, the entire left hand side which includes liabilities plus equity
is called the financial structure of the company. It contains all the long term and short term sources of capital. On
the other hand, capital structure is the sum total of all long term sources of capital and thus is a part of the
financial structure. It includes debentures, long term debt, preference share capital, equity share capital and
retained earnings. In the simplest of terms, capital structure of a company is that part of financial structure that
reflects long term sources of capital.
Consider the balance sheet of a company :
(Amt. in `)
Particulars
Note
No.
Amount as
at 31st March,
2012
Amount as at
31st March,
2011
EQUITY AND LIABILITIES
(1)
Shareholders funds
(a)
Share Capital
(b)
Reserve and Surplus
(2)
Current liabilities
1,28,000
(a)
Trade payable
1,28,000
2,00,000
1
72,000
84 PP-FT&FM
(b)
Provision for income Tax
60,000
TOTAL
4,60,000
II.
ASSETS
(1)
Non current-assets
(a)
Fixed Assets
(b)
Preliminary expenses
(2)
Current Assets
(a)
inventories
48,000
(b)
Trade receivable
88,000
(c)
Cash at bank
52,000
TOTAL
4,60,000
8,000
In the above illustration, the total liabilities size of ` 4,60,000 is the financial structure of the firm while the long
term block of ` 2,72,000 is the capital structure. We can also say that that the total financial structure minus the
current liabilities structure gives us the capital structure.
We can enunciate the following differences between financial structure and capital structure:
Capital structure relates to long term capital deployment for creation of long term assets. Financial
structure involves creation of both long term and short term assets.
Capital structure is the core element of the financial structure. Capital structure can exist without the
current liabilities and in such cases;
Capital structure shall be equal to the financial structure. But we cannot have a situation where the firm
has only current liabilities and no long term capital.
The financial structure of a firm is considered to be a balanced one if the amount of current liabilities is
less than the capital structure net of outside debt because in such cases the long term capital is considered
sufficient to pay current liabilities in case of sudden loss of current assets.
Components of the capital structure may be used to build up the level of current assets but the current
liabilities should not be used to finance acquisition of fixed assets. This would result in an asset liability
mismatch.
PLANNING AND DESIGNING OF CAPITAL STRUCTURE

Just as planning and design of a physical structure is important, the same holds true for capital structure as well.
A well thought out plan for the capital structure supplemented by a careful design ensures that prime goal of the
firm, i.e. maximisation of the shareholder wealth is easily achieved.
Planning of the capital structure is a preliminary activity and it might commence as early at the time of incorporation
of the firm. Once the firm is established, the next logical step is to move in the direction of implementation of the
project. For meeting the cost of the project, the means of finance are to be arranged. Hence the need for timely
and early planning of the capital structure.
Attributes of a Well Planned Capital Structure

A well-planned capital structure should have the following attributes:
1. Long Tenure: The plan should be for a fairly long tenure and should cover the working of at least five
Lesson 3
Capital Structure
85
to seven years of the project. Expansion of the capacity, addition of product lines etc. should be accounted
for in the plan.
2. Consistency: The planned capital structure should be consistent with the over all financing philosophy
of the firm. If the firm has a risk averse philosophy, then the plan should have minimum component of
debt.
3. Feasibility: The planned capital structure should have feasibility, i.e. it should not be impractical. Feasibility
also means that it should be workable within the amount of share capital, debt and retained earnings
expected to be available to the firm.
Designing a Capital Structure

After planning the capital structure, we are faced with the issue of its design. Design takes off from where the
plan ends. Planning establishes the broad parameters of the structure. It is left for the design to fill in the minor
details. While designing a capital structure, following points need to be kept in view:
1. Design should be functional: The design should create synergy with the long term strategy of the firm
and should not be dysfunctional. It should facilitate the day to day working of the firm rather than create
systematic bottlenecks.
2. Design should be flexible: The capital structure should be designed to incorporate a reasonable
amount of flexibility in order to allow for temporary expansion or contraction of the share of each
component.
3. Design should be conforming statutory guidelines: The design should conform to the statutory
guidelines, if any, regarding the proportion and amount of each component. The limits imposed
by lenders regarding the minimum level of owners equity required in the firm should be complied
with.
OPTIMAL CAPITAL STRUCTURE

Is there an optimal capital structure for a firm? By the term optimal capital structure we mean a particular
arrangement of various components of the structure which is just in tune with the both the long term and short
term objectives of the firm. A combination less or more than the optimal combination would be less than satisfying.
Hence a sub-optimal combination would affect the achievement of the goal of maximisation of the shareholders
wealth.
But can we plan and design an optimal capital structure? For designing such a structure, one would need the
following information:
The requirement of capital of the firm
Availability of different components
Cost of these components
Rate of return from investment
It has to be further kept in mind that the above information should be exact information. In reality it is not possible
to have the exact information on all the above four parameters. Secondly whatever information is available is for
a particular period. Thus we have to design the structure in a static set-up which makes the design devoid of all
flexibility.
The real world of business, however, is a dynamic world with ever changing demand and supply of various
components of the capital structure. Hence we can not formulate the optimal capital structure in a static framework.
The process has to be carried out in a dynamic framework of interdependent investment and financing decisions
86 PP-FT&FM
that yield optimal values within the constraints at the time and place when the decisions were made. We can,
therefore, say that the optimal capital structure is an ideal situation which can function as the benchmark of
performance for a firm. But this benchmark is invincible and the firm can expect to achieve moderated or toned
down versions of this benchmark depending upon dynamics of each project.
FACTORS INFLUENCING CAPITAL STRUCTURE

A company can finance its operations both through equity and debt. These two types of financing require servicing.
Interest is paid on debt and return is to be provided to stockholders in the form of equity. Interest paid being 100%
tax-deductible, provides the company a tax shield. Let us take an example to compare two modes of financing:
Particulars
Firm A
Firm B
Equity Capital
1000
2000
Debt
1000
nil
Turnover
2000
2000
Cost of Goods Sold
1200
1200
Other expenses
100
100
Interest
150
Profit Before Tax
550
700
Tax @40%
220
280
Profit after tax
330
420
Dividend
100
200
Retained Earning
230
220
We have two firms A and B entailing same investment of ` 2000 lacs. Firm A has equal mix of debt and equity
financing while firm B has only equity financing. Rate of interest is 15% p.a. Tax rate is 40% and rate of dividend
is 10%. A comparison of bottomline in both the cases shows that firm B has a higher profit before tax but lower
retained earning because of higher tax outgo and higher dividend payment. In case the management of the firm
is keen on internal accruals, a mix of equity and debt would be better suited but if the management is considering
profit after tax as the key criterion, then the firm should avoid taking on debt.
Normally a company wishes to raise capital by way of both equity and debt. In the real world, deciding on the
capital structure is not so easy. In deciding the capital structure of a firm, following points need to be considered.
(a) Corporate Strategy

It is the main factor determining the financial structure of a company. The company has to determine the overall
Capital Intensity Ratio (Debt/Equity) in line with its overall strategy. The company has to look at various options
of debt equity mix, the cost of each option, the consequences of increase in equity on its valuation, capability to
service both debt and equity etc. Other strategic decisions like management control level, risk averseness or
risk taking nature of the management have also to be considered. Ultimately, the most appropriate capital
structure will be the one, which most closely supports the strategic direction of the business with the least cost
and at a reasonably acceptable risk level.
(b) Nature of the Industry

The nature of the industry plays on important role in capital structure decisions. If the firm is capital intensive, it
Lesson 3
Capital Structure
87
would rely more on debt than equity. Generally speaking, long term assets should be financed by a balance
between term debt and equity and short term assets should be financed by long term sources and more by short
term debt. The current assets (short term assets) and fixed assets (long term assets) are determined by the
nature of the business itself. A trading firm might have more current assets than fixed assets. In business like
construction, capital and higher consumer goods their volumes and hence requirements of funds are affected
by the changes in national and global scene. Business subject to such variations need a capital structure that
can buffer the risks associated with such savings. The degree of competition is also a major factor to be considered
in deciding the capital structure. In highly competitive industry with low entry barriers companies need to be well
capitalized.
(c) Current and past capital structure

Current capital structure of a firm is determined largely by past decisions. Investment decision of the past,
acquisition, takeovers financing policy, dividends etc. go into forming the current capital structure which is
difficult to change overnight. However, alterations in the structure are possible by raising capital, retiring debts,
buying back shares, taking on debts, altering dividend pay-out policies, alteration in earning capacity etc. Also,
as past decisions determine current capital structure, current changes in the capital structure decide the future
capital structure. Hence, utmost care has to be exercised in decision and implementation of changes in the
capital structure.
While deciding upon the capital structure the firm has to consider the different life cycle stages which are:
The pioneering stage
The expansion stage
The stagnation/stabilization stage
The pioneering stage is one of rapid increase in demand for the products/services at the starting stage of the life
cycle of the company and the efficient companies are the one to survive. The financial cost of borrowing is very
high at this stage, due to risk perception about the company. To survive this stage, the capital structure should
orient more towards equity and avail more soft loans.
The expansion stage is the next stage, during which the strong companies survive the competition struggle and
aim to expand their market share and volumes. During this stage, huge investments are made to expand
production/service capacity. Requirement of funds is high during this stage. Subject to the corporate strategy of
funding projects and market conditions, the company may raise capital at the lowest possible cost. As the
earnings stabilize the company will be in a position to weather any small variations in business, then it can seek
to financially leverage itself within a pre-fixed ceiling, by bank loans.
Stabilization/stagnation stage is the last and final stage. A dynamic management will always be on the lookout
for expansion/diversification into new projects. It could again, depending on corporate strategy, go in for
green-field projects or takeover existing units, seek mergers, acquisitions and strategic alliances etc. Usually
a recession in economy opens up a vast number of such opportunities which cash rich companies can take
advantage of. In case of lack of such opportunity, the company could reduce the financial leverage and save
on interest.
DETERMINANTS OF CAPITAL STRUCTURE

We have seen above that there is no optimal capital structure for a firm and with the best of efforts, the firm can
hope to attain an approximation to it. Now let us discuss the factors which determine the formation of the capital
structure:
1. Minimisation of risk: The capital structure should aim at minimisation of risk of the firm. The term risk
here means financial risk. The term excludes the normal financial risk and concentrates on the abnormal
88 PP-FT&FM
financial risk that might arise from a particular capital structure decision. The normal risk has already
been factored in the projections while matching with the expected returns. It is the abnormal financial
risk which should be minimised.
2. Maximisation of profit: The capital structure is formulated with a view to achieve the goal of maximisation
of firms profits. These profits are after tax profits which add to shareholder wealth. Thus if the debt
obligations of the firm entail tax breaks, it would be advisable for the firm to enlarge the debt component
of the structure.
3. Nature of the project: Formulation of the structure is also determined by the nature of the investment
project. If the project is a capital intensive, long gestation project then it should be financed by debt of
matching maturity.
4. Control of the firm: This aspect of the firm also plays a part in the determination of the capital structure.
Since the key to control of the firm is ownership of the equity capital, the promoters would like to part
with only that proportion of equity capital as is necessary for execution of the project. Spreading of
equity among the public investors exposes the firm to risk of take over. Hence a capital structure which
makes the firm vulnerable in this respect is discouraged.
CAPITAL STRUCTURE AND VALUATION

There is a theme that the capital structure should be conducive to increase in valuation of the firm. By valuation,
we mean that the market value or the realisable value of the owners equity should increase. This can happen
in case value of both components of the shareholders equity, i.e. share capital and retained earnings
increases.
Value of the share capital is reflected in the market value of the firm in case the shares are traded on the stock
exchange. This market value, under ideal conditions, is indicative of the inherent value and is different from both
the face value and the book value. The capital structure should be such as maximises the inherent value of the
firm.
Retained earnings also have a book value, i.e. the value at which these earnings are carried in the books of
the firm. The inherent value of the retained earnings depends upon the future returns which these earnings
can generate for the owners. As earnings of the firm increase, its valuation also increases. Earnings can
increase either directly through increased level of operations of the firm or indirectly through decrease in
cost of capital of the firm. The direct increase in earnings is dependent upon the investment decisions and
the changes in capital structure have no explicit bearing upon these earnings. Capital structure plays an
important part in increase in earnings brought about by change in cost of different components of the
structure.
CAPITAL STRUCTURE THEORIES

There are basically three approaches to capital structure decision:
1. Net Income Approach
2. Net Operating Income Approach
3. Modigliani Miller Approach
1. Net Income Approach
According to this approach, the cost of debt capital, Kd and the cost of equity capital Ke remains unchanged
when D/S, the degree of leverage, varies. Here S stands for total capital employed (= D + E). The constancy of
Kd and Ke with respect to the degree of leverage means that K the average cost of capital, measured by the
following formula declines as the degree of leverage increases.
Lesson 3
Kd
D
(D E)
Ke
Capital Structure
89
E
(D E)
This happens because when the degree of leverage increases, Kd which is lower than Ke receives a higher
weight in the calculation of K. This can also be illustrated by a graph as shown below:
Ke
K
Cost of Capital
Kd
Degree of Leverage D/S

As our assumption is that the cost of debt and equity capital would not change with the change in the level of
leverage, K is seen to go down with the increasing proportion of debt in the capital.
Let us take a company that has an investment of ` 2,00,000 and a net operating income of ` 50,000. It is
considering two scenarios: (1) no debt and (2) equal levels of debt and equity of ` 1,00,000 each. Let us say that
the company finds out that the cost of equity is 12% and the cost of debt is 8%.
Calculations show that equity earnings would be ` 50,000 and ` 42,000 respectively in the two scenarios and
shown below. As the return expected on equity is 12%, we can say that this profit is 12% and therefore the
market value of equity would be such that this return becomes 12% on the same. This means that the market
value of equity would be ` 4,16,667 and ` 4,50,000 respectively in the two scenarios. Adding the market value
of debt and the market value of equity gives us the total value of the firm in the market.
Equity
Scenario A
Scenario B
Equity
2,00,000
1,00,000
1,00,000
12%
12%
8%
8%
50,000
50,000
Interest on Debt
8,000
Equity earnings
50,000
42,000
4,16,667
3,50,000
1,00,000
4,16,667
4,50,000
Debt
Cost of Equity
Cost of Debt
Net operating income
Market value of equity

Market value of debt
Total Value of firm
Average cost of capital Scenario A: 8% x (0/2,00,000) + 12% x (2,00,000/2,00,000) = 12%

Scenario B: 8% x (1,00,000/4,50,000) + 12% x (3,50,000/4,50,000) = 11.10%
90 PP-FT&FM
There are two points to be noted here
1. As the cost of capital decreases the value of the firm would go up as it is dependent upon the return
expected and the cost of capital. Inverse relationship exists between the value of the firm and cost of
capital for any given level of return.
2. This means that as we increase the level of debt in the company, the value of the firm would go up even
further. This would mean that the companies would like to employ as much debt as possible.
2. Net Operating Income Theory
Taking an opposite view from the view taken in the net income approach, this approach states that the cost of
capital for the whole firm remains constant, irrespective of the leverage employed in the firm. We can express
the cost of equity as:
Ke
Ko
(K o K d ) D
(D E)
Ke
Cost of Capital
Ko
Kd
Degree of Leverage D/S
Let us repeat the example we discussed earlier in net income approach. Let us take a company that has an
investment of ` 2,00,000 and net operating income of ` 50,000. It is considering two scenarios: 1) no debt and
2) equal levels of debt and equity of ` 100,000 each. Let us assume that the company finds out that the overall
cost of capital is 10% and the cost of debt is 8%.
As the return expected on total capital is 10 per cent, therefore the market value of total capital would be such
that this return becomes 10 per cent on the same. This means that the market value of capital would be `
5,00,000 in both the scenarios as our assumption in this case is that the total market value remains constant.
Also the value of debt would also remain constant as the cost of debt remains constant. This means that the
equity capitalization can be calculated by subtracting the market value of debt from the total market value of
the firm. Then the return on equity divided by the market capitalization of equity would give us the cost of
equity.
Equity
Scenario A
Scenario B
Equity
2,00,000
1,00,000
1,00,000
8%
8%
50,000
50,000
10%
10%
Debt
Cost of Debt
Net operating income
Overall Capitalization rate
Lesson 3
Total market value
Interest on debt
Debt capitalization rate
Capital Structure
91
5,00,000
5,00,000
8,000
0.08
0.08
1,00,000
5,00,000
4,00,000
There are two points to be noted here:

As the cost of total capital and debt is constant, the cost of equity would go up or down with increasing
or decreasing leverage, i.e., the amount of debt in the capital structure.
This means that as we increase the level of debt in the company, the value of the firm doesnt change
and the company does not benefit by taking on debt. This would mean that the companies would like to
employ as much equity as possible so as to reduce the risk of the company.
3. Modigliani - Miller Theory
In 1958, Franco Modigliani and Merton Miller (MM) published a theory of modern financial management
they concluded that the value of a firm depends solely on its future earnings stream, and hence its value is
unaffected by its debt/equity mix. In short, they concluded that a firms value stems from its assets, regardless
of how those assets are financed. In other words, a variant of the net operating income approach discussed
above.
In their paper, MM began with a very restrictive set of assumptions, including perfect capital markets (which
implies zero taxes). And then they used an arbitrage proof to demonstrate that capital structure is irrelevant.
Under their assumptions, if debt financing resulted in a higher value for the firm than equity financing, then
investors who owned shares in a leveraged (debt-financed) firm could increase their income by selling
those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equityfinanced) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in the
unleveraged firm would drive the prices of the stocks to the point where the values of the two firms would be
identical. Thus, according to MM Hypothesis, a firms stock price is not related to its mix of debt and equity
financing.
Modigliani and Miller have restated and amplified the net operating income position in terms of three basic
propositions. These are as follows:
Proposition I
The total value of a firm is equal to its expected operating income (PBIT when tax = 0) divided by the discount
rate appropriate to its risk class. It is independent of the degree of leverage.
Vl Vu
EBIT EBIT
K ol
K ou
Here the subscript l is used to denote leveraged firm and subscript u is used to denote unleveraged firm.
Since the V (Value of the firm) as established by the above equation is a constant, then under the MM model,
when there are no taxes, the value of the firm is independent of its leverage. This implies that the weighted
average cost of capital to any firm is completely independent of its capital structure and the WACC for any
firm, regardless of the amount of debt it uses, is equal to the cost of equity of unleveraged firm employing no
debt.
92 PP-FT&FM
Proposition II
The expected yield on equity, Ke is equal to Ko plus a premium. This premium is equal to the debt equity ratio
times the difference between Ko and the yield on debt, Kd. This means that as the firms use of debt increases its
cost of equity also rises, and in a mathematically precise manner.
Proposition III
The cut-off rate for investment decision making for a firm in a given risk class is not affected by the manner in
which the investment is financed. It emphasizes the point that investment and financing decisions are independent
because the average cost of capital is not affected by the financing decision.
Example
Let us take the case of two firms X and Y, similar in all respects except in their capital structure. Firm X is
financed by equity only; firm Y is financed by a mixture of equity and debt. The financial parameters of the two
firms are as follows:
Financial Particulars of Firms X and Y
(Amount in `)
Particulars
Firm X
Firm Y
Total Capital Employed
10,00,000
10,00,000
Equity Capital
10,00,000
6,00,000
Nil
4,00,000
1,00,000
1,00,000
Debt Interest
20,000
4,00,000
1,00,000
80,000
10%
12%
10,00,000
6,66,667
Total market value of the firm
10,00,000
10,66,667
10%
9.37%
0.6
Debt
Net operating Income
Equity earnings
Equity capitalization rate
Average cost of capital

Debt-Equity ratio
From the above particulars, it can be seen that the value of leverged firm Y is higher than that of the unleveraged
firm. According to Modigliani Miller approach, such a situation cannot persist because equity investors would do
well to sell their equity investment in firm Y and invest in the equity of firm X with personal leverage. For example,
an equity investor who owns 1% equity in firm Y would do well to:
Sell his equity in Firm Y for ` 6,667
Borrow ` 4,000 at 5% interest on personal account and
Buy 1.0667% of the equity of firm X with the amount of ` 10,667 that he has.
Such an action will result in the following income:
Lesson 3
Capital Structure
Particular
93
(` )
Income on investment in firm X
1066.70
Less: Interest (4000 x 0.5%)
200.00
Net Income
866.70
This net income of ` 866.7 is higher than a net income of ` 800 foregone by selling 1 percent equity of firm Y and
the leverage ratio is the same in both the cases.
When investors sell their equity in firm Y and buy the equity in firm X with personal leverage, the market value of
equity of firm Y tends to decline and the market value of equity of firm X tends to rise. This process continues
until the net market values of both the firms become equal because only then the possibility of earning a higher
income for a given level of investment and leverage by arbitraging is eliminated. As a result of this the cost of
capital for both the firms is the same.
The above example explained that due to the arbitrage mechanism the value of a leveraged firm cannot be
higher than that of an unleveraged firm, other things being equal. It can also be proved that the value of an
unleveraged firm cannot be higher than that of leveraged firm, other things being equal.
Let us assume the valuation of the two firms X and Y is the other way around and is as follows:
(Amount in `)
Particulars
Firm X
Firm Y
20,000
4,00,000
1,00,000
80,000
8%
12%
12,50,000
6,66,667
Total Market value
12,00,000
10,66,667
Debt Interest
Market Value of debt
(Debt capitalisation rate is 5%)
Equity earnings
Equity Capitalisation rate
If a situation like this arises, equity investors in firm X would do well to sell the equity in firm X and use the
proceeds partly for investment in the equity of firm Y and partly for investment in the debt of firm Y. For example,
an equity investor who owns 1 percent equity in firm X would do well to:
Sell his 1% equity in firm X for ` 12,500
Buy 1.01% of the equity and debt in firm Y involving an outlay of ` 12,500
Such an action will result in an increase of income by ` 172 without changing the risk shouldered by the investor.
When investors resort to such a change, the market value of the equity of firm X tends to decline and the market
value of the equity of firm Y tends to rise. This process continues until the total market value of both the firms
becomes equal.
CRITICISM OF MM HYPOTHESIS
If the MM theory was correct, managers would not need to concern themselves with capital structure decisions,
because such decisions would have no impact on stock prices. However, like most theories, MMs results would
hold true only under a particular set of assumptions. Still, by showing the conditions under which capital structure
is irrelevant, MM provided important insights into when and how debt financing can affect the value of a firm.
94 PP-FT&FM
MM Hypothesis with Corporate Taxes

In 1963, MM added corporate taxes to their model. With corporate taxes considered, a firms stock price was
shown to be directly related to its use to debt financing higher the percentage of debt financing, the higher the
stock price. Under the MM with tax theory, firms should use virtually 100% debt financing. The reason for this
result is the corporate tax structure returns to stockholders come from after-tax earnings, but returns to creditors
are paid before tax. The effect of this tax treatment is that more of a companys operating income is left for
investors when more debt financing is used.
Empirical evidence Against MM Hypothesis

In spite of the MM arguments, firms do not usually use anywhere close to 100% debt financing. In an attempt to
modify MMs model to make it more consistent with actual behaviour, many of their assumptions were relaxed in
papers by other authors. In particular, the possibility of financial distress drastically changed the MM results. In
the modified model, tax savings cause the value of a firm to rise as more and more debt is used, but at some
point (the optimal structure), the value of the firm begins to fall with additional debt because the tax benefits are
more than offset by the increasing costs of potential financial distress.
The MM model as modified to include financial distress suggests to managers .
that a certain amount of debt is good
that too much debt is bad, and
that there is an optimal amount of debt for every firm.
Thus, the modified MM theory, which is called the trade-off theory of capital structure, provides useful insights
into the factors that affect a firms optimal capital structure. Here the marginal costs and benefits of debt financing
are balanced against one another, and the result is an optimal capital structure that falls somewhere between
zero and 100% debt.
EBIT - EPS Analysis

One widely used means of examining the effect of leverage is to analyse the relationship between earnings
before interest and taxes (EBIT) and earnings per share (EPS). The use of EBIT EPS analysis indicates to
management the projected EPS for different financial plans. Generally, management wants to maximise EPS if
doing so also satisfies the primary goal of financial management - maximisation of the owners wealth as
represented by the value of business, i.e. the value of firms equity. If the firm attempts to use excessive amounts
of debt, shareholders ( who are risk - averters) may sell their shares, and thus its price will fall. While the use of
large amount of debt may result in higher EPS, it may also result in a reduction in the price of the firms equity.
The optimum financial structure for a firm (that is, the use of debt in relationship of equity and retained earnings
as sources of financing) should be the one which maximises the price of the equity.
Given the importance of earnings per share (EPS) as a measure of a firm performance, analysis of the impact of
financing alternatives on EPS is an important first step. Essentially, the method involves the comparison of
alternative methods of financing under various assumptions as to EBIT.
Let us assume that a firm has a capital structure of ` 100000. The equity capital is of ` 100 each and debt carries
rate of interest of 10% p.a. We further assume that the firm has the following combination of components of this
structure:
Capital Structure
Lesson 3
Case No.
Equity (%)
Debt (%)
1.
100
2.
75
25
3.
50
50
4.
25
75
95
For calculating the impact on EPS of various levels of EBIT, we take five values of ` 5000, ` 7,500, ` 12,500 and
` 15,000. The tax rate is assumed to be 40 %.
(a) If EBIT is ` 5,000
Debt Level (%)
25
50
75
5,000
5,000
5,000
5,000
Intt.
2,500
5,000
7,500
PBT
5,000
2,500
2,500
Tax
2,000
1,000
PAT
3,000
1,500
2,500
1,00,000
75,000
50,000
25,000
3.0
2.0
1.0
EBIT
Equity
EPS
We find that with increasing level of debt in the capital structure, the EPS decreases.
(b) If EBIT is ` 7,500
Debt Level (%)
25
50
75
7,500
7,500
7,500
7,500
Intt.
2,500
5,000
7,500
PBT
7,500
5,000
2,500
Tax
3,000
2,000
1,000
PAT
4,500
3,000
1,500
1,00,000
75,000
50,000
25,000
4.5
4.0
3.0
25
50
75
10,000
10,000
10,000
10,000
Intt.
2,500
5,000
7,500
PBT
10,000
7,500
5,000
2,500
Tax
4,000
3,000
2,000
1,000
EBIT
Equity
EPS
In this case also, the EPS decreases with increasing level of debt.
(c) If EBIT is ` 10,000
Debt Level (%)
EBIT
96 PP-FT&FM
PAT
Equity
6,000
4,500
3,000
1,500
1,00,000
75,000
50,000
25,000
6.0
6.0
6.0
6.0
EPS
At this level of EBIT, the EPS remains unchanged irrespective of any change in the capital structure.
(d) If EBIT is ` 12,500
Debt Level (%)
25
50
75
12,500
12,500
12,500
12,500
Intt.
2,500
5,000
7,500
PBT
12,500
10,000
7,500
5,000
Tax
5,000
4,000
3,000
2,000
PAT
7,500
6,000
4,500
3,000
1,00,000
75,000
50,000
25,000
7.5
8.0
9.0
12.0
25
50
75
15,000
15,000
15,000
15,000
Intt.
2,500
5,000
7,500
PBT
15,000
12,500
10,000
7,500
Tax
6,000
5,000
4,000
3,000
PAT
9,000
7,500
6,000
4,500
1,00,000
75,000
50,000
25,000
9.0
10.0
12.0
18.0
EBIT
Equity
EPS
Now we see that EPS increases with increasing level of debt.
(e) If EBIT is ` 15,000
Debt Level (%)
EBIT
Equity
EPS
If we increase the EBIT further, the impact on EPS is better still.

We can conclude from the above illustration that the firm should resort to financing its operations through debt
only beyond a threshold or indifference level in order to benefit from tax breaks provided by interest on borrowings.
In other words, debt is suitable if the EBIT is expanding rapidly. If the operations are shrinking, it should change
its capital structure immediately in favour of equity capital.
The EBIT-EPS analysis of the above illustration can be summarised in the form of following table :
Debt Levels (%)
0
EBIT
25
50
75
EPS at above levels
5,000
3.0
2.0
?1.0
7,500
4.5
4.0
3.0
Lesson 3
Capital Structure
97
10,000
6.0
6.0
6.0
6.0
12,500
7.5
8.0
9.0
12.0
15,000
9.0
10.0
12.0
18.0
The indifference point of a firm (EBIT of ` 10000 in this case) varies from firm to firm but normally it approximates
the breakeven point.
EBITDA ANALYSIS (EARNINGS BEFORE INTEREST, TAX, DEPRECIATION AND AMORTIZATION),

EBITDA, an acronym for earnings before interest, taxes, depreciation and amortization, is an often-used measure
of the value of a business. EBITDA is calculated by taking net income and adding interest, taxes, depreciation
and amortization expenses back to it. EBITDA is used to analyze a companys operating profitability before nonoperating expenses (such as interest and other non-core expenses) and non-cash charges (depreciation and
amortization).
Analysis with EBITDA

EBIDTA enables analysts to exclude the impacts of non-operating activities and focus on the outcome of operating
decisions. Non-operating activities include interest expenses, tax rates, and large non-cash items such as
depreciation and amortization.
By removing the non-operating effects, EBITDA gives investors the ability to focus on the profitability of their
operations. This type of analysis is particularly important when comparing similar companies across a single
industry for example.
Limitations of EBITDA
Factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear
to be fiscally healthy. The use of EBITDA as measure of financial health made these firms look attractive.
EBITDA numbers are easy to manipulate. If fraudulent accounting techniques are used to inflate revenues and
interest, taxes, depreciation and amortization are factored out of the equation, almost any company may appears
to be profitable and great.
Operating cash flow is a better measure of how much cash a company is generating because it adds non-cash
charges (depreciation and amortization) back to net income and includes the changes in working capital that
also use or provide cash (such as changes in receivables, payables and inventories). These working capital
factors are the key to determining how much cash a company is generating. If investors do not include changes
in working capital in their analysis and rely solely on EBITDA, they will miss clues that indicate whether a
company is losing money because it isnt making any sales.
Despite various shortcomings, there are some good reasons for using EBITDA.
1. The first factor to consider is that EBITDA can be used as a shortcut to estimate the cash flow available
to pay debt on long-term assets, such as equipment and other items with a lifespan measured in decades
rather than years. Dividing EBITDA by the amount of required debt payments yields a debt coverage
ratio. Factoring out the ITDA of EBITDA was designed to account for the cost of the long-term assets
and provide a look at the profits that would be left after the cost of these tools was taken into consideration
2. Another factor is that EBITDA estimate to be reasonably accurate, the company under evaluation must
have legitimate profitability. Using EBITDA to evaluate old-line industrial firms is likely to produce useful
results. This idea was lost during the 1980s, when leveraged buyouts were fashionable, and EBITDA
began to be used as a proxy for cash flow. This evolved into the more recent practice of using EBITDA
to evaluate unprofitable dotcoms as well as firms such as telecoms, where technology upgrades are a
constant expense.
98 PP-FT&FM
3. EBITDA can also be used to compare companies against each other and against industry averages. In
addition, EBITDA is a good measure of core profit trends because it eliminates some of the extraneous
factors and allows a more apples-to-apples comparison.
Ultimately, EBITDA should not replace the measure of cash flow, which includes the significant factor of changes
in working capital. Remember cash is king because it shows true profitability and a companys ability to
continue operations.
MEASURES OF OPERATING AND FINANCIAL LEVERAGE

The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting
heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the
ability to use fixed cost assets or funds to increase the return to its shareholders.
Definition of Leverage
James Horne has defined leverage as, the employment of an asset or fund for which the firm pays a fixed cost
or fixed return.
Types of Leverage
Leverage can be classified into three major headings according to the nature of the finance mix of the company.
Leverages
Operating Leverages
Financial Leverage
Combined Leverage
The company may use finance or leverage or operating leverage, to increase the EBIT and EPS.
OPERATING LEVERAGE
The leverage associated with investment activities is called as operating leverage. It is caused due to fixed
operating expenses in the company. Operating leverage may be defined as the companys ability to use fixed
operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating
leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have
a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable
cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating
leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage
change in the sales. It can be calculated with the help of the following formula:
DOL =
Percentage change in profits

Percentage change in sales
Lesson 3
Capital Structure
99
Exercise:
From the following selected operating data, determine the degree of operating leverage. Which company has
the greater amount of business risk? Why?
Amount in `
Company A `
Company B `
Sales
25,00,000
30,00,000
Fixed costs
7,50,000
15,00,000
Variable expenses as a percentage of sales are 50% for company A and 25% for company B.
Solution
Statement of Profit
Amount in `
Company A
Company B
Sales
25,00,000
30,00,000
Variable cost
12,50,000
7,50,000
Contribution
12,50,000
22,50,000
Fixed cost
7,50,000
15,00,000
Operating Profit
5,00,000
7,50,000
= 2.5
Similarly Company B Operating Leverage would be 3
Comments
Operating leverage for B Company is higher than that of A Company; B Company has a higher degree of operating
risk. The tendency of operating profit may vary portionately with sales, is higher for B Company as compared to A
Company.
Uses of Operating Leverage

Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in
the profits of the company. If any change in the sales, it will lead to corresponding changes in profit. Operating
leverage helps to identify the position of fixed cost and variable cost.
Operating leverage measures the relationship between the sales and revenue of the company during a particular
period. Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses
of business activities. Operating leverage describes the overall position of the fixed operating cost.
FINANCIAL LEVERAGE
A leverage activity with financing activities is called financial leverage. Financial leverage represents the
relationship between the companys earnings before interest and taxes (EBIT) or operating profit and the
earning available to equity shareholders.
100 PP-FT&FM
Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of
changes in EBIT on the earnings per share. It involves the use of funds obtained at a fixed cost in the hope of
increasing the return to the shareholders. The use of long-term fixed interest bearing debt and preference
share capital along with share capital is called financial leverage or trading on equity.
Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.
Favourable financial leverage occurs when the company earns more on the assets purchased with the funds,
then the fixed cost of their use. Hence, it is also called as positive financial leverage.
Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it
is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:
OP
FL =
PBT
Where
FL = Financial leverage
OP = Operating profit (EBIT) PBT = Profit before tax.
Degree of Financial Leverage

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

Percentage change in EBIT
Alternative Definition of Financial Leverage

According to Gitmar, financial leverage is the ability of a firm to use fixed financial changes to magnify the
effects of change in EBIT and EPS.
EBIT
EPS
FL =
Where
FL = Financial Leverage
EBIT = Earnings before Interest and Tax
EPS = Earnings Per share.
Exercise
A Company has the following capital structure.
`
Equity share capital
1,00,000
10% Prof. share capital
1,00,000
8% Debentures
1,25,000
Lesson 3
Capital Structure 101
The present EBIT is ` 50,000. Calculate the financial leverage assuring that the company is in 50% tax bracket.
Solution
Statement of Profit
Earnings before Interest and Tax (EBIT) or operating profit
50,000
Interest on Debenture (1,25,000 8 100)
10,000
Earnings before Tax (EBT)
40,000
Income Tax
20,000
Profit
20,000
Financial leverage =
Operating Profit (OP)

Profit before Tax (PBT)
= 50,000
40,000
= 1.25
Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS.
Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the
total capital of the company. If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease. The impact of financial leverage can be
understood with the help of the following exercise.
Exercise 3
XYZ Ltd. decides to use two financial plans and they need ` 50,000 for total investment.
Particulars
Plan A
Plan B
Debenture (interest at 10%)
` 40,000
`10,000
Equity share (` 10 each)
` 10,000
`40,000
Total investment needed
` 50,000
` 4,000
Number of equity shares
50,000
1,000
The earnings before interest and tax are assumed at ` 5,000, and 12,500. The tax rate is 50%. Calculate the
EPS.
102 PP-FT&FM
Solution
When EBIT is ` 5,000
Particulars
Plan A
Plan B
Earnings before interest and tax (EBIT)
` 5,000
` 5,000
Less : Interest on debt (10%)
` 4,000
` 1,000
Earnings before tax (EBT)
` 1,000
` 4,000
Less : Tax at 50%
` 500
` 2,000
Earnings available to equity shareholders.
` 500
` 2,000
No. of equity shares
1,000
4,000
` 0.5
` 0.5
Plan A
Plan B
` 12,500
` 12,500
Less : Interest on debt (10%)
` 4,000
` 1,000
Earnings before tax (EBT)
` 8,500
` 11,500
Less : Tax at 50%
` 4,250
` 5,750
Earnings available to equity shareholders.
` 4,250
` 5,750
No. of equity shares
1,000
4,000
Earnings per share (EPS) Earnings/No. of equity shares
` 4.25
` 1.44
Earnings per share (EPS) Earnings/No. of equity shares

When EBIT is ` 12,500
Particulars
Earnings before interest and tax (EBIT)
DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Sl. No
Operating Leverage
Financial Leverage
Operating leverage is associated with

investment activities of the company.
Financial leverage is associated with

financing activities of the company.
Operating leverage consists of fixed operating

expenses of the company.
Financial leverage consists of operating profit

of the company.
It represents the ability to use fixed operating cost.
It represents the relationship between EBIT

and EPS
Operating leverage can be calculated by
Financial leverage can be calculated by
A percentage change in the profits resulting from a

percentage change in the sales is called as
degree of operating leverage.
A percentage change in taxable profit is the

result of percentage change in EBIT.
Trading on equity is not possible while the company Trading on equity is possible only when the
is operating leverage.
company uses financial leverage.
Lesson 3
Operating leverage depends upon fixed cost and

variable cost.
Financial leverage depends upon the

operating profits.
Tax rate and interest rate will not affect the

operating leverage.
Financial leverage will change due to tax rate

and interest rate.
Financial BEP
It is the level of EBIT which covers all fixed financing costs of the company. It is the level of EBIT at which EPS
is zero.
Indifference Point
It is the point at which different sets of debt ratios (percentage of debt to total capital employed in the company)
gives the same EPS.
COMBINED LEVERAGE
When the company uses both financial and operating leverage to magnification of any change in sales into a
larger relative changes in earning per share. Combined leverage is also called as composite leverage or total
leverage.
Combined leverage expresses the relationship between the revenue in the account of sales and the taxable
income.
Combined leverage can be calculated with the help of the following formulas:
CL = OL FL
Degree of Combined Leverage

The percentage change in a firms earning per share (EPS) results from one percent change in sales. This is
also equal to the firms degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a
particular level of sales.
Degree of contributed coverage =
Percentage change in EPS

Percentage change in sales
Exercise 4
Kumar Company has sales of ` 25,00,000. Variable cost of ` 12,50,000 and fixed cost of ` 50,000 and debt of `
12,50,000 at 8% rate of interest. Calculate combined leverage.
Solution
Statement of Profit
Amount in `
Sales
Less:
Less:
25,00,000
Variable cost
15,00,000
Contribution
10,00,000
Fixed cost
5,00,000
Operating Profit
5,00,000
Combined leverage =Operating leverage x Financial leverage
104 PP-FT&FM
Calculation of operating leverage
Contribution
Operating Profit
= 10,00,000
5,00,000
=2
Calculation of financial leverage

Earning before Interest and Tax (EBIT)
` 5,00,000
Less: Interest on Debenture ( 8% of 12,50,000)
` 1,00,000
Earnings before Tax
` 4,00,000
= 1.25
Combined leverage = 2 1.25 = 2.5
WORKING CAPITAL LEVERAGE

One of the new models of leverage is working capital leverage which is used to locate the investment in working
capital or current assets in the company.
Working capital leverage measures the sensitivity of return in investment of charges in the level of current
assets.
If the earnings are not affected by the changes in current assets, the working capital leverage can be calculated
with the help of the following formula.
where,
CA = Current Assets
TA = Total Assets
DCA = Changes in the level of Current Assets
Exercise 7
The following information is available for two companies.
You are required to compare the sensitivity earnings of the two companies for 30% charge in the level of their
current assets.
Solution
Lesson 3
X Ltd.
Y Ltd.
` 4,00,000
` 1,00,000
Current Assets
` 10,00,000
` 4,00,000
Total Assets
` 14,00,000
` 14,00,000
` 1,50,000
` 1,50,000
Fixed Assets
Earnings before interest and taxes
= 0.90
= 0.3125
EFFECTS OF LEVERAGE ON SHAREHOLDERS RETURNS

Financial plan is one of the vital decisions of a firm because a financial plan affects the market value, cost of
capital and shareholders return of a firm. The Proportion of Debt to Equity in the financial plan of a firm is called
leverage. Since optimal debt ratio influences a firms market value and shareholders return, different firms use
different debt ratio at different levels to maximize market value and shareholders return. Leverage has statistically
significant effect on the shareholders return and proper management of leverage can maximize the value of
EPS
1. Operating Leverage Effect : % Change of EBIT is more than % Change in Sale

If % change of earning before interest and tax is more than % change in sale, this operating leverage will effect
ROE positively because at this level, per unit fixed cost will decrease and small increase in sale will boost EBIT.
If EBIT will increase, ROE will also increase. After dividing % Change of EBIT with % changes in sales. We can
take ratio of it and it indicates, how will change EBIT if changes will be done in sales. 2:1 of operating leverage
means if 100% sales will increase 200% EBIT will increase. As interest is fixed cost, so with this ROE will
increase.
A. Situation: HighOperating Leverage:
Too high operating leverage is not good, it may be high risky.
B. Situation: Low Operating Leverage:
Low operating leverage may be useful when sale market is fluctuating.
2. Operating Leverage Effect : % Change of EBIT is less than % Change in Sale

Now see also second face when % changes of EBIT is less than % changes in sales, it means 200% sale will
increase, 100% EBIT will increase if operating leverage is 1:2. This situation is less effective for enhancing ROE.
3. Effect of Financial Leverage on ROE

If we have to check real effect of leverage on ROE, we have to study financial leverage. Financial leverage
106 PP-FT&FM
refers to the use of debt to acquire additional assets. Financial leverage may decrease or increase return on
equity in different conditions.
A. Situation: High Financial Leverage:
Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and utilizing
the excess funds in high risk investments in order to maximize returns.
B. Situation: Low Financial Leverage:
Financial low-leveraging means incurring alow debt by borrowing funds. It may affect positively, if decrease the
value ofbought asset with this low debt.
4. Effect of High Operating leverage and High Financial Leverage

It will increase ROE but it is high risky also.
5. Effect of Low Operating leverage and High Financial Leverage

It is optimum combination for bringing optimum return on equity.
RISK AND LEVERAGE

Risk is the probability that the future revenue streams of a firm shall show a variation from the expected figures.
The variation is normally on the negative or the lower side because a positive variation reduces the investment
risk and a reduction of risk is always welcome.
For linkage with leverage, we can divide risk into two broad categories, i.e. business risk and financial risk.
Business risk pertains to risks associated with day to day operations of the firm. For example, decisions made
regarding purchase of raw materials, manufacturing expenses and administrative expenses change the business
risk profile of the firm. These decisions have an impact upon the operational profitability of the firm, i.e. the profits
before interest and taxes. Financial risk, on the other hand, is associated with introduction of fixed interest
bearing debt obligations in the capital structure of the firm. These obligations create a prior charge on EBIT
before distribution of post tax profits among the owners.
The distinction between business risk and financial risk can be clarified through the following illustration:
ABC Company Limited
Profit and Loss Statement for the year ended 31.03.2012
(Amount in ` Lacs)
(a) Net Sales
8,500
(b) Cost of goods Sold
5,000
(c ) Gross Profit
3,500
(d) Selling Expenses
1,500
(2)
(e) EBIT
2,000
(3)
(1)
Business risk is associated with the impact of item no. (3) above of changes in item nos. (1) and (2). The Cost
of goods sold item consists of cost of raw materials, labour cost, factory rent and other manufacturing expenses.
Out of these elements, labour cost and factory rent are fixed costs while the rest are variable depending upon
the level of sales. Now if the fixed costs are increased the expectation would be that the sales would rise in
anticipated proportion. However if the sales do not rise as anticipated, business risk of the firm increases.
Uptill now we have assumed that the firm has no debt and as such, no interest cost. Let us assume that the firm raises
debt with yearly interest payment of ` 500 lacs. The Profit & loss account would now be extended as shown below:
Lesson 3
Sr.
No
Particulars
(a)
EBIT
(b)
Interest
(c)
Profit before tax
(d)
Tax @ 40%
600
(e)
Profit after Tax
900
Amount
2,000
500
(4)
1,500
(5)
Now item no. (5) i.e. profit after tax is dependent on interest payments which are fixed. If EBIT decreases as a
result of changes in items (1) and (2) and item no. (4) remains the same, the venture would become riskier as an
additional element of financial risk has been built in. The change in risk profile of the firm has been caused by
change in its leverage. The changes in fixed labour costs and factory rent are referred to as changes in operating
leverage while the changes in fixed interest costs are described as changes in financial leverage.
A firm has operating leverage when it can expand output and sales without a proportionate increase in fixed
costs. Let us assume that in our earlier illustration, cost of sales has the following break-up:
Cost of raw materials
` 2,500
Labour Cost
` 500
Factory rent
` 500
Other manufacturing costs
` 1,500
Labour cost and factory rent are fixed costs for running the factory for manufacturing, say, 1,00,000 units of the
product. The firm now plans to expand the capacity to 2,00,000 units in the same factory by increasing the
number of factory labour and installation of new machinery. The profit and loss account under the two levels of
capacity would now read as under:
Amount in `
Capacity
Capacity
(100000 units)
(200000 units)
Sr. No.
Particulars
1.
Net Sales
8,500
17,000
2.
Cost of raw material
2,500
5,000
3.
Labour cost
500
1,000
4.
Factory rent
500
500
5.
Other mfg. Costs
1,500
2,500
6.
Gross profit
3,500
8,000
7.
Selling Expenses
1,500
2,500
8.
EBIT
2,000
5,500
9.
Tax @ 40%
800
2,200
10.
Profit after tax
1,200
3,300
We see that while net sales have increased by 100%, the EBIT has increased by 175%, thanks to the operating
108 PP-FT&FM
leverage provided by the fixed factory rent and the fixed component of manufacturing expenses and selling
expenses, which we assume to be ` 500 lacs each.
Now, if due to recessionary conditions, capacity utilisation of the factory is reduced to 50% and 40% in two
subsequent years respectively, profitability of the firm would change as under:
Amount in `
Capacity
50%
Capacity
40%
Net Sales
8,500
6,800
2.
2,500
2,000
3.
Labour cost
1,000
1,000
4.
Factory rent
500
500
5.
Other mfg. Costs
1,500
1,300
6.
Gross profit
3,000
2,000
7.
Selling Expenses
1,500
1,300
8.
EBIT
1,500
700
9.
Tax @ 40%
600
280
10.
Profit after tax
900
420
Sr. No
Particulars
1.
We see that the fall in EBIT is much sharper than the decline in sales. This has happened due to operating
leverage.
Let us assume that the firm decides to move from rented factory premises to own premises. This is achieved by
borrowing a sum of ` 15 crores from the bank carrying fixed interest of 12% p.a. The capacity is also simultaneously
doubled. The comparative profit & loss figures shall now read as under:
Amount in `
Original
Capacity
Double
Capacity
Sr. No.
Particulars
1.
Net Sales
8,500
17,000
2.
2,500
5,000
3.
Labour cost
500
1,000
4.
Other mfg. Costs
1,500
2,500
5.
Gross profit
4,000
8,500
6.
Selling Expenses
1,500
2,500
7.
EBIT
2,500
6,000
8.
Interest
180
180
9.
Profit before tax
2,320
5,820
10.
Tax @ 40%
928
2,328
11.
Profit after tax
1,392
3,492
Lesson 3
By creating financial leverage, the firm has not only ensured rise in EBIT but in PAT as well. But at the same time,
it has increased its financial risk, i.e. the risk of default on repayment of loan amount and the interest on loan.
Now let us see how financial leverage impacts the performance of the firm in recessionary conditions:
Amount in `
Original
Capacity
Double
Capacity
Sr. No.
Particulars
1.
Net Sales
8,500
6,800
2.
2,500
2,000
3.
Labour cost
1,000
1,000
4.
Other mfg. Costs
1,500
1,300
5.
Gross profit
3,500
2,500
6.
Selling Expenses
1,500
1,300
7.
EBIT
2,000
1,200
8.
Interest
180
180
9.
Profit before tax
1,820
1,020
10.
Tax @ 40%
728
408
11.
Profit after tax
1,112
612
We can see that in case of financial leverage, the impact on PAT upon reduction in capacity utilisation is much
severe. The degree of financial leverage can be calculated by the rate of change of PAT for a one percent
change in sales.
Relationship between Financial Risk and Financial Leverage

As the financial leverage increases, the breakeven point of the company increases and the company now has to
sell more of its product (or service) in order to break even. High financial leverage increases the risk to banks and
other lenders because of the higher probability of bankruptcy and the risk to stockholders because greater losses
may be incurred if the company goes bankrupt. Increase in financial leverage increases, the risk to stockholders
because the higher leverage will cause greater volatility in earnings and greater volatility in the stock price.
SOME CASE STUDIES

Example No. 1: Calculate the operating, financial and combined leverage under situations 1 and 2 and the
financial plans for X and Y respectively from the following information relating to the operating and capital
structure of a company, and also find out which gives the highest and the least value ? Installed capacity is 5000
units. Annual Production and sales at 60% of installed capacity.
Selling price per unit ` 25
Variable cost per unit ` 15
Fixed cost:
Situation 1
: ` 10,000
Situation 2
: ` 12,000
Capital structure:
110 PP-FT&FM
Financial Plan
X(`)
Y (`)
Equity
25000
50000
Debt (10%^)
50000
25000
75000
75000
Solution
Annual production and sales 60% of 5,000 = 3000 Unit
Contribution per Unit
Selling Price
25
Per Unit Variable Price
15 Per Unit
10 Per Unit
Total contribution is 3000 Units` 10=` 30,000

Computation of leverage.
Amount in `
PLAN- X
PLAN- Y
Situation 1
Situation 2
Situation 1
Situation 2
Contribution
30,000
30,000
30,000
30,000
Fixed cost
10,000
12,000
10,000
12,000
operating Profit or EBIT
20,000
18,000
20,000
18,000
10% of 50,000
5,000
5,000
10% of 25,000
2,500
2,500
15,000
13,000
17,500
15,500
Operating Leverage ( Contribution/EBIT)
1.50
1.67
1.5
1.67
Financial Leverage ( EBIT/EBT)
1.33
1.38
1.14
1.16
(iii) Combined leverage ( CL X FL)
2.00
2.30
1.71
1.94
2.00
2.31
1.71428571
1.94
Interest on Debts
Earnings before Tax
Highest and least value of combined leverage. Highest Value = 2.30 under situation 2 plan X. Least Value = 1.71
under situation 1 plan Y.
Example No. 2. XYZ company has a choice of the following three financial plans. You are required to calculate
the financial leverage in each case
Plan I
Plan II
Plan III
Equity capital
` 2,000
` 1,000
` 3,000
Debt
` 2,000
` 3,000
` 1,000
EBIT
` 400
` 400
` 400
Lesson 3
Interest @10% per annum on debts in all cases.

Solution
Amount in `
Plan I
Plan II
Plan III
EBIT
400
400
400
Less Interest-(I)
200
300
100
EBT
200
100
300
1.33
FL (EBIT/EBT)
Example No. 3. Calculate operating leverage and financial leverage under situations A, B and C and financial
plans 1, 2 and 3 respectively from the following information relating to the operating and financial leverage which
give the highest value and the least value.
Installed capacity (units)
Actual production and sales (units)
1,200
800
Selling price per unit (`)
15
Variable cost per unit (`)
10
Fixed costs (`) Situation A
1,000
Situation B
2,000
Situation C
3,000
Financial Plan
Sources of Fund
Equity
` 5,000
` 7,500
` 2,500
Debt
` 5,000
` 2,500
` 7,500
Cost of debt
12 per cent
Solution
Amount in `
A
S VC
4,000
4,000
4,000
EBIT
3,000
2,000
1,000
1.33
3,000
3,000
3,000
600
300
900
2,400
2,700
2,100
1.25
1.11
1.43
Degree of Operative Leverage = (S VC)/EBIT

FINANCIAL LEVERAGE
Situation A
EBIT
Less : Interest
EBT
Financial Leverage
112 PP-FT&FM
Situation B
EBIT
2,000
2,000
2,000
600
300
900
1,400
1,700
1,100
1.43
1.18
1.82
1,000
1,000
1,000
Less : Interest
600
300
900
EBT
400
700
100
Financial Leverage
2.5
1.43
10
Less : Interest
EBT
Financial Leverage
Situation C
EBIT
LESSON ROUND-UP
Capital Structure of a firm is a reflection of the overall investment and financing strategy of the firm. It
shows how much reliance is being placed by the firm on external sources of finance and how much
internal accruals are being used to finance expansions.
Optimal capital structure means arrangement of various components of the structure in tune with both
the long-term and short term objectives of the firm.
The three Capital Structure Theories areNet Income Approach, Net Operating Income Approach
and Modigliani Millar Approach.
Net income approach provides that the cost of debt capital, Kd and the cost of equity capital Ke remains
unchanged when the degree of leverage, varies.
Net Operating Income approach states that cost of the capital for the whole firm remains constant,
irrespective of the leverage employed in the firm.
Modigliani and Miller have restated the net operating income position in terms of three basic propositions:
Proposition I The total value of a firm is equal to its expected operating income divided by the
discount rate appropriate to its risk class.
Proposition II The expected yield on equity, Ke is equal to Ko plus a premium.
Proposition III The cut off rate for investment decision making for a firm in a given risk class is not
affected by the manner in which the investment is financed.
Leverage: leverage refers to relationship between two variables as reflected in a unit change in one
variable consequent upon a unit change in another variable.
Leverage =
Unit change in desired result

Unit change in chosen variable
Two major types of Leverages are: Financial leverage and operating leverage.
Financial leverage measures the extent to which the cost of project has been funded by borrowed
money as compared to owners equity.
EBIT EPS Analysis indicates the projected EPS for different financial plans.
Lesson 3
SELF-TEST QUESTIONS
(These are meant for re-capitulation only. Answers to these questions are not to be submitted for
evaluation)
1. What is the significance of capital structure? Describe its various kinds.
2. What points need to be kept in mind while deciding the capital structure of a firm?
3. Describe the process of planning and designing of capital structure.
4. Briefly discuss the theories of capital structure.
5. Illustrate the difference between operating leverage and financial leverage.
6. What factors determine the cost of capital?
7. Explain the various types and leverages and their significance in financial decision making.
114 PP-FT&FM
Lesson 4
Cost of Capital
LESSON OUTLINE
Lesson 4
Cost of Capital 115
LEARNING OBJECTIVES
Cost of capital is a very important which decides

the fate of various investment decisions. Cost
of capital is an integral part of investment
decision as it is used to measure the worth of
investment proposal provided by the business
concern. It is used as a discount rate in
determining the present value of future cash
flows associated with capital projects. Cost of
capital is also called as cut-off rate, target rate,
hurdle rate and required rate of return. When
the firms are using different sources of finance,
the finance manager must take careful decision
with regard to the cost of capital; because it is
closely associated with the value of the firm and
the earning capacity of the firm.
Factors Affecting Cost of Capital

Measurement of Cost of Capital
(a) Cost of redeemable debt
(b) Cost of irredeemable debt
(c) Cost of irredeemable preference
shares
(d) Cost of redeemable Preference Share
(e) Cost of Equity
The objective of this lesson is to enable the

students to learn about
Marginal Cost of Capital
The factors affecting the cost of capital

of accompany
LESSON ROUND UP
Calculation of cost of capital of for

different sources of finance
SELF TEST QUESTIONS
Calculation of Weighted Cost of Capital

Calculation of Marginal cost of Capital
Cost of a capital of a company is not only important Capital Budgeting decisions but it very important
in deciding the capital structure of a company and various important financial decisions.
115
116 PP-FT&FM
COST OF CAPITAL
The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating
funds in the marketplace. It is used to evaluate new projects of a company as it is the minimum return that
investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained
earnings. If a firm fails to earn return at the expected rate, the market value of the shares will fall and it will result
in the reduction of overall wealth of the shareholders.
Definitions of the term cost of Capital

The following important definitions are commonly used to understand the meaning and concept of the cost of
capital.
According to the definition of John J. Hampton Cost of capital is the rate of return the firm required from
investment in order to increase the value of the firm in the market place
According to the definition of Solomon Ezra, Cost of capital is the minimum required rate of earnings or the cutoff rate of capital expenditure.
According to the definition of James C. Van Horne, Cost of capital is A cut-off rate for the allocation of capital to
investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.
According to the definition of William and Donaldson, Cost of capital may be defined as the rate that must be
earned on the net proceeds to provide the cost elements of the burden at the time they are due.
Assumption of Cost of Capital

Cost of capital is based on certain assumptions which are closely associated while calculating and measuring
the cost of capital. It is to be considered that there are three basic concepts:
A. It is not a cost as such. It is merely a hurdle rate.
B. It is the minimum rate of return.
C. It consists of three important risks such as zero risk level, business risk and financial risk. Cost of capital
can be measured with the help of the following equation.
K = rj + b + f.
Where,
K = Cost of capital.
rj = The riskless cost of the particular type of finance. b = The business risk premium.
f = The financial risk premium.
CLASSIFICATION OF COST OF CAPITAL

Cost of capital may be classified into the following types on the basis of nature and usage:
Lesson 4
Cost of Capital 117
A. Explicit and Implicit Cost.

B. Average and Marginal Cost.
C. Historical and Future Cost.
D. Specific and Combined Cost.
Explicit and Implicit Cost

The cost of capital may be explicit or implicit cost on the basis of the computation of cost of capital.
Explicit cost is the rate that the firm pays to procure financing. This may be calculated with the help of the
following equation;
n
CIo =
t+1
COt
(t + C)t
Where,
CIo = initial cash inflow
C = outflow in the period concerned
N = duration for which the funds are provided
T = tax rate
Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders
that will be forgone if the projects presently under consideration by the firm were accepted.
Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It
considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc.
Marginal cost is the weighted average cost of new finance raised by the company. It is the additional cost of
capital when the company goes for further raising of finance.
Historical and Future Cost

Historical cost is the cost which has already been incurred for financing a particular project. It is based on the
actual cost incurred in the previous project.
Future cost is the expected cost of financing in the proposed project. Expected cost is calculated on the basis of
previous experience.
Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of
capital. It is very useful to determine the each and every specific source of capital.
The composite or combined cost of capital is the combination of all sources of capital. It is also called as overall
cost of capital. It is used to understand the total cost associated with the total finance of the firm.
IMPORTANCE OF COST OF CAPITAL

Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern.
1. Importance to Capital Budgeting Decision; Capital budget decision largely depends on the cost of
118 PP-FT&FM
capital of each source. According to net present value method, present value of cash inflow must be
more than the present value of cash outflow. Hence, cost of capital is used to capital budgeting decision.
2. Importance to Structure Decision: Capital structure is the mix or proportion of the different kinds of
long term securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost
of capital helps to take decision regarding structure.
3. Importance to Evolution of Financial Performance: Cost of capital is one of the important determining
which affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate
the financial performance of the firm.
4. Importance to Other Financial Decisions: Apart from the above points, cost of capital is also used in
some other areas such as, market value of share, earning capacity of securities etc. hence; it plays a
major part in the financial management.
FACTORS DETERMINING THE FIRMS COST OF CAPITAL

Cost of capital, like all other costs, is a variable term, subject to changes in a number of factors. The various
factors that play a part in determination of cost of capital are described below: There are four main factors which
mainly determine the cost of Capital of a firm.
General economic conditions, the marketability of the firms securities (market conditions), operating and financing
conditions within the company, and the amount of financing needed for new investments. Now we will discuss
each one of them.
Factor 1: General Economic Conditions

General economic conditions determine the demand for and supply of capital within the economy, as well as the
level of expected inflation. This economic variable is reflected in the risk less rate of return. This rate represents
the rate of return on risk- free investments, such as the interest rate on short-term government securities. In
principle, as the demand for money in the economy changes relative to the supply, investors alter their required
rate of return. For example, if the demand for money increases without an equivalent increase in the supply,
lenders will raise their required interest rate. At the same time, if inflation is expected to deteriorate the purchasing
power of the euro, investors require a higher rate of return to compensate for this anticipated loss.
Factor 2: Market Conditions

When an investor purchases a security with significant risk, an opportunity for additional returns is necessary to
make the investment attractive. Essentially, as risk increases, the investor requires a higher rate of return. This
increase is called a risk premium. When investors increase their required rate of return, the cost of capital rises
simultaneously. If the security is not readily marketable when the investor wants to sell, or even if a continuous
demand for the security exists but the price varies significantly, an investor will require a relatively high rate of
return. Conversely, if a security is readily marketable and its price is reasonably stable, the investor will require
a lower rate of return and the companys cost of capital will be lower.
Factor 3: Operating and Financing Decisions

Risk, or the variability of returns, also results from decisions made within the company. Risk resulting from these
decisions is generally divided into two types: business risk and financial risk. Business risk is the variability in
returns on assets and is affected by the companys investment decisions. Financial risk is the increased variability
in returns to common stockholders as a result of financing with debt or preferred stock. As business risk and
financial risk increase or decrease, the investors required rate of return (and the cost of capital) will move in the
same direction.
Lesson 4
Cost of Capital 119
Factor 4: Amount of Financing

The last factor determining the corporations cost of funds is the level of financing that the firm requires. As the
financing requirements of the firm become larger, the weighted cost of capital increases for several reasons. For
instance, as more securities are issued, additional flotation costs, or the cost incurred by the firm from issuing
securities, will affect the percentage cost of the funds to the firm. Also, as management approaches the market
for large amounts of capital relative to the firms size, the investors required rate of return may rise. Suppliers of
capital become hesitant to grant relatively large sums without evidence of managements capability to absorb
this capital into the business. This is typically too much too soon. Also, as the size of the issue increases, there
is greater difficulty in placing it in the market without reducing the price of the security, which also increases the
firms cost of capital.
Controllable Factors Affecting Cost of Capital

These are the factors affecting cost of capital that the company has control over
(1) Capital Structure Policy
A firm has control over its capital structure, and it targets an optimal capital structure. As more debt is issued, the
cost of debt increases, and as more equity is issued, the cost of equity increases.
(2) Dividend Policy
Given that the firm has control over its payout ratio, the breakpoint of the marginal cost of capital schedule can
be changed. For example, as the payout ratio of the company increases, the breakpoint between lower-cost
internally generated equity and newly issued equity is lowered.
(3) Investment Policy
It is assumed that, when making investment decisions, the company is making investments with similar degrees
of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity
change.
Uncontrollable Factors Affecting the Cost of Capital

These are the factors affecting cost of capital that the company has no control over:
(1) Level of Interest Rates
The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when
interest rates increase the cost of debt increases, which increases the cost of capital.
(2) Tax Rates
Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost
of capital.
MEASUREMENT OF COST OF CAPITAL

Cost of Debt (Kd)
Cost of Debt refers to the cost of long Term debentures/bond. Short term debts are ignored in calculating the
cost of debt assuming that either short term debt plays insignificant part in determining the cost of debt or that
the interest on short term debt is balanced by interest on short term receivables
Cost of Debt is calculated after tax because interest payments are tax deductible for the firm. Cost of capital is
denoted by the term Kd
Kd after taxes = Kd (1 tax rate)
120 PP-FT&FM
Example 1
If the cost of debt for Cowboy Energy Services is 10% (effective rate) and its tax rate is 40% then:
Kd after taxes =Kd (1 tax rate)
= 10 (1 0.4) = 6.0 %
Example 2
Jain & Co sells a new issue of 6% irredeemable debentures to raise ` 100,000 and realizes the full face value of
` 100. The company falls in 40% tax bracket. Debts are issued at par. Find Cost of Capital
Solution
Before tax cost of debt = Interest / Sale value or Interest /Principal being issued at par
6,000 / 1,00,000 * 100 = 6%
Cost of debt after tax = (1 - T) * before tax cost of debt
= (1 - 0.40) * 6%
= 0.036 or 3.6%
Cost of debt which are issued at premium
Example 3
Jain & Co sells a new issue of 6% 1000 irredeemable debentures of ` 100 each @ 10 % premium. The company
falls in 40% tax bracket. Find Cost of Capital
Solution
Sale value or net proceeds from sale of Debentures (SV) = ` (1,000*100+ 1,000*100*10%)
= ` 1, 10,000
Kd = I (1 - T) / SV
Where:
Kd = cost of debt after tax
SV = Sale value of debentures
T = Tax rate
I = Annual interest payment
Cost of debt = 6,000 / 1,10,000 * (1 - 0.40) = 3.27%
Cost of debt which are issued at Discount

Example 4
Jain & Co sells a new issue of 6% 1000 irredeemable debentures of ` 100 each @ 10 % Discount. The company
falls in 40% tax bracket. Find Cost of Capital
Solution
Sale value or net proceeds from sale of Debentures (SV) = ` (1,000*100- 1,000*100*10%)
= ` 90,000
Lesson 4
Cost of Capital 121
Kd = I (1 - T) / SV
Cost of debt = 6,000 / 90,000 * (1 - 0.40) = 4%
Cost of Bond/Debentures redeemable after certain period

Cost of Redeemable debt:
In case of debentures redeemable after a certain period of time, cost of debt is calculated taking thee average of
sale value and redemption value. It is calculated by under given formula
Kd (before tax) = (I + [RV - SV] / n) / (RV + SV) / 2
Where:
I = Annual fixed interest
RV = Redeemable Value of debenture net of commission and floatation costs, if any.
SV= Sale Value of debentures net of discount or premium.
N = Term of debt till maturity
After tax cost of Redeemable debt :Kd (after tax) = Kd (before tax) * ( 1 - T )
Example 5
A firm issues debentures worth ` 1,00,000 and realizes ` 98,000 after allowing 2% commission to brokers. They
carry an interest rate of 10% and are due for maturity at the end of 10th year. The company has 40% tax bracket.
Solution
Redeemable value = `1,00,000; Sale value = ` 98,000. Annual interest (I) = ` 10,000
Cost of debt = ((10,000 + [1,00,000 - 98,000] / 10) / [(1,00,000 + 98,000) / 2)]
Cost of debt (after tax) = 6.18%
Example 6
X Limited issues its Bond at par @ `1,000 per bond. These bonds will mature after 20 years at part and bears
coupon rate of 10%. Coupons are annual. The bond will sell for par but flotation costs amount to ` 50 per bond.
What is the pre-tax and after-tax cost of debt for X Limited?
Solution
Present realization from sale of 1 Bond = ` 950
Annual Interest
= ` 100
Maturity value after 20 Years
= Rs 1000
Let Pre tax cost of debt is Kd

Present Value of realization from Bond= P. V. of interest for 20 Years @ kd + P.V of Redemption Value @ Kd
950 = 100(PVIFA 20, Kd) + 1000(PVIF 20, Kd)
Using a financial calculator:
Kd = 10.61%
After-tax cost of debt:
Kd = Kd (1 - T)
122 PP-FT&FM
Kd = .1061 (1 - .34)
Kd = .07 = 7%
B. COST OF PREFERENCE SHARE CAPITAL

Preference shares represent a special type of ownership interest in the firm. They are entitled to a fixed dividend,
but subject to availability of profit for distribution. The preference share holders have to be paid their fixed
dividends before any distribution of dividends to the equity shareholders. Their dividends are not allowed as an
expense for the purpose of taxation. In fact, the preference dividend is a distribution of profits of the business.
Dividends are paid out of profits after taxes so the cost of preference shareholder is after tax only.
Preference shares can be divided into:
1. Irredeemable preference shares
2. Redeemable preference shares
(1) Cost of Irredeemable preference shares

Irredeemable preference shares are those shares issuing by which the company has no obligation to pay back
the principal amount of the shares during its lifetime. The only liability of the company is to pay the annual
dividends. The cost of irredeemable preference shares is:
Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference stock
Example 7
Calculate the cost of 10% preference capital of 10,000 preference shares whose face value is `100. The market
price of the share is currently ` 115.
Solution
Annual dividend = 10% of ` 100 = `10 per share
Kp = ` 10/` 115 = 8.7%
Cumulative preference shares:
In case of cumulative preference shares, the market price of the preference stock will be increased by such
amount of dividend in arrears. Cumulative preference shares are those shares whose dividends will get
accumulated if they are not paid periodically. All the arrears of cumulative preference shares must be paid
before paying anything to the equity share holders.
Non-cumulative preference shares:
These are preference shares whose dividends do not get carried forward to the next year if they are not paid
during a year.
If the company issues new preference shares,
The cost of preference capital would be:
Kp = Annual dividend / Net proceeds after floatation costs, if any.
Example 8:A limited company issues 8% preference shares which are irredeemable. The face value of share
is `100 but they are issued at `105. The floatation cost is `3 per share, calculate case of capital.
Solution
Net proceed = `(105-3)= ` 102
Lesson 4
Cost of Capital 123
Kp = (8/102) *100= 7.84%
(2) Cost of Redeemable preference shares

Redeemable preference shares are those shares which have a fixed maturity date at which they would be
redeemed.
Cost of Redeemable preference shares =
Kp = D + (RV - SV) / N
(RV + SV) / 2
Where Kp= Cost of preference Shares

RV- Redemption value
SV= Sale value
N= No of years to Maturity
D= Annual Dividend
Example 9:A company issues 10,000, 8% preference shares of `100 each redeemable after 20 years at face
value. The floatation costs are `3 per share find case of capital.
Solution
Redeemable value = `100;
Sale value = `100-`3 = `97
Annual dividend = `8 per share.
Kp =
8 + (100 - 97) / 20 = 8.27%

(100 + 97) / 2
COST OF EQUITY CAPITAL

Equity Capital is the money invested by the promoters in the firm. The return which promoters get is of two kinds:
Periodic Payments in the form of dividends. This is an explicit return.
The capital appreciation which they might get by selling the shares at the increase in the market value
of the shares. This return is an implicit return. The market value is an indicative measure of the return to
the investors when they wish to redeem their investment
The cost of equity capital is the minimum rate of return that a company must earn on the equity financed portion
of its investments in order to maintain the market price of the equity share at the current level. The cost of equity
capital is rather difficult to estimate because there is no definite commitment on the part of the company to pay
dividends. However, there are various approaches for computing the cost of equity capital. They are:
1. CAPM model
This is a popular approach to estimate the cost of equity. According to the SML, the cost of equity capital is:
Ke = Krf + (Km - Krf)
Where:
Ke = Cost of equity
Krf = Risk-free rate
Km = Equity market required return (expected return on the market portfolio)
124 PP-FT&FM
= beta - Systematic Risk Coefficient.
Example 10:
Calculate the cost of equity capital for a company whose Risk-free rate =10%, equity market required return
=18% with a beta of 0.5.
Solution
Ke= 0.10 + 0.5(0.18 - 0.10)
= 0.14 or 14%.
2. Bond Yield Plus Risk Premium Approach

This approach is a subjective procedure to estimate the cost of equity. In this approach, a judgmental risk
premium to the observed yield on the long-term bonds of the firm is added to get the cost of equity.
Cost of equity = Yield on long-term bonds + Risk Premium.
Example 11
Given, the yield on debt is 10% and the risk premium as 5%, calculate the cost of equity.
Solution
Cost of equity = 0.10 + 0.05 = 0.15 or 15%.
Firms that have risky and consequently high cost of debt will also have risky and consequently high cost equity.
Thus it makes sense to base the cost of equity on a readily observable cost of debt. The disadvantage or a
challenge to this approach is the determination of the risk premium. There is no objective way to determine it
and hence many financial analysts look at the operating and financial risks of the business and arrive at a
subjectively determined risk premium that ranges between 2 percent and 6 percent.
3. Dividend Growth Model Approach

The price of an equity stock depends ultimately on the dividends expected from it. It can be represented as
follows:
P0 = D1/ (1+R) 1 + D2/ (1+R) 2 +D3/ (1+R) 3 +----------------------------------Where:
P0 = Current price of the stock
D1 = Expected dividend at the end of year 1
D2 = Expected dividend at the end of year 2 and so on..
t = Year t
r = Equity shareholders' required rate of return
If the dividends are expected to grow at a constant rate of g% per year, then the equation becomes:
P0 = D1(1+G) / (1+R) 1 + D2(1+G) / (1+R) 2 +D3(1+G) / (1+R) 3 +----------Simplifying this equation, we get: P0 =D1/(r-g)
and solving for r, we get r = D1/P0+ g
Example 12
A company has issued 5,000 equity shares of ` 100 each. Its current market price is ` 95 per Share and the
Lesson 4
Cost of Capital 125
current dividend is Rs, 4.5 per share. The dividends are expected to grow at the rate of 6%. Compute the cost of
equity capital.
Solution
Here, D1 = `4.5 + growth rate 6% = ` 4.77 per share
P0 = `95
Ke =
`4.77 + 6% = 0.11 or 11%

` 95
4. Earnings-Price Ratio approach

According to this approach, the cost of equity capital is:
Ke = E1
P0
Where:
E1 = Expected earnings per share for the next year
P0= Current market price per share
E1 = (Current EPS) * (1 + growth rate of EPS)
Example 13
A company has currently 10,000 equity shares of `100 each and its earnings are ` 150,000. Its current market
price is `112 and the growth rate of EPS is expected to be 5%. Calculate the cost of equity.
Solution
Current EPS=
Earnings available for equity shareholders

=`150,000 / 10,000 shares = `15 per share.

E1 = `15 + 5% = `15.75 per share
Ke = `15.75 / `112 = 0.14 or 14%.

The weighted average cost of capital (WACC), as the name implies, is the weighted average of the costs of
different components of the capital structure of a firm. WACC is calculated after assigning different weights to
the components according to the proportion of that component in the capital structure.
Example No 14
Kritika Limited is currently financed with `1, 000,000 of 7% bonds, and `2, 000,000 of common stock. The stock
has a beta of 1.5, and the risk free rate is 4%, and the market risk premium is 3.5%. The marginal tax rate for a
corporation of AKL's size is 35%. What is Kritika Limited WACC?
Solution
Ration of Debt to Total Capital
= 10,00,000/ (10,00,000+ 20,00,000)

= 1/3
Ration of Common stock to total capital = 20,00,000/ (10,00,000+ 20,00,000)

= 2/3
126 PP-FT&FM
Cost of Equity:
E(Ri)= Ri + im = x (E(Rm) Rf) 4% + 1.5 x 3.5 9.25
Cost of debt = 0.07(1-0.35) = 0.455 or 4.55%
WACC = (4.55%*1/3) + (9.25%*2/3)
= 0.076833
Example No 15
A firm is considering a new project which would be similar in terms of risk to its existing projects. The firm needs
a discount rate for evaluation purposes. The firm has enough cash on hand to provide the necessary equity
financing for the project.
Also, the firm has 10,00,000 common shares outstanding current price ` 11.25 per share. Next years dividend
expected to be `1 per share firm estimates dividends will grow at 5% per year.
It has 1,50,000 preferred shares outstanding. The current price of preference share is `9.50 per share and
dividend is `0.95 per share. if new preferred are issued, they must be sold at 5% less than the current market
price (to ensure they sell) and involve direct flotation costs of `0.25 per share
It has a total of `10,00,000 (par value) in debt outstanding. The debt is in the form of bonds with 10 years left to
maturity. They pay annual coupons at a coupon rate of 11.3%. Currently, the bonds sell at 106% of par value.
Flotation costs for new bonds would equal 6% of par value.
The firms tax rate is 40%. What is the appropriate discount rate for the new project?
Solution:
Market value of common = 11.25(1000000)
Market value of preferred = 9.50(150000)
Market value of debt = 10000000(106%)
` 1,06,00,000
Total value of firm
` 2,32,75,000
Cost of Equity:
Div1
g
P
1
0.05
11.25
0.1389
Cost of Preference Share Capital
Div
net P
0.95
9.50(1 0.05) 0.25
0.1083
` 1,12,50,000
` 14,25,000
Cost of Capital 127
Lesson 4
Cost of debt:
Net price = 106% - 6% = 100% of par value
Net price = par
Therefore, cost of debt = coupon rate
r = 11.3%
Therefore:
11250000
1425000
10600000
WACC
0.1389
0.1083
0.1131 0.4
23275000
23275000
23275000
0.1046
10.46%
Marginal Cost of Capital (MCC)
MCC can be defined as the cost of additional capital introduced in the capital structure since we have assumed
that the capital structure can vary according to changing requirements of the firm.
The following illustration shows how marginal cost of capital can be calculated:
Let us assume that the capital structure of the firm has been expanded by addition to various components. The
addition has been ` 2,000 lacs for debt, ` 1,000 lacs for preference capital, ` 2,000 lacs for equity capital and
` 6,000 lacs for retained earnings. The cost of each component of the capital structure after addition would be
the weighted average of the old and new values of the component:
Componen
Existing
Value
Cost
(%)
Additional
Value
Cost
(%)
Weighted
Average
Cost (%)
Debt
4,000
14
2,000
16
14.6
Pref. Capital
1,000
1,000
12
10.5
Equity Capital
1,000
15
2,000
20
18.34
Ret. Earnings
4,000
18
6,000
18
18.00
Having calculated the weighted cost of each component, we calculate the weighted average cost of the entire
capital structure now:
Component
Weight (%)
Cost (%)
Weighted Cost
Debt
28.57
14.6
14.6 x 0.29
= 4.23
Preference capital
9.52
10.5
10.5 x 0.0952
= 1.00
Equity capital
14.28
18.34
18.34 x 0.1428 = 2.62
Retained earnings
47.62
18
18 x 0.4762 = 8.57
Total
WACC = 4.23 + 1.00 + 2.62 + 8.57 = 16.42 %
Marginal cost of addition is 16.42 15.2 = 1.22%. The return on investment has to be more than the revised
weighted average cost of capital in order to ensure that the investors stay invested.
128 PP-FT&FM
COST OF CAPITAL AND ITS IMPLICATIONS IN BUDGETING DECISIONS

Investment decisions are directly related to financial decisions influenced by cost of capital. Management of a
company is always anxious to maximise return on investments with a view to ensure that cost of capital is
covered although management may alternatively decide to minimise investment which may yield highest returns
for reasons of high risk involved or it may decide to maximise investments for obtaining highest growth through
expansion of the productive processes. Management is guided by such considerations as:
(1) Opportunities created by technological change requiring replacements, necessitating expansion or taking up
new activities.
(2) Competition strategies to avail of economic opportunities, investment being planned by them and the threat
which may arise to the existing or proposed market shares of the firm;
(3) Short-term and long-term market forecasts with reference to sales, revenue proceeds, net profits etc.;
(4) Incentives offered by the state to promote investment in particular areas of production required for meeting
urgent local needs of the nation or for exporting to earn foreign exchange etc. Nevertheless, the management of
a corporate enterprise while preparing capital outlays prepares the particulars of the expected receipts (cash
inflows) generated from the activity through such investment. Both are compared over-time and for optimum
decision receipts should cover cost of financing the capital outlays. As such investment or capital budgeting
decisions are directly linked with the cost of capital.
Before dealing with the application of cost of capital budgeting decisions, it is considered necessary to apprise
the readers of the sources of capital and the cost of capital and its significance in investment decisions in the
following paragraphs:
IMPLICATIONS IN BUDGETING DECISIONS

Despite the above objections, cost of capital is used as the basis to evaluate investments whose cash flows are
perfectly correlated with the cash flows from the companys present assets. With perfect co-relation between the
two sets of cash flows risk is the same. But if the timing of the cash flows is not also the same, the same discount
rate cannot be used for both investments. But weighted average cost of capital represents an averaging of all
risks of the company and can be used to evaluate investments in much the same manner that the pay-back
method. It gives some insight and guidance and to that extent it is good to be used. Present value of an investment
can be computed using a weighted average cost of capital and this can be compared with present values
calculated using the other discount rates. It may be that an investment with a positive present value should be
rejected because of its risk characteristics or that an investment with a negative present value using the weighted
average cost of capital should be accepted. All this will differ from situation to situation and case to case.
Nevertheless, evaluation of capital investment projects requires some basis which could serve as the minimum
rate of return which a project should generate. In such cases, weighted cost of capital could serve as an accepted
discounting rate for evaluating investment decisions as no project will be acceptable which does not generate
funds equal or greater to the cut-off rate represented by weighted cost.
Some Case Study

Exercise 1: Identify each of the following statements as true or false, and explain your answers.
A. Information costs both increase the marginal cost of capital and reduce the internal rate of return on
investment projects.
B. Depreciation expenses involve no direct cash outlay and can be safely ignored in investment-project evaluation.
C. The marginal cost of capital will be less elastic for larger firms than for smaller firms.
D. In practice, the component costs of debt and equity are jointly rather than independently determined.
Lesson 4
Cost of Capital 129
E. Investments necessary to replace worn-out or damaged equipment tend to have low levels of risk.
SOLUTION
A. True: The need to gather information concerning the creditworthiness of borrowers increases the interest
rates charged by creditors. Similarly, the task of information gathering in the investment project evaluation
process reduces the IRR from those projects.
B. False: Even though depreciation expenses involve no direct cash outlay, they must be explicitly
considered in investment project evaluation because they affect corporate cash outlays for income tax
payments.
C. False: The marginal cost of capital will tend to be more elastic for larger as opposed to smaller firms.
Large firms tend to have easy access to capital markets given their relatively long operating history, and
substantial resources. On the other hand, the marginal cost of capital can increase rapidly (be quite
inelastic) for smaller firms which, for example, face capital constraints due to scarce managerial talent.
D. True: The component costs of debt and equity tend to be jointly as opposed to independently determined.
Higher levels of debt, for example, will usually increase the perceived level of risk for debt holders and
equity holders alike, and, therefore, raise the interest rate charged by creditors and the rate of return
requirement of stockholders.
E. True: Investments necessary to replace worn out or damaged equipment have highly predictable returns
and low levels of risk.
Exercise 2
ABC Ltd. has the following capital structure.
`
Equity (expected dividend 12%)
10% preference
10,00,000
5,00,000
8% loan
15,00,000
You are required to calculate the weighted average cost of capital, assuming 50% as the rate of income-tax,
before and after tax.
Solution
Sources of Funds
Amount in `
After Tax
Cost of Capital
Weights
Cost
Equity
10,00,000
12%
33.33%
3.99
Preference
5,00,000
10%
16.67
1.67
8% Loan
15,00,000
4%
50.00
2.00
7.66%
Weight average cost of capital = 7.66%
130 PP-FT&FM
Exercise 3
A company has on its books the following amounts and specific costs of each type of capital.
Type of Capital
Book Value
Market Value
Specific Costs (%)
Debt
4,00,000
3,80,000
Preference
1,00,000
1,10,000
Equity
6,00,000
9,00,000
15
Retained Earnings
2,00,000
3,00,000
13
13,00,000
16,90,000
Determine the weighted average cost of capital using:

(a) Book value weights, and
(b) Market value weights.
How are they different? Can you think of a situation where the weighted average cost of capital would be the
same using either of the weights?
Solution
A. Computation of Weighted Average Cost of Capital using book value
Source of Funds
Amount
Cost % (X)
Weighted Cost
Debt
4,00,000
20,000
Preference Shares
1,00,000
8,000
Equity Shares
6,00,000
15
90,000
Retained Earnings
2,00,000
13
26,000
W = 13,00,000
XW
W
Kw =
Kw =
1,44,000 x 100
13,00,000
= 11.1%
XW = 1,44,000
Cost of Capital 131
Lesson 4
B. Computation Weighted Average Cost of Capital using Market Value
Source of Funds
Amount
Cost % (X)
Weighted Cost
Debt
3,80,000
19,000
Preference Shares
1,10,000
8,800
Equity Shares
9,00,000
15
13,500
Retained Earnings
3,00,000
13
39,000
W = 16,90,000
KW =
XW
W
Kw =
2,01,800
100
16,90,000
XW = 2,01,800
= 11.9%
LESSON ROUND-UP
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's
funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on
a portfolio company's existing securities"
Cost of capital is used to evaluate new projects of a company and it is the minimum return that investors
expect for providing capital to the company.
For an investment to be worthwhile, the expected return on capital must be greater than the cost of
capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative
investment of equivalent risk.
Cost of capital may be classified into the following types on the basis of nature and usage:
(a) Explicit and Implicit Cost.
(b) Average and Marginal Cost.
(c) Historical and Future Cost.
(d) Specific and Combined Cost.
There are four main factors which mainly determine the cost of Capital of a firm. General economic
conditions, the marketability of the firms securities (market conditions), operating and financing
conditions within the company, and the amount of financing needed for new investments.
There are factors affecting cost of capital that the company has control over and includes Capital
Structure Policy, Dividend Policy, Investment Policy etc.
There are some factors affecting cost of capital that the company has not control over and these
factors includes Level of Interest Rates, Tax Rates.
Cost of Debt is calculated after tax because interest payments are tax deductible for the firm. Cost of
capital is denoted by the term Kd.
Kd after taxes = Kd (1 tax rate)
132 PP-FT&FM
Irredeemable preference shares are those shares issuing by which the company has no obligation to
pay back the principal amount of the shares during its lifetime. The only liability of the company is to
pay the annual dividends. The cost of irredeemable preference shares is:
Kp (cost of pref. share) =
Annual dividend of preference shares

Market price of the preference stock
Redeemable preference shares are those shares which have a fixed maturity date at which they
would be redeemed. The cost of redeemable preference shares is calculated by under given formulae.
Cost of Redeemable preference shares =
Kp = D + (RV - SV) / N
(RV + SV) / 2
Where Kp= Cost of preference Shares

RV- Redemption value
SV= Sale value
N= No of years to Maturity
D= Annual Dividend
The cost of equity capital is the minimum rate of return that a company must earn on the equity
financed portion of its investments in order to maintain the market price of the equity share at the
current level. The cost of equity capital is rather difficult to estimate because there is no definite
commitment on the part of the company to pay dividends. However, there are various approaches for
computing the cost of equity capital. They are:
CAPM model : This is a popular approach to estimate the cost of equity. According to the SML, the
cost of equity capital is:
Ke = Krf + (Km - Krf)
Where:
Ke = Cost of equity
Krf = Risk-free rate
Km = Equity market required return (expected return on the market portfolio)
= beta- Systematic Risk Coefficient.
Bond Yield Plus Risk Premium Approach
This approach is a subjective procedure to estimate the cost of equity. In this approach, a judgmental
risk premium to the observed yield on the long-term bonds of the firm is added to get the cost of
equity.
Cost of equity=Yield on long-term bonds + Risk Premium.
Dividend Growth Model Approach
The price of an equity stock depends ultimately on the dividends expected from it. According to
this approach P0 =D1/(r-g) and r = D1/P0+ g. here
P0 = Current price of the stock
D1= Expected dividend at the end of year 1
r = Equity shareholders' required rate of return
Lesson 4
Cost of Capital 133
g = Growth rate
Earnings-Price Ratio approach
According to this approach, the cost of equity capital is:
Ke =
E1
P0
Where:
E1 = Expected earnings per share for the next year
P0 = Current market price per share
E1 = (Current EPS) * (1 + growth rate of EPS)
The weighted average cost of capital (WACC), as the name implies, is the weighted average of the
costs of different components of the capital structure of a firm. WACC is calculated after assigning
different weights to the components according to the proportion of that component in the capital structure.
Marginal Cost of Capital (MCC) can be defined as the cost of additional capital introduced in the
capital structure since we have assumed that the capital structure can vary according to changing
requirements of the firm.
SELF-TEST QUESTIONS
1. What is cost of capital? Define cost of capital.
2. Cost of capital computation based on certain assumptions. Discuss. Explain the classification of cost.
3. Mention the importance of cost of capital. Explain the computation of specific sources of cost of capital.
4. How overall cost of capital is calculated? Explain various approaches for calculation of cost of equity.
5. Rama Company issued 1,20,000 10% debentures of ` 10 each at a premium of 10%. The costs of
floatation are 4%. The rate of tax applicable to the company is 55%. Complete the cost of debt capital.
(Ans. 4.26%)
6. Siva Ltd., issued 8,000 8% debentures for ` 100 each at a discount of 5%. The commission payable to
underwriters and brokers is ` 40,000. The debentures are redeemable after 5 years. Compute the
after tax cost of debt assuming a tax rate of 60%. (Ans. 3.69%)
7. Suraiya Limited issued 4,000 12% preference shares of ` 100 each at a discount of 5%. Costs of
raising capital are ` 8,000. Compute the cost of preference capital. (Ans. 12.90%)
134 PP-FT&FM
Lesson 5
Lesson 5
Financial Services
LESSON OUTLINE
Financial Services 135
LEARNING OBJECTIVES
Meaning of Financial Services
Financial Services is a very important vertical

of Financial system. To deal with various
participants of Financial system, it is important
to know about different financial services
provided by these participants. In a country like
India Financial Services Industry is in growing
stage and it is high growth potential area.
Significance of Financial Services

Scope and Structure of Financial
Services,
Types of Financial Services
The object of the study is to enable the student

to understand:
Merchant Banking,
The meaning of Project Planning
Housing Finance,
Securitization of Debt
Meaning of Financial System & Its

different components
Loan Syndication
Meaning of Financial services, its scope

and significance
Custodial and Advisory
Structure of Financial Services Sector

Merchant Banking Services
LESSON ROUND UP
Loan Syndication
SELF TEST QUESTIONS
Securitization
Housing Finance
Custodial Services
Regulation of Financial Services Sector
Future of Financial services is very bright in developing country like India but for using various
financial services in an efficient manner Financial literacy will be the key.
Unknown
135
136 PP-FT&FM
FINANCIAL SYSTEM
The economic development of a nation is reflected by the progress of the various economic units, broadly
classified into corporate sector, government and household sector. While performing their activities these units
will be placed in a surplus/deficit/balanced budgetary situations.
There are areas or people with surplus funds and there are those with a deficit. A financial system or financial
sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of
deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices,
money managers, analysts, transactions and claims and liabilities.
Seekers of funds
(mainly firms and
government)
Suppliers of
funds (mainly
householder
Flow of funds (savings)
Flow of financial services
Incomes, and financial claims

Financial System of any country consists of financial markets, financial intermediation (which includes financial
institutions and financial services) and financial instruments or financial products.
COMPONENTS OF INDIAN FINANCIAL SYSTEM
Financial Institutions
Non
Institution
Banking Institution
Cooperative
Banks
Banks
Captial Mkt
Term
Type
Fund Based
Leasing
Treasury bills
Medium term
Hire purchase
Commercial Bill
Long term
Factoring
Short term
Private Sector
Foreign Banks
Call money market
Public Sector
RRBs
Financial Services
Financial Instruments
Money Mkt
Commercial
Financial Market
Banking
Fee based
Primary Market
Primary Securities
Merchant Banking
Secondary Market
Secondary Securities
Credit Rating
Derivative Market
Innovative Instruments Mergers
Organised financial
Unorganised financia
Institutions
institutions
Since this lesson is concentrated on financial services, we will make elaborate discussion about Financial
Services.
MEANING OF FINANCIAL SERVICES

Financial services refer to services provided by the financial institutions in a financial system. The finance
Lesson 5
industry encompasses a broad range of organizations that deal with the management of money. Among these
organizations are Asset Management Companies like leasing companies, merchant bankers and Liability
Management Companies like discounting houses and acceptance houses, and further general financial institutions
like banks, credit card companies, insurance companies, consumer finance companies, stock exchanges, and
some government sponsored enterprises. The term Financial Services in a broad sense means mobilising
and allocating savings. Thus, it includes all activities involved in the transformation of savings into investment
Functions of financial services

1. Facilitating transactions (exchange of goods and services) in the economy.
2. Mobilizing savings (for which the outlets would otherwise be much more limited).
3. Allocating capital funds (notably to finance productive investment).
4. Monitoring managers (so that the funds allocated will be spent as envisaged).
5. Transforming risk (reducing it through aggregation and enabling it to be carried by those more willing to
bear it).
Characteristics and Features of Financial Services

(i) Customer-Specific: Financial services are usually customer focused. The firms providing these services,
study the needs of their customers in detail before deciding their financial strategy, giving due regard to costs,
liquidity and maturity considerations. Financial services firms continuously remain in touch with their customers,
so that they can design products which can cater to the specific needs of their customers. The providers of
financial services constantly carry out market surveys, so they can offer new products much ahead of need and
impending legislation. Newer technologies are being used to introduce innovative, customer friendly products
and services which clearly indicate that the concentration of the providers of financial services is on generating
firm/customer specific services.
(ii) Intangibility: In a highly competitive global environment brand image is very crucial. Unless the financial
institutions providing financial products and services have good image, enjoying the confidence of their clients,
they may not be successful. Thus institutions have to focus on the quality and innovativeness of their services to
build up their credibility.
(iii) Concomitant: Production of financial services and supply of these services have to be concomitant. Both
these functions i.e. production of new and innovative financial services and supplying of these services are to be
performed simultaneously.
(iv) Tendency to Perish: Unlike any other service, financial services do tend to perish and hence cannot be
stored. They have to be supplied as required by the customers. Hence financial institutions have to ensure a
proper synchronization of demand and supply.
(v) People based services: Marketing of financial services has to be people intensive and hence its subjected
to variability of performance or quality of service. The personnel in financial services organisation need to be
selected on the basis of their suitability and trained properly, so that they can perform their activities efficiently
and effectively.
(vi) Market Dynamics: The market dynamics depends to a great extent, on socioeconomic changes such as
disposable income, standard of living and educational changes related to the various classes of customers.
Therefore financial services have to be constantly redefined and refined taking into consideration the market
dynamics. The institutions providing financial services, while evolving new services could be proactive in visualizing
in advance what the market wants, or being reactive to the needs and wants of their customers.
138 PP-FT&FM
SCOPE OF FINANCIAL SERVICES

Financial services cover a wide range of activities. They can be broadly classified into two, namely:
(i) Traditional. Activities
(ii) Modern activities.
(i) Traditional Activities
Traditionally, the financial intermediaries have been rendering a wide range of services encompassing both
capital and money market activities. They can be grouped under two heads, viz.
(a) Fund based activities: The traditional services which come under fund based activities are the following:
Underwriting or investment in shares, debentures, bonds, etc. of new issues (primary market activities).
Dealing in secondary market activities.
Participating in money market instruments like commercial
Papers, certificate of deposits, treasury bills, discounting of bills etc.
Involving in equipment leasing, hire purchase, venture capital, seed capital,
Dealing in foreign exchange market activities. Non fund based activities
(b) Non-fund based activities
Financial intermediaries provide services on the basis of non-fund activities also. This can be called fee based
activity. Today customers, whether individual or corporate, are not satisfied with mere provisions of finance.
They expect more from financial services companies. Hence a wide variety of services, are being provided
under this head. They include:
Managing the capital issue i.e. management of pre-issue and post-issue activities relating to the
capital issue in accordance with the SEBI guidelines and thus enabling the promoters to market their
issue.
Making arrangements for the placement of capital and debt instruments with investment institutions.
Arrangement of funds from financial institutions for the clients project cost or his working capital
requirements.
Assisting in the process of getting all Government and other clearances.
(ii) Modern Activities
Beside the above traditional services, the financial intermediaries render innumerable services in recent times.
Most of them are in the nature of non-fund based activity. In view of the importance, these activities have been
in brief under the head New financial products and services. However, some of the modern services provided
by them are given in brief hereunder.
Rendering project advisory services right from the preparation of the project report till the raising of
funds for starting the project with necessary Government approvals.
Planning for M&A and assisting for their smooth carry out.
Guiding corporate customers in capital restructuring.
Acting as trustees to the debenture holders.
Recommending suitable changes in the management structure and management style with a view to
achieving better results.
Lesson 5
Structuring the financial collaborations / joint ventures by identifying suitable joint venture partners and
preparing joint venture agreements.
Rehabilitating and restructuring sick companies through appropriate scheme of reconstruction and
facilitating the implementation of the scheme.
Hedging of risks due to exchange rate risk, interest rate risk, economic risk, and political risk by using
swaps and other derivative products.
Managing In- portfolio of large Public Sector Corporations.
Undertaking risk management services like insurance services, buy-hack options etc.
Advising the clients on the questions of selecting the best source of funds taking into consideration the
quantum of funds required, their cost, lending period etc.
Guiding the clients in the minimization of the cost of debt and in the determination of the optimum debtequity mix.
Promoting credit rating agencies for the purpose of rating companies which want to go public by the
issue of debt instrument.
Undertaking services relating to the capital market, such as 1) Clearing services, 2) Registration and
transfers, 3) Safe custody of securities, 4) Collection of income on securities
STRUCTURE OF FINANCIAL SERVICES SECTOR

Financial services industry encompasses a considerable range and depth of activities and includes not only the
traditional financial intermediaries such as commercial banks, insurance companies, mutual funds and unit
trusts etc. but also the special purpose financial institutions or development banks, regulatory bodies and divisions
and affiliates of non-financial firms which provide financial services such as loan, accepting deposits, transferring
funds etc. In essence, it involves any service industry dealing in transactions of money based services and
products.
Thus, while the major players of the financial services industry comprise of the financial intermediaries and
institutions, what is new is their customer-orientation as manifested in provision of a wide spectra of services to
commercial and personal finance segments. An illustrative, and by no means exhaustive, list of financial services
would include: acceptances, brokerage, credit cards, credit information, credit rating, deposit acceptance, deposit
insurance and other insurance, discounting and re-discounting, factoring, financial and performance guarantees,
funds transfer, credit, hire purchase and installment credit, leasing, loan syndicating, managing capital issues,
merchant banking, portfolio management, refinancing, safe deposit vaults, stock holding, technical and economic
consultancy, underwriting etc.
The chart below illustrates the various financial services across the two major market segments, viz., the corporate/
commercial financial services and the personal financial services:
140 PP-FT&FM
FINANCIAL SERVICES
CORPORATE/COMMERCIAL
PERSONAL
TRANSACTIONAL
SECURITY
FUND BASED
Equipment leasing
Hire Purchase
Bill Discounting
Loans/Investments
Venture Capital
Housing Finance
Capital Restructuring
WEALTH
ACCUMULATION
GENERATION
OF FINANCIAL
NON-FUND/FEE BASED
Issue Management Services
Portfolio Management
Corporate Counseling
Loan Syndication
Arranging Foreign Collaboration
Merger & Acquisition
Factoring
Corporate Financial Services

The financial needs of the Corporate/Commercial sectors are so varied, complex and large that these put a
great demand on financial industrys expertise in effectively meeting them. Their needs may include:
(a) The need for money in short term, medium term and long term;
(b) The need to earn a return on money held in short term, medium term and long term;
(c) The need to move money domestically as well as internationally;
(d) The need to manage trading as well as non-trading risks;
(e) The need for information;
(f) The need for advice or expertise.
Personal Financial Services

The personal financial services industry offers three basic, generic products and service benefits to individual
savers, borrowers and investors:
1. Transactional products and services.
2. Wealth accumulation products and services.
3. Products and services generating financial security.
Transactional products and services range from bank cheque-book accounts through standing orders, direct
debits and automatic teller machine (ATM) facilities to the provision of branded credit cards offering the facility of
payment and housing and consumer loan. Wealth accumulation products and services revolve around savings
which are represented by a diverse range of savings and deposit accounts, units, investment in corporate
securities etc. Generation of financial security centre around pension/providend funds, insurance etc.
Lesson 5
SIGNIFICANCE OF FINANCIAL SERVICES

Financial services are fundamental to economic growth and development. Banking, savings and investment,
insurance, and debt and equity financing help private citizens save money, guard against uncertainty, and build
credit, while enabling businesses to start up, expand, increase efficiency, and compete in local and international
markets. For the poor, these services reduce vulnerability and enable people to manage the assets available to
them in ways that generate income and options ultimately creating paths out of poverty.
The financial services sector is the largest in the world in terms of earnings, comprised of a wide range of
businesses including merchant banks, credit card companies, stock brokerages, and insurance companies,
among others. These large firms have the expertise, reputation, and geographic reach to have significant direct
impact and, through engagement and example, to change the way entire markets operate. They are using
increasingly deliberate strategies to expand economic opportunity through business models that serve poor
individuals and SMEs as clients. They are also developing initiatives to build human and institutional capacity
and using their experience and influence to shape policy frameworks in the regions in which they work.
Despite their potential, to date the impact of large commercial banks on expanding economic opportunity has
remained limited in the developing world, where a vicious cycle of insufficient information, inappropriate products,
inadequate infrastructure, and inflexible regulatory environments has kept costs, and therefore prices, high,
limiting companies markets to clients within the top tiers of the economic pyramid.
One of the most critical obstacles to financial inclusion is informality. The poor often live and work in the informal
sector, lacking legal ownership of land, homes, and businesses. Some one billion people worldwide live in
informal settlements in urban areas alone, meaning that they cannot use their land or their homes as collateral
on a loan; often they lack addresses they could associate with a bank account or credit application. Entrepreneurs
can face high fees, inefficient and sometimes corrupt procedures, and burdensome regulation that essentially
make it too costly to incorporate legally, forcing many small and start-up enterprises to remain in the informal or
extra-legal sector. The results are telling. Of 1.1 billion people in India, only 30 million are formally employed; of
8.8 million in Bolivia, only 400,000 are formally employed. The remainder largely operates their own microenterprises without the legal recognition required to obtain traditional lines of credit, enforce contracts, or declare
bankruptcy.
Informality contributes to insufficient market information for financial institutions. Because most of the poor have
never held checking or savings accounts, taken bank loans, or entered into legal contracts, it can be difficult and
costly for commercial financial institutions to determine what assets they have, what kinds of services they might
need, or what levels of risk they might represent. Banking system regulations, such as interest rate caps,
directed lending, and high reserve requirements discourage them further still.6 As a result, in developing countries,
only 26% of citizens have even basic checking or savings bank accounts.7 Worldwide, only one billion of 6.5
billion people have bank accounts.
In recent years, however, two major trends have drawn attention to the potential market opportunity associated
with low-income individuals and small businesses, catalyzing increased innovation and experimentation around
these challenges and enabling promising business models to emerge.
First, against a backdrop of 30 years practical experience, widespread publicity around the United Nations
International Year of Microcredit in 2005 and Muhammad Yunus receipt of Nobel Peace Prize in 2006 have
increased overall public awareness of microfinance? Awareness has led to growing recognition of two important
facts:
The poor are able to pay (often very high interest rates) for financial services, and
They present no greater credit risk than the average higher-income borrower. In fact, many microfinance
institutions have better repayment rates than traditional commercial finance institutions.
142 PP-FT&FM
Increasing acceptance of microfinance has, in turn, laid the groundwork for an increasing focus on mesofinance, or small and medium enterprise finance loans and investments larger than micro-loans, but smaller
than would be profitable for a large, commercial financial institution to make.
Second, remittances from developed to developing countries, sent home by migrants, have reached sizes and
growth rates too large for the major commercial players to ignore. The World Bank has shown that these flows
totaled some $199 billion in 2006, more than twice the amount in 2001. And this figure includes only transfers
through official channels. Available household surveys suggest that unrecorded flows through informal channels
may add 50 percent or more to this estimate.
Almost all multinational banks now have microfinance initiatives, and the challenge has become moving their
commitments and activities into mainstream business operations where they can scale to match the enormous
global demand.12,13 Another challenge is to expand the focus from microfinance to meso-finance, roughly
defined as financing in the $50,000 to $1 million range, which would enable small and start-up businesses to
grow to levels where they could begin taking advantage of economies of scale and creating significant numbers
of jobs.
MERCHANT BANKING SERVICES

Merchant banking services strengthen the economic development of a country as they acts as sources of funds
and information for corporations. Considering the way the Indian economy is growing, the role of merchant
banking services in India is indispensable. Mobilisation of funds from the capital market by way of public issues/
offers for sale of equity shares, preference shares, debentures, bonds and other innovative instruments is a
specialized task. The success of public issues of capital is so crucial for corporate existence and image that by
sheer necessity corporate clients look up to the financial services sector. Procurement of funds is not the end
objective for which corporate efforts have to be exhausted, principle of management by exception too suggests
that corporate efforts and experience be utilised for the achievement of the objectives of the enterprise.
A merchant banker is any person who is engaged in the business of issue management either by making
arrangements regarding selling, buying or subscribing to securities or acting as manager/consultant/advisors or
rendering corporate advisory service in relation to such issue management. As far as new issue management in
India is concerned, during the first half of the 1990s, the managing agents for a particular corporate house or
group used to manage public issues and raise capital from the market with the help of stock brokers. With the
abolition of managing agency system, the financial services sector has taken upon itself the task of providing
public issues related services to its corporate clients.
History of Merchant Banking in India

The formal beginning of the merchant banking services in India began in 1967 when the Reserve Bank of India
provided license to the Grindlays Bank. The Grindlays Bank was engaged in capital issue management and it
provided diverse financial services to the emerging section of entrepreneurs, especially those belonging to the
small and medium enterprise sector.
Citibank started the merchant banking services in 1970 and the State Bank of India followed the same in 1972.
After few years, the national merchant banks started collaborating with their counterparts in different countries to
start their merchant banking divisions abroad.
Subsequent period, too, witnessed substantial growth in public limited companies providing range of services.
Besides, involvement of large number of agencies requiring co-ordinated approach and supervision, close
competition for funds in capital market, increasing consciousness for public interest to protect investors and
consequent stringency of legislation etc. necessitated for merchant bankers a definite role in management of
public issues. In view of the overwhelming importance of merchant bankers in the process of capital issues, it is
now mandatory that all public issues should be managed by merchant banker(s) functioning as the lead manager(s).
Lesson 5
Types of Merchant Banking Organizations

According to the Securities and exchanges Board of India, four categories of the merchant banking organizations
exist in the country:
Institutional based merchant banking organizations operate as subsidiaries of private financial institutions
or those recognized by the state or central governments.
Banker based organizations are those that operate as divisions or subsidiaries of the nationalized
commercial banks or the foreign banks functioning in the country.
The third category consists of qualified brokers who provide skilled merchant banking services like
portfolio management.
The private merchant banking organizations work as sole proprietorships, private limited, public limited
or partnership companies.
Functions of Merchant Banking Organizations

Broadly, the various services offered by merchant bankers include: corporate counselling; project Counselling
and pre-investment studies; capital re-structuring; credit syndication and project finance; issue management
and underwriting; portfolio management; non-resident investment counselling and management; acceptance
credit and bill-discounting; advising on mergers, amalgamations and take-overs, arranging off-shore finance;
fixed deposit brokering; and relief to sick industries.
With regard to issues management capital can be raised through various types of instruments by corporates, for
which it has to conform to SEBI stipulations. Here, the obligations of the lead merchant banker(s) fall into four
groups: (i) pre-issue, (ii) post-issue and (iii) compiance with other requirements (iv) operational guidelines
prescribed by SEBI.
The pre-issue obligations of the merchant banker(s) relate to due diligence, requisite fee, submission of documents,
appointment of intermediaries, underwriting, making public the offer document, despatch of issue material, nocomplaints certificate, mandatory collection centres, authorised collection agents, advertisement for rights postissues, appointment of compliance officer, and an abridged prospectus.
The major post-issue obligations relate to association with allotment procedure, post-issue monitoring reports,
redressal of investors grievances, coordination with intermediaries, post-issue advertisements, basis of
allotment in over-subscribed issues, other responsibilities and a certificate regarding realisation of
stockinvests.
The compliance by merchant banker(s) to other issue management requirements pertain to listing of pure debt/
convertible issues by unlisted infrastructure companies, capital structure, firm allotment and reservations, terms
of issue, restriction on further capital issues, period of subscription, price band, retention of oversubscription,
underwriting, updation of the offer document, compliance officers, incentives to prospective shareholders, new
financial instruments, issue of debentures bearing interest below bank rate, requirement of monitoring agency,
safety net/buyback arrangement, utilisation of funds, option to receive securities in a dematarialised form, issue
opening date and presentation of financials in case of change of denomiation.
The compliance requirements of merchant banker(s) in relation to operational guidelines cover submission of
the draft and final offer document, instruction(s) on post-issue obligations, issue of penalty points and so on.
Thus merchant bankers undertake the following activities:
(a) Managing of public issue of securities;
(b) Underwriting connected with the aforesaid public issue management business;
144 PP-FT&FM
(c) Managing/Advising on international offerings of debt/equity i.e. GDR, ADR, bonds and other instruments;
(d) Private placement of securities;
(e) Primary or satellite dealership of government securities;
(f) Corporate advisory services related to securities market including takeovers, acquisition and
disinvestment;
(g) Stock broking;
(h) Advisory services for projects;
(i) Syndication of rupee term loans;
(j) International financial advisory services.
The activities of the merchant bankers in the Indian capital market are regulated by SEBI (Merchant Bankers)
Regulations, 1992 notified by SEBI in exercise of the powers conferred by Section 30 of SEBI Act, 1992 after
approval of the Central Government.
LOAN SYNDICATION
Loan syndication involves obtaining commitment for term loans from the financial institutions and banks to
finance the project. Basically it refers to the services rendered by merchant bankers in arranging and procuring
credit from financial institutions, banks and other lending and investment organisation or financing the client
project cost or working capital requirements. In a service, it is project finance service.
Loan syndication is infact a tie up of term loans from the different financial institutions. The process of loan
syndication involves the following steps:
1. Firstly, where the borrower directly submits the loan application to the lead financial institutions for a
particular industry, the loan syndication gets automatically arranged through the lead institution who on
its own would like the other financial institutions to participate in the financial assistance to the borrower.
In this case, borrower need not approach the different financial institutions.
2. Secondly, where the borrower engages a merchant bank for arranging the loan syndication, then it
becomes the duty of the merchant bank to approach the financial institutions before making a formal
application to ascertain the possibilities of getting loan for a particular industry from the financial institutions.
On getting the positive response, the merchant bank submits the formal information or applications form
to the financial institution for the loan on behalf the borrower. The merchant banker also makes an
indepth study of the investment proposal before taking up the project for loan syndication.
The process of loan syndication involves the formalities such as:
(1) Preparation of project details,
(2) Preparation of loan application,
(3) Selection of financial institutions for loan syndication,
(4) Issue of sanction letter of intent from the financial institutions
(5) Compliance of terms and conditions for the availment of the loan,
(6) Documentation, and
(7) Disbursement of the loan.
The public financial institutions require the borrower to submit the requisite information for the loan in the prescribed
forms along with the project report which is thoroughly scrutinised by them at individual levels and discussed in
Lesson 5
the inter-institutional meetings. After the officers of the institutions satisfy themselves of the viability of the project,
the proposal for the loan is submitted to the sanctioning authority and it is after this sanction the formal letter of
intent is issued to the borrower.
This letter of intent is only an offer for financial assistance which is required to be accepted by the borrower in its
board meeting with all the necessary terms and conditions appended to it. On complying with the terms and
conditions of the loan, the borrower company avails of the loan amount in suitable installments as per the project
details submitted and agreed to by the Financial Institutions. Before compliance of all the formalities and before
the creation of security, the borrower also can avail of a Bridge Loan against the sanctioned amount of the loan.
In this way, it has been seen that the merchant bankers are neither creators of credit like commercial banks nor
are they purveyors of credit like development banks. What they do is that they arrange/procure finance on
request for the projects that come up for counseling. That is, in sequence of merchant banking services
arrangement of finance comes next to project counseling. Otherwise too, after having decided the project to be
undertaken, its implementation as a pre-requisite would require arrangement of funds that would involve,
(a) Assessing the quantum and nature of funds required;
(b) Locating the various sources of finance;
(c) Approaching these sources with loan application forms and complying with other formalities etc.
Estimating Capital Requirements

Quantum of funds required to get the project going would depend upon an estimation of the cost of different
items of expenditure particularly with reference to the following elements of cost:
(i) Preliminary expenses covering cost of promotion, incorporation etc.;
(ii) Cost of fixed assets covering acquisition of land, construction of building, roads, railway siding,
procurement of plant and equipment, furniture and fixtures or other miscellaneous fixed assets;
(iii) Cost of current assets, particularly inventory, receivables etc.
(iv) Cost of acquiring know-how covering expenses incurred on foreign or Indian technicians, training of
personnel in India and abroad etc.;
(v) Basis for provision of contingencies and margin money requirements for working capital;
(vi) Cost of financing, brokerage, underwriting etc.;
(vii) Any other element of cost likely to be incurred.
Some of the items like preliminary expenses etc. may not be relevant for established concern requiring funds for
expansion, modernisation or diversification in which case costs of restructuring the business may become
relevant.
It would always be advisable to compare these cost estimates with reference to similar concern in the same
industry and in the same geographical area, of some size and scale of operation etc. Further, provision may also
be made for likely escalation/ inflation and the tolerance limits for under/over estimation may also be provided
for.
Other than estimating the quantum of funds required for financing the project an important aspect to be considered
is to identify the nature of funds required, i.e. whether funds are going to be in the nature of venture capital,
bridge loan, special purpose loan such as loans under special schemes for rehabilitation, modernisation,
diversification expansion etc., concessional loans such as backward area finance etc. Likewise, besides
determining the target capital structure, there would be a need to separately address to the requirements of
short-term, medium-term and long-term finances.
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Locating the various sources of finances

The choice for sources of fund would depend upon the quantum of funds required as well as nature thereof. For
example, there are special schemes of development finance institutions for modernisation, expansion etc. in
which case choice of sources of finance will be limited except making applications to the specified institutions
under the designated schemes. Generally however, it would be better to survey the various sources of finance
from two angles viz. (a) the period for which the funds are required, (b) nature of stake.
Sources of short-term funds are commercial banks, trade credit, public deposits, discount and finance houses
etc.
Medium-term funds are provided on loan basis by,
(i) State Financial Corporations;
(ii) Commercial banks;
(iii) All Indian Finance Institutions through special schemes pertaining the equipment credit, suppliers credit,
buyers credit, bill discounting, instalment credit, public deposits etc.
Where funds are needed for a period of more than five years, such finance is termed as long-term finance.
Owned funds are provided by promoters and public. Borrowed funds may be procured from all India and State
level financial institutions. Long term funds may also be borrowed from international financing institutions where
loan-syndication services can play an important role. While public offers of companys securities is beyond the
purview of this financial service, loan syndication does cover private placement of debentures with investment
institutions on behalf of the corporate issuer.
Loan Application
This is an important aspect of loan syndication which would include preparation of loan application, filing and
following up the loan application with the financial institution and arranging the disbursal of the same. Adequate
care has to be taken particularly with regard to the compliance of what are known as covenants or the terms
and conditions stipulated in the letter of intent/sanction, particularly with regard to security, conversion option
etc. Other than these, the company has to ensure the compliance of the provisions of the Companies Act,
especially those pertaining to powers of the company to borrow and other relevant legislations to be entitled for
obtaining the disbursement of the amount of loan.
Syndication for working capital requirements

Here too, the services provided include not only the assessment of working capital requirements of the project
but also the nature of advances provided by the commercial banks. For example, bank borrowings may comprise
of two broad categories viz.,
(i) fund based advances consisting of cash credit facility, bill finance, overdraft facility, demand loan; and
(ii) non fund facilities consisting of letter of credit, letter of guarantee etc.
Here the merchant bankers will have to make necessary arrangements with regard to consortium finance in
cases where working capital requirements are very large. They are also required to ensure proper co-ordination
between banks (especially the lead bank) and financial institutions in case a joint application for term loans and
working capital finance is being furnished.
SECURITIZATION OF DEBT
Securitisation constitutes a key segment of structured finance. It is a technique by which identified receivables
and other financial assets can be packaged into transferable securities and sold to investors. The instruments
issued under a securitisation deal derive their value from the cash flows (current or future) or collateral value of
Lesson 5
a specified financial asset or pool of financial assets, general debt obligations or other financial receivables.
Normally, these instruments do not have any recourse to the Originator other than aforementioned assets and
specified third party support mechanisms that are clearly defined and are not unlimited (i.e. credit enhancements).
The simplest way to understand the concept of securitisation is to take an example. Let us say, I want to own a
car to run it for hire. I could take a loan with which I could buy the car. The loan is my obligation and the car is my
asset, and both are affected by my other assets and other obligations. This is the case of simple financing.
On the other hand, if I were to analytically envisage the car, my asset in the instant case, as claim to value over
a period of time, that is, ability to generate a series of hire rentals over a period of time, I might sell a part of the
cash flow by way of hire rentals for a stipulated time and thereby raise enough money to buy the car. The
investor is happier now, because he has a claim for a cash flow which is not affected by my other obligations; I
am happier because I have the cake and eat it also and also because the obligation to repay the financier is
taken care of by the cash flows from the car itself.
In this way, in securitization the loan itself is not sold to another lender but rather a security instrument is created
backed by the principal and interest payments on the loan. Through this means the beneficial ownerships of the
loan is effectively transferred. The purchaser of the loan assumes the risk in the event of loan default, and the
lender removes the risk from its balance sheet. Once securitization has taken place, then the securities themselves
can be traded in a secondary market. To the borrowers, securitisation does not matter for what they get is loan
and to them it makes no difference as to who holds the claim.
Securitisation can be classified into two categories:
(1) Asset backed securitisation (ABS)- Securitisation of receivables which are existing i.e. the obligation
of the Obligor to make payments is not dependent on further action or performance by the Originator.
E.g. Mortgage-backed receivables, auto receivables securitisation and hire purchase rental receivables.
(2) Future Flow securitisation (FFS)- Securitisation of receivables which are to be generated in the future
i.e. the obligation of the Obligor to make payments depends on further substantial performance by the
Originator . E.g. Typical FFS receivables are trade receivables (long term), electricity receivables, and
toll road receivables.
Participants of the securitisation process

The following parties are involved in a typical securitisation deal:
1. Originator: This is the entity that requires the financing and hence is the driver of the deal. Typically the
Originator owns the assets or cash flows around which the transaction is structured.
2. SPV (Special Purpose Vehicle): An SPV is typically used in structured transaction for ensuring
bankruptcy remoteness from the Originator. The SPV is the issuer of securities or the entity through
which the financing is channeled. Typically the ownership of the cash flows or assets around which the
transaction is structured is transferred from the Originator to the SPV at the time of execution of the
transaction. The SPV is typically a marginally capitalized entity with narrowly defined purposes and
activities and usually has independent trustees/directors.
3. Investors: The investors are the providers of funds and could be individuals or institutional investors
like banks, financial institutions, mutual funds, provident funds, pension funds, insurance companies,
etc.
4. Obligor(s): The Obligor is the Originators debtor. The amount outstanding from the Obligor is the asset
that is transferred to the SPV. The credit standing of the Obligor(s) is of paramount importance in a
structured finance transaction.
5. Guarantor/Credit Enhancement Provider/Insurer: These are entities that provide protection to the
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Investor for the finance provided and the returns thereon against identified risks. Typically, on the
happening of pre-identified events, affecting the underlying assets or cash flows or the payment ability
of the Obligors, these entities pay moneys, which are passed on, to the Investor.
Besides these primary parties, the other parties involved in a deal are given below:
1. Rating Agency: Since structured finance deals are generally complex with intricate payment structures
and legal mechanisms, rating of the transaction by an independent qualified rating agency plays an
important role in attracting Investors.
2. Administrator or Servicer: The Servicer performs the functions of collecting the cash flows, maintaining
the assets, keeping records and general monitoring of the Obligors. In many cases, especially in the
Indian context, the Originator also performs the role of the Servicer.
3. Agent and Trustee: The Trustee is the manager of the SPV and plays a key role in the transaction. The
Trustee generally administers the transaction, manages the inflow and outflow of moneys, and does all
acts and deeds for protecting the rights of the Investors including initiating legal action against various
participants in case of any breach of terms and triggering payment from various credit enhancement
structures.
4. Structurer: Normally, an investment banker acts as the structurer and designs and executes the
transaction. The Structurer also brings together the Originator, Credit Enhancement Provider, the Investors
and other parties to a deal. In some cases (like ICICI), the Investor also acts as the Structurer.
Generic deal diagram
A securitisation deal normally has the following stages:1. The originator issues loan to the obligors
2. The cashflows (principal + interest) on the loan are collected by the collection agent on behalf of the
originator.
3. Support mechanisms (or credit enhancements) are appointed in the structure in order to minimise or
mitigate potential credit risks.
4. The loan pool is selected and credit rating is taken.
5. A structure, generally, a merchant banker is appointed.
6. The SPV is formed. It acquires the receivables under an agreement at their discounted value.
7. The SPV pays the purchase consideration to the originator.
Lesson 5
8. & 9. The SPV funds the purchase by issuing class A (senior) Pass Through Certificates (PTCs) and
class B (Subordinated) PTCs.
10. The collection agent collects the receivables, usually in an escrow mechanism, and pays off the collection
to the SPV.
11. The SPV either passes the collection to the investors, or reinvests the same to pay off to investors at
stated intervals.
Since the early 1990s, securitization has been one of the dominant means of capital formation in the United
States. Several trillion dollars in securitizations were outstanding at its peak before the financial crisis, and it
remains an important source of financing. The investors can be banks, mutual funds, other financial institutions,
government etc. In India only qualified institutional buyers (QIBs) who possess the expertise and the financial
muscle to invest in securities market are allowed to invest in PTCs. In order to prevent unhealthy practices
surrounding securitization viz; origination of loans for the sole purpose of securitization and in order to align the
interest of the originator with that of the investors and with a view to redistribute credit risk to a wide spectrum of
investors, it was felt necessary by the Reserve Bank of India that originators should retain a portion of each
securitization originated and ensure more effective screening of loans. In addition, a minimum period of retention
of loans prior to securitization was also considered desirable, to give comfort to the investors regarding the due
diligence exercised by the originator. The Bank vide its circular DBOD.No.BP.BC-103/21.04.177/2011-12 dated
May 07, 2012 has issued the final guidelines in this regard to banks. It has been decided to extend the guidelines
to NBFCs also.
HOUSING FINANCE SERVICES

The housing finance sector in India has undergone unprecedented change, especially over the past two decades.
Traditionally, the chief source of finance for housing was individual personal savings. The personal savings
were supplemented by borrowings from money lenders. Many households remained houseless for several
years, mainly because of lack of funds. Gradually, the government realized the importance of housing and,
accordingly, initiated several measures to improve housing conditions. Housing not only serves a social need of
the people but also creates employment, both directly and indirectly. Presently, the construction industry is one
of the major sources of employment.
Organisation of Housing Finance in India
Housing Finance System
Other Players
Central and
State
Governments
Housing and
Urban
Development
Corporation
Insurance
Organisation
National Housing Bank
Banks
Cooperative
Bank
Specialized Housing
Financing Institutions
150 PP-FT&FM
Institutional Infrastructure of Housing Finance Sector in India

The responsibility to provide housing finance largely rested with the Government of India till the early eighties.
The setting up of the NHB in 1988 as the apex/principal housing finance institution was the beginning of the
emergence of housing finance as a fund-based financial service in country. Although still at an early stage of
development, with the entry of a number of specialized HFIs/HFCs, it has grown in volume and depth.
A diversified housing finance system is emerging in the country. The main components of the system are the
NHB, the HUDCO, insurance organisations, commercial and cooperative banks and specialized HFIs in the
public, private and /joint sectors such as the HDFCs, the SBIHF, Canfin Home, Indbank Housing, Citihome,
Dewan Housing Finance and so on.
HOUSING DEVELOPMENT FINANCE CORPORATION LIMITED (HDFC)

In the year 1977, HDFC was incorporated with the main objective of promoting home ownership by providing
long-term loans. It was promoted as a company with an initial share capital of Rs. 10 crores. Its Board of
Directors, consisting of 15 persons, representing government, financial institutions, construction industry and
other representatives of the public, manages HDFC.
Main Objectives of HDFC

1. To increase the number of residential houses in the country by providing housing finance in a systematic
and professional manner.
2. To promote home-ownership.
3. To increase the flow of funds to the housing sector.
4. To strengthen housing finance by improving the domestic financial market and financial services.
5. To develop a close relationship with individual households, i.e., providing direct housing loans to
individuals.
6. To maintain its position as one of the premier housing finance institutions in the country.
7. To transform various ideas into viable and creative solutions, i.e., building houses on the basis of cost,
utility, and modernization.
8. To provide consistently high returns to shareholders.
9. To diversify activities to client-base by entering into mutual funds, leasing, commercial banking, insurance,
etc.
10. To align with national priorities and adopt flexible housing finance policy by providing more houses to
the weaker sections of the society.
Types of Loans Offered

In order to provide housing finance, HDFC offers the following type of loans to individuals:
1. For dwelling house : Loans are given to individuals, based on their income. They are repayable over
a maximum period of 20 years.
2. Extension of existing houses : Loans are made available for extending existing small houses either
by constructing vertically or by extending horizontally.
3. Purchase of land : Of late, HDFC provides loans to enable individuals to purchase land or plots for
constructing houses.
4. Repairs/renovation : Loans are granted for undertaking repairs in an existing house or for modernization.
Lesson 5
5. Large-scale construction : HDFC provides loans for constructing large-scale housing, under group
housing or for employees of a particular organization on the basis of collective responsibility.
6. Facility to weaker sections : The corporation provides loans for creating housing facility to people
belonging to the weaker sections of society. This is done through low-cost housing, by using hollowblocks for construction.
Special Features of HDFC

1. Loans are granted for individuals upto a maximum of Rs. 1 crore, repayable within 20 years. This will
come under the heading Home Extension Loan
2. Home improvement loan can be obtained either individually or jointly, where loan is sanctioned upto Rs.
1 crore.
3. Short-term building loan can also be applied for a maximum period of 24 months.
4. HDFC home equity loan is available for the owners of current property. Here, loan is available to a
maximum of Rs. 50 lakhs and minimum of Rs. 1 lakh, but the market value of the dwelling unit should be
at least Rs. 10 lakhs.
HOUSING AND URBAN DEVELOPMENT CORPORATION OF INDIA (HUDCO)

Incorporated on 25th April, 1970, HUDCO was an expression of the concern of the Central Government towards
the deteriorating housing conditions in the country, and a desire to assist various agencies in dealing with it in a
positive manner. The principal mandate of HUDCO was to ameliorate the housing conditions of all groups and
with a thrust to meet the needs of the low-income group and economically weaker sections.
Objectives
1. To provide long-term finance for construction of houses for residential purposes in urban and rural
areas, and finance or undertake housing and urban infrastructure development programmers in the
country.
2. To finance or undertake, wholly or partly, the setting up of new or satellite towns.
3. To subscribe to debentures and bonds issued by the State Housing and Urban Development Boards,
Improvement Trusts, and Development Authorities, etc especially for the purpose of housing and urban
development programmes.
4. To finance or undertake the setting up of industrial enterprise for building material.
5. To administrate the amount received, from time to time, from the Government of India and other sources
as grants or otherwise, for the purpose of financing or undertaking housing and urban development
programmes in the country
6. To promote, establish, assist, collaborate and provide consultancy services for the projects in designing
and planning of works relating to housing and urban development in India and abroad.
Housing Programmes
HUDCO undertakes the following housing programs:
Urban housing
Rural housing
Cooperative housing
Construction housing
152 PP-FT&FM
Staff rental housing
Repairs, renewals and upgradations
Night shelters for pavement dwellers
Working women ownership condominium
Housing schemes through NGOs/CBOs
Housing through private sector
Individual housing loans through HUDCO Niwas
NATIONAL HOUSING BANK (NHB)

The sub-group on housing finance during the Seventh Five-Year Plan (1985-90) identified the vacuum in the
availability of long-term housing finance, particularly for individual households, and recommended the setting up
of a national-level institution. The Government of India accepted the recommendations and introduced the
National Housing Bank Bill in the winter session (1987) of Parliament. The bill was passed in Parliament and,
with the assent of the President of India on December 23, 1987, it became an Act of Parliament.
The vision statement of NHB states that NHB ensures a sound and healthy housing finance system in India
through effective regulation and supervision of housing finance institutions. As a financial institution, NHB is
known for its commitment, innovation and quality of service, offering a broad spectrum of financial products to
address the needs of the housing sector with motivated employees working in a congenial and participative
work environment.
The principal objectives of the NHB

(a) To promote a sound, healthy, viable and cost-effective housing finance system to cater to all segments
of the population and to integrate the housing finance system with the overall financial system.
(b) To promote a network of dedicated housing finance institutions to adequately serve various regions and
different income groups.
(c) To augment resources for the sector and channelize them for housing.
(d) To make housing credit more affordable.
(e) To regulate the activities of housing finance companies based on regulatory and supervisory authority
derived under the act.
(f) To encourage augmentation of supply of buildable land and also building materials for housing and to
upgrade the housing stock in the country.
The principal activities of NHB

To provide refinance assistance to HFCs with respect to their direct lending up to INR 1 crore to individual
for purchase/construction/repair and upgradation of housing units. Financial assistance is provided
either at fixed or floating rates of interest. The HFC has the option to choose either floating or fixed
interest rate depending on its requirement.
Equity participation in housing finance companies; and
To provide advisory services to the Central and State Governments, local authorities and other agencies,
for formulation of overall policies aimed at promoting the growth of housing and housing finance
institutions. It advises the government to bring up a legislation relating to matters having a bearing on
shelter, housing,and human settlement.
Lesson 5
The part played by it in the supply of housing finance falls into three categories: (i) promotional, (ii)
regulatory and (iii) financial. The promotional role includes promotion of HFIs/HFCs, coordination with
Government and other agencies in securing necessary amendments to the existing laws to remove
impediments in the housing sector and encouragement to participation of NGOs and social action groups
in housing development. The regulatory powers exercised earlier by the RBI relating to HFCs are now
the domain of the NHB. It regulates them through directions and guidelines. The financial support by the
NHB to HFCs is in the form of equity capital and refinance, promotion of loan linked savings instruments
and mortgage-based securitizations.
In pursuance of its objective to promote HFCs and to provide financial and other support to them, the
NHB issues operating guidelines to them from time to time. These pertain to share capital and activity
norms, nominee directors and auditors, lending norms in terms of target groups, refinance rates of
interest and other charges, ceiling on administrative cost, quarterly returns and so on.
The NHB prudential norms for HFI relate to income recognition, provisioning, asset classification, capital
adequacy, concentration of credit/investment and so on.
NEW DEVELOPMENT IN HOUSING FINANCE

An important development in the housing finance business has been the entry of new players. The relatively low
risk in a housing portfolio has spurred new entrants in the last few years. Arguably, the most significant entrant
has been ICICI Home finance. Among non-banking finance companies, Sundaram Finance and Tata Finance
have launched housing finance subsidiaries in the recent past, while banks have shown increased interest in
acquiring housing assets.
The entry of new players and the consequent increase in competition has been followed by an interesting trend.
The interest rates of most housing finance companies (HFC) move in unison, thereby suggesting that interest
rate is not likely to be a competitive tool. The high level of competition has made it impossible for an HFC, with
branches across the country, to charge an interest rate higher than the competition. Commercial banks are an
exception to the rule, in the sense that they always charge lower than the competition.
Banks have always had subsidiaries handling housing finance, but in the recent past, they seem to have taken
a greater interest in building retail assets. Banks have a clear advantage in the field simply because they access
the lowest cost funds in India. As things stand, a loan from a bank is less expensive than one from a housing
finance company.
IMPEDIMENTS IN HOUSING FINANCE

The major problem in the housing finance sector is paucity of funds. The available funds for the sector are not
sufficient to meet the growing needs of housing and real estate. To meet the increasing requirement of funds,
the Government of India introduced a scheme in 1993 for NRI investment in housing and real estate development.
The government also permitted 100 per cent foreign direct investment (FDI) in housing development. FDI is
permitted in integrated development of townships, housing, build-up infrastructure and construction development
projects. The FDI is subject to a stipulation of minimum land holding of 100 acres and has a minimum lock-in
period of three years with respect to repatriation of profit on the original capital invested.
Some of the major issues facing the Indian housing financial sector are discussed below:
(i) Archaic Laws: There are certain legislations that hamper the growth of housing finance in India. For
instance, the archaic Urban Land Ceiling Regulation Act (ULCRA) has been a failure in the Indian
housing finance system. The Act has only helped contribute towards the galloping prices of land, because
it has failed to release adequate land for the purpose of housing development and financing.
(ii) Lack of Clear Title: Another major issue confronting Indian housing is the lack of clear title to property.
154 PP-FT&FM
Around 90 percent of all the land in India does not have a clear title. The ownership in unclear and
hence, the land is off the market, thereby creating scarcity of land. This problem could be attributed to
poor record keeping and complicated processes.
(iii) High Stamp Duty: The cost of transferring land, stamp duty and registration charges payable are
prohibitively high. This dissuades people from seeking housing development and financing. Moreover,
the procedure followed is also not transparent.
(iv) Obsolete Rental Laws: Obsolete tenancy and rental control laws keep a large part of the urban properties
off the market. The rental laws must be revised to protect the owner and the property from the tenant. It
is incumbent that steps are taken to get rid of all the old tenancies, remove restrictions on increase of
rentals and empower owners to reclaim their properties without any court proceedings, which currently
may even take decades.
(v) Foreclosure Laws: Though the level of foreclosure for the housing finance companies are relatively
low at around 1.5 to 2 percent, the foreclosure laws are obsolete and outdated. The laws for nonpayment of Equated monthly Installment (EMI) and consequent foreclosure and repossession of the
property must be revised. This would help financing companies to have the final rights on the property,
which is the collateral for the housing loan. Moreover, this would further boost the housing finance
business.
(vi) Inadequate Building Codes and Standards: Although there are several building guidelines and
standards in various cities and states, neither the housing developers follow them and nor do the
authorities implement them. The system needs to be made more transparent and direct, so that there is
no room for ambiguity and confusion. Presently too much of paperwork in the form of different permissions
that needs to be obtained from too many authorities. They need to be centralized, simplified, streamlined
and made transparent, so that there is no scope for corruption and time delays. There must be a single
window clearance for all building and construction requirements. This will reduce time, paperwork and
corruption at all levels and attract further investment capital. Mandatory ratings of developers and projects
can be undertaken by rating agencies like NAREDCO, ICRA, CRISIL, etc to safeguard the interests of
the public and increase investor confidence.
(vii) Inadequate Development and Planning: The city or state authorities must use professionals to plan
and execute all development plans for cities and towns, with future development in mind. This must be
done without any political compulsions. The plans must be prepared in advance and executed without
any exceptions and all regulations must be strictly enforced. The central and the state governments
must lay down specific overall guidelines for the city/town coporations to follow and enforce them strictly.
This will allow porper zoning within cities and towns, and green areas and other infrastructure systems
to fall into place as the development plans unfold.
(viii) Inadequate Infrastructure: This is one problem area which needs to be tackled on a war footing. Most
Indian cities lack the infrastructure since they fail to keep pace with the growth in population and
development. The central and state governments must provide sufficient power, water and roads to
cope with the growth. The electricity boards must be able to provide reliable power and the corporation
must charge reasonable property taxes to cover the costs of roads and water supply. The assessment
base of property tax must be changed from historical value to capital value. The user charge for water,
sewage and electricity and other municipal services boards may have to be considered very seriously.
Presently, the property taxes do not cover the infrastructure costs. There is also pilferage and actual
charges are not collected. The government cannot continue to subsidize these infrastructure costs
indefinitely.
Lesson 5
CUSTODIAL AND ADVISORY SERVICES

Custodial services constitute an important modern financial service rendered by institutions of finance. Custodial
services refer to safekeeping of securities of a client. The person who provides custodial services is known as a
custodian. A custodian maintains the accounts of securities of his client; collects benefits accruing to the client
in respect of securities under custody; keeps the client informed of the actions taken by the issuer of securities;
and maintains and reconciles records of the services.
The provision of efficient custodial services forms an important element in the evolution of a matured
stock market system. The custodians of securities who provide custodial services play a critical role in
the secondary market. Recognising their importance securities market, the SEBI (Custodian of Securities)
Regulations, 1996 was framed for the proper conduct of their business. According to the SEBI regulations,
custodial services in relation to securities mean (i) safe-keeping of the securities of a client who enters
into an agreement to avail of these securities and (ii) providing services incidental thereto, including:
Maintaining accounts of the securities of a client;
Collecting the benefits/rights accruing to him in respect of securities;
Keeping him informed of the actions taken/ to be taken by the issuer of securities, having a bearing on
the benefits/ rights accruing to him; and
Maintaining and reconciling records of the services referred to above.
Depository System in India

A depository is an organisation, which assists in the allotment and transfer of securities, and securities lending.
The shares in a depository are held in the form of electronic accounts, i.e., in dematerialised form and the
depository system revolves around the concept of paper-less or scripless trading. An effective and fully developed
securities depository system is essential for maintaining and enhancing the market efficiency, which is one of
the core characteristics of a mature capital market.
The National Securities Depository Limited (NSDL), the first depository in India which has been promoted by three
premier institutions in India viz. IDBI, UTI and NSE, started operating from November 8, 1996. NSDL carries out its
operations through participants and the clearing corporation of the stock exchange, with participants acting as
market intermediates through whom NSDL interacts with the investors and the clearing members. To begin with
only the capital market segment of the National Stock Exchange of India Limited (NSE) has been associated with
the NSDL as only the NSE has a clearing corporation (NSCCL), which guarantees performance of trade obligations
and has been admitted into the depository. The National Stock Exchange has also set up clearing corporation
limited which acts as a counter party to every trade executed on the capital market segment of exchange.
The Depository System functions very much like the banking system. A bank holds funds in accounts whereas
a Depository holds securities in accounts for its clients. A Bank transfers funds between accounts whereas a
Depository transfers securities between accounts. In both systems, the transfer of funds or securities happens
without the actual handling of funds or securities. Both the Banks and the Depository are accountable for the
safe keeping of funds and securities respectively.
In the depository system, share certificates belonging to the investors are to be dematerialised and their names
are required to be entered in the records of depository as beneficial owners. Consequent to these changes, the
investors names in the companies register are replaced by the name of depository as the registered owner of
the securities. The depository, however, does not have any voting rights or other economic rights in respect of
the shares as a registered owner. The beneficial owner continues to enjoy all the rights and benefits and is
subject to all the liabilities in respect of the securities held by a depository. Shares in the depository mode are
fungible and cease to have distinctive numbers. The transfer of ownership changes in the depository is done
automatically on the basis of delivery v. payment.
156 PP-FT&FM
In the Depository mode, corporate actions such as IPOs, rights, conversions, bonus, mergers/amalgamations,
subdivisions & consolidations are carried out without the movement of papers, saving both cost & time. Information
of beneficiary owners is readily available. The issuer gets information on changes in shareholding pattern on a
regular basis, which enables the issuer to efficiently monitor the changes in shareholdings.
The Depository system links the issuing corporates, Depository Participants (DPs), the Depositories and clearing
corporation/ clearing house of stock exchanges. This network facilitates holding of securities in the soft form and
effects transfers by means of account transfers.
Benefits of depository system

In the depository system, the ownership and transfer of securities takes place by means of electronic book
entries. At the outset, this system rids the capital market of the dangers related to handling of paper. The system
provides numerous direct and indirect benefits, like:
1. Elimination of bad deliveries - In the depository environment, once holdings of an investor are
dematerialised, the question of bad delivery does not arise i.e. they cannot be held under objection. In
the physical environment, buyer of shares was required to take the risk of transfer and face uncertainty
of the quality of assets purchased. In a depository environment good money certainly begets good
quality of assets.
2. Elimination of all risks associated with physical certificates - Dealing in physical securities have
associated security risks of theft of stocks, mutilation of certificates, loss of certificates during movements
through and from the registrars, thus exposing the investor to the cost of obtaining duplicate certificates
and advertisements, etc. This problem does not arise in the depository environment.
3. Immediate transfer and registration of securities - In the depository environment, once the securities
are credited to the investors account on pay out, he becomes the legal owner of the securities. There is
no further need to send it to the companys registrar for registration. Having purchased securities in the
physical environment, the investor has to send it to the companys registrar so that the change of
ownership can be registered. This process usually takes around three to four months and is rarely
completed within the statutory framework of two months thus exposing the investor to opportunity cost
of delay in transfer and to risk of loss in transit. To overcome this, the normally accepted practice is to
hold the securities in street names i.e. not to register the change of ownership. However, if the investors
miss a book closure the securities are not good for delivery and the investor would also stand to loose
his corporate entitlements.
4. Faster disbursement of non cash corporate benefits like rights, bonus, etc. - Depository system
provides for direct credit of non cash corporate entitlements to an investors account, thereby ensuring
faster disbursement and avoiding risk of loss of certificates in transit.
5. Reduction in brokerage by many brokers for trading in dematerialised securities - Brokers provide
this benefit to investors as dealing in dematerialised securities reduces their back office cost of handling
paper and also eliminates the risk of being the introducing broker.
6. Reduction in Paper work - Reduction in handling of huge volumes of paper and periodic status reports
to investors on their holdings and transactions, leading to better controls.
7. Elimination of problems related to change of address of investor, transmission, etc. - In case of
change of address or transmission of demat shares, investors are saved from undergoing the entire
change procedure with each company or registrar. Investors have to only inform their DP with all relevant
documents and the required changes are effected in the database of all the companies, where the
investor is a registered holder of securities.
Lesson 5
8. Elimination of problems related to selling securities on behalf of a minor - A natural guardian is not
required to take court approval for selling demat securities on behalf of a minor.
Types of Advisory Services

Advisory Services is an important form of financial services. Now with the progress of economy, different types
of advisory financial services have got emerged. Few of them are discussed below.
1. Providing an investment planning service
Designing or offering to design a plan that:
is based on an analysis of an individuals current and future overall financial situation and
identifies their investment goals and
Includes recommendations or opinions on how to realise those goals.
Investment planning services is getting very popular now a days. Investment planning services are mainly
provided by corporate professionals like Chartered Accountants, Cost Accountants and investment consultants.
2. Providing financial advice
Making a recommendation, or giving an opinion about acquiring, holding or disposing of a financial product.
Providing factual information only about a financial product, in the absence of any recommendation or opinion
would not be considered financial advice.
3. Providing Insurance and Banking advisory services
Insurance advisory services are a very old form of financial services and now it is getting revamped. Now many
banks and corporate have also started providing these types of financial services.
REGULATION OF THE FINANCIAL SERVICES SECTOR

The financial services sector until recently the world over has been regulated by a plethora of legislation. As the
winds of liberalization are sweeping the real sectors of economies, de-regulation of this sector is also underway.
Hence, the freeing of interest/exchange rates, increased competition among the providers of the financial services
viz. freer entry, de-regulated capital markets etc. However, the approach followed in regard to financial liberalization
the world over has been much more cautious than a policy of free rein. While it is being seen that the impediments
and road block, towards the development of an efficient and vibrant financial sector are removed, it is also being
increasingly recognized that some type of discipline is necessary to varied interests of the different players at
the financial services market place. Thus, prudential norms rather than inhibitive control is the watch word as
far as regulation of this sector is concerned. It is in this spirit that the apparent contradiction between real-sector
liberalisation and financial re-regulation should be viewed. Thus, a watch-dog body over the financial service
sector is of prime necessity even in the wider context of de-regulation and liberalisation.
LESSON ROUND-UP
Various services offered by merchant bankers include: corporate counseling; project Counseling and
pre-investment studies; capital re-structuring; credit syndication and project finance; issue management
and underwriting; portfolio management; non-resident investment counseling and management;
acceptance credit and bill-discounting; advising on mergers, amalgamations and take-over, arranging
off-shore finance; fixed deposit brokering; and relief to sick industries
A diversified housing finance system is emerging in the country. The main components of the system
are the NHB, the HUDCO, insurance organisations, commercial and cooperative banks and specialized
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HFIs in the public, private and /joint sectors such as the HDFCs, the SBIHF, Canfin Home, Indbank
Housing, Citihome, Dewan Housing Finance and so on.
Securitisation is the process of pooling and repackaging of homogeneous illiquid financial assets into
marketable securities that can be sold to investors. The process leads to the creation of financial
instruments that represent ownership interest in, or are secured by a segregated income producing
asset or pool, of assets. The pool of assets collateralises securities. These assets are generally secured
by personal or real property such as automobiles, real estate,or equipment loans but in some cases
are unsecured, for example, credit card debt and consumer loans.
Custodial services constitute an important modern financial service rendered by institutions of finance.
Custodial services refer to safekeeping of securities of a client. The person who provides custodial
services is known as a custodian. A custodian maintains the accounts of securities of his client;
collects benefits accruing to the client in respect of securities under custody; keeps the client informed
of the actions taken by the issuer of securities; and maintains and reconciles records of the services.
In Depository System, share certificates belonging to the investors are to be dematerialized and their
names are required to be entered in the records of depository as beneficial owners.
SELF-TEST QUESTIONS
(These are meant for re-capitulation only. Answers to these questions are not to be submitted for
evaluation)
1. What do you mean by the term Financial Services? State various types of financial Services.
2. What is the significance of financial services in a country like India? Elucidate.,
2. Describe the role of Merchant Bankers in managing pre-capital issues.
3. Loan syndication is one of the project finance services. Discuss.
4. Define a financial service industry and discuss the various services rendered by it.
(a) Depository system in India
(b) Merchant Banking
Lesson 5
160 PP-FT&FM
Lesson 6
Project Planning
LESSON OUTLINE
Lesson 6
Project Planning 161
LEARNING OBJECTIVES
Project Planning
Project Finance is very important aspect of

Financial management. To be successful in his
endeavour, a finance manager should be well
versed about various aspects of project
financing, project appraisal techniques,
essential of loan documents, project
management and control techniques.
Preparation of Project Report,

Project Appraisal under Normal,
Inflationary and Deflationary Conditions,
Project Appraisal by Financial
Institutions
Lending Policies and Appraisal, Norms
by Financial Institutions and Banks;

to understand:
Loan Documentation,
The meaning of Project Planning
Project Review and Control;
Project Appraisal by various Financial

Institutions
Social Cost and Benefit Analysis of

Project. (UNIDO Approach),
Project Evaluation Technique
Term Loans from Financial Institutions

and Banks;
Loan Documentation
Loan Syndication Bridge Loans against
Sanctioned Loan
Lease and Hire Purchase Finance;

Venture Capital Funds;
Monitoring the progress of units assisted

by the Financial Institutions
Private Equity;
International Finance and Syndication of
Loans,
Social Cost Benefit Analysis
Deferred Payment Arrangements;
Follow-up Reports and Procedures
Project Review and Control
Corporate Taxation and its Impact on

Corporate Financing,
Financing Cost Escalation
LESSON ROUND UP
SELF TEST QUESTIONS
Planning without action is futile, action without planning is fatal.

Cornelius Fitchner
161
162 PP-FT&FM
PROJECT PLANNING
What is Project Planning?
Project planning defines the project activities and end products that will be performed and describes how the
activities will be accomplished. The purpose of project planning is to define each major task, estimate the time
and resources required, and provide a framework for management review and control. The project planning
activities and goals include defining:
1. The specific work to be performed and goals that define and bind the project.
2. Estimates to be documented for planning, tracking, and controlling the project.
3. Commitments that are planned, documented, and agreed to by affected groups.
4. Project alternatives, assumptions, and constraints.
The planning process includes steps to estimate the size of the project, estimate the technical scope of the
effort, estimate the resources required to complete the project, produce a schedule, identify and assess risks,
and negotiate commitments.
Repetition of these steps is necessary to establish the project plan. Typically, several iterations of the planning
process are performed before a plan is actually completed.
Importance of the Project Plan

A project plan is a formal, approved document that is used to manage and control a project.
The project plan forms the basis for all management efforts associated with the project. It is a document that is
also expected to change over time. The project plan documents the pertinent information associated with the
project; the information associated with the plan evolves as the project moves through its various stages and is
to be updated as new information unfolds about the project.
Steps in the Project Planning Process
The planning process consists of the following basic tasks:
(a) Define the technical approach used to solve the problem.
(b) Define and sequence the tasks to be performed and identify all deliverables associated with the project.
(c) Define the dependency relations between tasks.
(d) Estimate the resources required to perform each task.
(e) Schedule all tasks to be performed.
(f) Define a budget for performing the tasks.
(g) Define the organization used to execute the project.
(h) Identify the known risks in executing the project.
(i) Define the process used for ensuring quality.
(j) Define the process used for specifying and controlling requirements.
Lesson 6
The Evolving Plan of a Project
Strategic
Planning
Business Needs
Budgeting Estimates
IT Strategy
Resources
Project
Start-up
Detailed Specifications
Identified Project Risks
Project Organization
Estimate to Complete
Detailed Project Schedule
Detailed WBS
Staffing & Resource Plan
Deliverable Assignments
Technical Approach
Quality Plan
Baselined Project Plan
Planning
Risk ID
Project
Close-Out
Concept
Definition
Concept Paper
Project Categorization
Pre-project Team Org
Cost Constraints
Schedule Requirements
Project Sponsor ID
Technology Assessment
Cost Benefit Analysis
Make Buy Decision
Critical Success Factors
Project Methodology Tailoring
Project
Performance
Requirement Changes
Risk & Mitigation List
Current Project Organization
Current Estimate to Complete
Planned vs Actual Schedule
Current WBS
Planned vs Actual Staffing
Current Deliverable Assignments
Updated Technical Approach
Project Action Items
Quality Audits
Updated Project Plan
Statement of Work
Oversight Risk Assail
Pre-Project Team Org
Project Budget Estimates
Project Timeframe
Key Schedule Milestones
Identified Project Tasks
Resource Identification
Deliverable Requirements
Technical Approach Req
Quality Activities
Draft Project Plan
Lessons Learned
Team Awards
Final Cost
Values Admin
Closure Contract Closure
The plan defines the objectives of the project, the approach to be taken, and the commitment being assumed.
The project plan evolves through the early stages and, by the time the project is ready to begin project execution,
contains the detail required to successfully complete the project. Then, when implementation begins, the plan is
updated as required.
(1) Planning in the Concept Phase
In the projects concept phase, a need that would result in a product is identified. While only very general
information may be known about the project at this time, it is important to capture this information for the planning
phase. In this stage, the focus of planning is on the project definition and on getting the project underway. A
strategy for deriving a solution to the stated goals is important at this point. The problem being addressed by the
project is clearly stated; the project goals and objectives are identified; and success criteria for the project are
documented. Also, the assumptions, constraints, and risks that apply to the project are defined. Without a
description of this concept information, the completed project plan is difficult to thoroughly understand. Results
of the technology assessment also are documented as a precursor to the technical approach that is later defined
(2) Planning in the Planning Stage
The project plan is completed in the Project Planning and Risk Identification stage of a project. For large projects,
this stage may be run as a mini-project, with a team of people dedicated to performing the effort. For very small
projects, the plan may be developed by a group of people as a part-time job. Since various skill sets are required
164 PP-FT&FM
to complete a successful project plan, it is a difficult task for one person to develop the entire plan. During this
project stage, details of the plan are determined and an approach is defined. The full project plan is then developed.
The plan may include the following elements: a brief project summary, a work breakdown structure, a project
organization chart, a schedule, an approach, a list of identified risks, an estimated budget and cost, a list of
deliverables, a description of planned quality activities, a description of the configuration management process
to be used, and a summary of project requirements.
Even during the planning stage, the development of the project plan is an iterative process. Each element of the
plan is regularly revisited for changes and refinements, based upon further analysis and decisions made in
developing other plan elements. This refinement also develops .buy-in. from the project team and stakeholders.
It is critical to get buy off on the project plan from the involved parties prior to actually starting the project.
Approval of the plan commits the resources needed to perform the work.
(3) Planning in the Project Start-up Stage
To transition a project from the initial conceptualization and planning to execution requires some type of start-up
activities. The project start-up stage is typically a short period that transitions a project from the planning to the
execution stage. In the start-up stage, the team is assembled and a kickoff meeting is held to familiarize the
team with the elements of the plan and the requirements of the system. Specific work packages detail and
specify the activities being performed by the teams, as well as the cost and schedule associated with those
activities.
Sometimes, particularly in systems that include procurement, there may be a need to update the project plan
during this stage to reflect negotiations or refinements in scope that occurred prior to the actual start of the
project. In these cases, the plan is reviewed and updated prior to presentation to the team. Also, in some
projects, auxiliary plans (such as the configuration management or quality assurance plans) are detailed in the
start-up phase. These plans are developed from strategies defined in the project planning stage.
(4) Planning in the Project Execution Stage
Planning in the project execution stage consists of re-planning when it is determined that the project is not on
track with the current plan. This might occur for a variety of reasons. It is very important to know that project
plans will change and that re-planning is a natural part of the planning process. Re-planning does not necessarily
mean that a project is in trouble. Frequent and extensive re-planning may, however, indicate that there are some
serious issues with the project plan. It is better to re-plan than to simply throw away the original plan and operate
without a plan.
(5) Planning in the Project Close-Out Stage
A close-out process is performed once the project objectives have been met. Closing a project should be fairly
routine. The first step is acceptance of the system by the users. It is important that the user decides when the
project is completed. The determination is based upon the success criteria defined in the very early concept and
planning stages of the project. This acceptance may be very informal or it may be very formal and depends upon
the criteria defined in the plan.
PREPARATION OF PROJECT REPORT

The project report is an extremely important aspect of the project. It should be properly structured and also
necessary and appropriate information regarding the project.
Preparation of project report is a pre-investment study of investment proposal but encompasses a thorough
investigating process covering economic, technical, social managerial and commercial aspects. Project report
is a working plan for implementation of project proposal after investment decision by a company has been taken.
Importance of preparation of project report has been felt in the wake of sophisticated technology being adopted
Lesson 6
and the heavy financial state of public funds through financial institutions, banks and investment organisation
being contemplated. High technology involvement, higher cost in the project implementation and as such economy
cannot afford to tolerate failure of the project. Therefore, to ensure before taking in hand a project whether or not
the proposed project is viable, preparation of project report has become essential exercise for all corporate units
particularly in the light of the following background:
(1) Planning in advance, the accomplishment of the following objectives:
(a) Performance Objectives
(b) Marketing Objectives
(c) Operations Objectives
(d) Technical Objectives
(e) Financial Objectives
(f) Personnel Objectives
(g) Organisation Objectives
(h) The end product Objectives
(i) The customer benefit Objectives, and
(j) The societal Objectives
(2) To evaluate above objectives in the right perspective it is essential to consider the input data, analyse
the data, predict outcome, choose best alternatives, take action and measure results with predictions.
Stress is laid that the objectives become measurable, tangible, verifiable, attainable and the risk of
failures is avoided to the maximum desired extents.
(3) To evaluate constraints on resources viz. manpower, equipment, financial and technological.
(4) To avail of the financial facilities who require a systematic project report to evaluate desirability of
financing the project. Besides, the financial intermediaries today check up and verify the project
proposals for accepting the responsibility for a company to procure funds from the capital market.
Merchant banks who have entered in the capital market as financial intermediaries are quite careful
about the project viability before taking up a contract for making financial services available to corporate
units.
(5) Successful implementation of a project depends upon the course of action suggested in the project
report. Besides, comparison of results will depend upon the projected profitability and cash flows,
production schedule and targets as planned in the project report.
The above background necessitating the preparation of a project report leaves the impression that the task of
preparation of project report involves skills, expertise and experience of field work covering different aspects by
financial, technical, commercial, socio-economic, government rules and regulations and the legal requirements
under different laws and can only be handled by a team of experts in different areas. Project idea can be
formulated by an entrepreneur but project report cannot be prepared single-handedly as it requires a multidisciplinary approach to incorporate the following set of analysis in the project report:
166 PP-FT&FM
Potential Market
Market Analysis
Market Share
Technical Viability
Technical Analysis
Sensible Choices
Risk
Financial Analysis
Return
Benefits and Costs in Shadow Prices
Ecological Analysis
Restoration Measures
(1) Technical analysis comprising systems analysis using technique of operation research to sort out complex
problems like allocation problems, replacement problems, inventory problems, scheduling and queuing
of operations with use of PERT/CPM, Linear programming. Inter programming, Goal Programming and
simulation etc.
(2) Marketing research to forecast demand for goods/services which may be produced on implementation
of the project, capture market and elicit cooperation of the consumers etc.
(3) Financial analysis, to project future cash flows, profitability, evaluate net worth, to do cost-benefit analysis,
profit plannings, budgeting and resource allocation, etc.
(4) Techno-economic Analysis suggesting to adopt optimal technology for project size/objectives, to explore
economic conditions to absorb projects products, etc.
(5) Project Design and network analysis i.e. detailed work plan to the project and its time profile.
(6) Input output analysis etc.
Format of Project Report

There is no prescribed format for the preparation of a project report - but a project report should contain mainly
the following set of information in general:
(1) Information about industry and its status in the economy, present production and demand, indicating
Licensed, installed capacity, Government policies and export potential. Generally speaking, broad
guidelines in this respect may be had from the plan documents of the Government.
(2) Broad market trend of the product within and outside the states for 5 years.
(3) Raw material survey, giving specifications and quality of raw materials required and their availability.
(4) Process - broad description of different processes and their relative economics.
(5) Availability of technical know-how.
Lesson 6
(6) Location of Plant, its advantages.

(7) Water - requirement of water for process, boiler feed, cooling etc., sources of water available and
making it useable for the factory and to townships.
(8) Power - total power requirement for the factory specification of power and choice between purchased
power and generated power. If power to be generated - total cost of investment, choice of fuel and the
cost for fuel available to factory.
(9) Fuel - its requirement for steam raising or processing source and price at which it will be available for
factory including taxes and surcharge.
(10) Effluents - type and quality of effluents, their treatment and disposal, investment in the effluent treatment
and disposal. Government of India has since decided that any project proposal has to have a clearance
of Environmental Authority set up by the government.
(11) Implementation programme: implementation and construction programme in form of CPM/PERT.
(12) Cost of Project - (Specify foreign exchange cost if any):
(a) Land, inclusive of development expenditure incurred on the land;
(b) Buildings to be erected for housing the plant and machinery, the administrative office, stores, services,
etc. requirements estimates to be included in the project cost;
(c) Plant and machinery; including other equipments and their estimated cost;
(d) Offsite facilities: utilities and auxiliary facilities;
(e) Preliminary expenses (share issue, stamp duty, cost of raising equity etc.);
(f) Contingencies;
(g) Cost of spare, repairs and maintenance during trial run and commissioning period;
(h) Pre-commissioning and commissioning expenses;
(i) Working capital margin-details of estimation be given.
(13) Margin of financing-broad pattern to be indicated.
(14) Cost of production - project broad pattern five years vis-a-vis design capacity. Breakeven point of
production cost should be given, effect of variation of cost of raw materials, utilities, selling price etc. be
indicated and elaborated. Price trend of raw material and finished goods be discussed.
(15) Profitability for five years after commission of the project should be worked out in the prescribed format.
(16) Cash flow statement and pay period should be worked out for the project.
(17) Technical feasibility be discussed in detail with financial viability.
(18) Organisation and management description of corporate management, promoters experience and
background organisational chart, key personnels and delegation of power and responsibility structure
be fully described.
PROJECT APPRAISAL UNDER NORMAL CONDITIONS

Appraisal means to critically examine with a focus of attention on specific aspects, areas of operations, and
target goals to ensure the conformity of the performance to the proposed goals. Basic task before the appraiser
is to study progress in term of cost productivity ratio, time schedule relationship, inter-action between different
agencies, and performance of personnel in terms of their responsibilities and objectives of the company.
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Important ingredients of appraisal are the following:
(1) Objectives as defined in the proposal to be kept in view for satisfactory assessment of operational
courses;
(2) Accuracy of methods and measurements planned to be adopted is well adhered to;
(3) Objectivity of the proposal is highlighted so as to keep off from the bias and personnel prejudices;
(4) Ensure the reliability of the data and projected statements;
(5) Predictors made to conform to reality and should be objective.
In project appraisal above points should be kept in view by the members of appraisal team irrespective of the
fact whether the appraisal is being done for an industrial project being implemented by a corporate unit or the
project devoted to the national economy sponsored by the state agency.
Form the angle of a company unit the project appraisal of the project may be done at three stages as under:
(1) Projects appraisal by the corporate unit itself i.e. the promoters of the company are interested in ensuring
that on successful implementation of the project whether or not it would generate the required rate of
return on the total investment. The promoters make selection of the projects following investment criteria
of obtaining the required rate of return. In this appraisal , all aspects with reference to project idea are
identified and evaluated. As a matter of fact, it is a feasibility study done to identify the project, identify
internal constraints and external difficulties, environmental constraints including government placed
restrictions and regulations. Once the promoters are satisfied on this aspect, they have the formal
feasibility report prepared and consider it for investment purposes.
(2) Second stage of project appraisal arises when a project report duly accepted by the promoters is submitted
by the corporate unit of financial institution for considering it for grant of financial institution for considering
it for grant of financial facilities to finance the cost of implementation of the project.
(3) Project appraisal is done by Government agencies for according approvals required to clear a particular
project under the different statues or state regulations. The main criterion followed by Government
agencies is the cost benefit analysis and social gains.
PROJECT APPRAISAL UNDER INFLATIONARY CONDITIONS

Timing for project appraisal is most important consideration for all types of appraisers. A project under normal
circumstances is appraised from different angles viz. technical feasibility, managerial aspects, commercial aspects,
financial viability and economic and social aspects.
Under the normal conditions when prices are generally stable, demand pattern as projected in the project report
is unchangeable, the project cost described in the project report remains unchanged at current prices and as
such there is not much danger of any sudden escalation in project cost or over run in the projected resources.
There is practically no risk involved of either business or financial nature and evaluation of the project could be
done from different angles without providing for any change in project cost and planning for additional financial
resources to meet the over run or escalations.
Nevertheless, project appraisal cant be devoid of inflationary pressures as normal conditions for a project do
not exist. Because the project is to be implemented over a period of time ranging upon the size and magnitude
of the project, i.e. it could be six months or beyond to run or two or more years. During such a period, it cant be
predicted as and when the trade cycles set in and the up-turn in economy is generated.
In a developing economy like India, inflation grow at a planned steady rate because of the economic development
activities and as such provision for a probable escalation in the project cost is generally provided as a cushion
to inflationary pressures.
Lesson 6
However, during inflationary conditions the project cost is affected in magnitude of parameters. Cost of project
on all heads viz. labour wage, raw material, fixed assets, equipments, plant and machinery, building material,
remuneration of technicians and managerial personnels undergo a shift change. Besides, inflationary conditions
place constraints on the resources of the consumers of the product and affect the demand pattern. Thus cost at
production are affected besides the projected statements of profitability and cash flow by the change in the
demand pattern and market forecasting figures. The inflationary pressures alone do not stop here. The financial
institution and banks revise their rate of lending and their financing cost further escalate during inflationary
conditions. Under such conditions, the appraisal of the project generally be done keeping in view the following
guidelines which are usually followed by the Government agencies, banks and financial institutions:
(1) Make provisions for delay in project implementation, escalation in project cost as per the forecasted rate
of inflation in the economy particularly on all heads of cost.
(2) Sources of finance should be carefully scrutinized with reference to revision in the rate of interest to be
made by lender and the revision which could be followed in the interest bearing securities. All these
factors will push up the cost of financial resources for the corporate unit.
(3) Profitability and cash flow projections as made in the project report require revision and adjustment
should be made to take care of the inflationary pressures affecting adversely future projections.
(4) Explain fully the criteria followed in adjusting the inflationary pressures viz. there are two criteria followed
given as under:(a) take inflationary rate at average rate and escalate the total cost at that rate;
(b) adjust each cost item against inflationary rate. This would make adjustment for inflationary pressures
in the cost elements responsible outflows and the revenue elements in the cash. Both cash inflows
and outflows will accordingly adjust to inflationary changes at the appropriate rate applicable to
each of them respectively.
(5) Examine the financial viability of the project at the revised rates and assess the same with reference to
economic justification of the project. The appropriate measure for this aspect is the economic rate of
return for the project which will equate the present value of capital expenditure to net cash flows over
the life of the project. The rate of return should be acceptable which accommodates the rate of inflation
per annum.
(6) In inflationary times, early pay back projects should be prepared. Because projects with long pay back are
more subjected to inflationary pressures and the cash flow generated by the project will bear high risk.
PROJECT APPRAISAL UNDER DEFLATIONARY CONDITIONS

A different situation may arise in deflationary or recessionary situation. The economy is in down swing, prices
are falling, lack of effective demand is discernible, production capacities are already affected narrowing the cash
inflows affecting liquidity of the project adversely because wages and salaries and other overhead costs do not
fall which keeps the outflow at static rate with declining inflows. The main consideration in project appraisal
during this period is the cash inflow, sales, the demand for the projects and sales forecasting outliving the
predictions. As a matter of fact new project are delayed as the appraisal never remains so realistic and the
sources of supply of money become tight; investors have no enthusiasm in investing this money or savings in
the corporate securities for the uncertain working results and higher risk investment. Nevertheless, the appraisal
of the project should be done keeping in view the above factors.
From the above discussion, it is concluded that the difference in project appraisal during normal inflationary and
deflationary condition is only of degree if due care is taken to adjust the economic, commercial or financial
aspects of the project affecting the cost and cash inflows, the profitability and liquidity of the project.
170 PP-FT&FM
PROJECT APPRAISAL BY FINANCIAL INSTITUTIONS

Project Report submitted by a corporate unit to a financial institution for grant of financial facilities is properly
appraised by a team of expert drawn from different disciplines.
The project appraisal is done as a business risk and, therefore, efforts are made to corroborate the data
submitted by a company with authentic sources. Each project is appraised on its own merits and flexibility is
observed while applying the norms of ratio analysis, funds flow analysis, financial indicators, technical norms
etc. The basic objective during appraisal remains the project and its future in the form of successful implementation
and efficient operation so as to contribute to national economy. If a project remains successful, the money lend
by financial institutions is returned safely. The growth of the project is the best security for the financial institutions
than the physical and legal security. No doubt this security from an important part in the entire transaction for
lending and borrowing for the project.
Viewing from the above angle, project appraisal, in general, by the financial institutions seek to consider inter
alia the following aspects:
(1) The project profile, its reliable and formulation and project report;
(2) The promoters capacity and competence;
(3) Viability Tests:
(A) Technical Aspects
(B) Financial Aspects
(C) Economic Aspects
(D) Societal/Distributive Aspects
(E) Environment, Energy Management and Economical Aspects
(F) Organisation and Management Aspects
(G) Commercial Inclduing Marketing Aspects
Now, we would be analyzing each aspect in detail
The Project
The first and foremost consideration for appraisal of project report by a financial institution is the examination of
the project itself. It may be recalled that the term lending financial institutions have been established by the
Government with the sole objective to promote development and growth of the industries which are given
planned priorities for the economic development of the country. Therefore, the project should be such which
meet this standard and falls within the category of approved projects.
Another important consideration in this area is that the project report prepared by the corporate unit should
confirm to the prescribed standard of the financial institutions. To be on the safe side, it is desirable if the project
report is prepared by the reputed consultants approved by the financial institutions or the Technical Consultancies
organisation established in different parts of the country by the financial institution.
There is no standard performa for preparation of report but to facilitate its easy appraisal it should be self
contained study with all necessary feasibility reports, market surveys, projected financial statements, managerial
personnel and organisational charts, status of the company in the ownership and title to the property and the
legal relationship with the promoters be clearly specified to avoid discrepancies and confusions. In reality, the
prescribed application form for financing by the financial institutions contains clauses to bring out most of the
salient features in accepting a project proposal.
Lesson 6
2. The Promoters: Capacity and competence

The promoters capacity and competence should be examined with reference to their management background,
traits as entrepreneurs, business or industrial experience, and past performance in other concerns, their integrity
and reputation, market standing and legal competence.
Different considerations have got to be applied for the established entrepreneurs, or promoters and the new
entrepreneurs. The basic requirement is that their profile should inspire confidence of their abilities and capacities
to run the project successfully and continue the interest therein till the repayment of the financial facilities disbursed
by the institutions to the unit promoted by them. In the cases of technocrats who are coming up and taking up the
industrial project, these aspects are paid more attention than their experience with entrepreneurism ability or
skills.
3. Viability Tests
After analyzing the Project and Promoters capacity, a bank/financial institution carries out the different validity
tests
A. Technical Aspects of Project Appraisal
This involves studying the feasibility of selected technical processes and its suitability under Indian conditions,
Location of the project, Plant layout, appropriateness of the chosen equipment, machinery and technology,
availability of raw material, power and other inputs, appropriateness of technology chosen from social point of
view, availability of infrastructure for the project, the techno economic assumptions and parameters used for
analyzing costs and benefits and viability provision for treatment of effluents, training of manpower, legal
requirement on documentation, license and registration.
The technical feasibility is generally examined by technical specialists in the organizations. In case of highly
specialized projects, the banks seek opinions or get the projects appraised through experts like consultants, or
organizations like Technical Consultancy Organizations (TCOs).
B. The Financial Aspects of Project Appraisal
Financial Appraisal of a project is most important for a banker. The primary aim of financial analysis is to determine
whether the project satisfies the investment criteria of generating acceptable level of profitability. The project
should be able to service the debt and ensure expected returns to the investor. The important aspects which are
examined while conducting financial appraisal are investment outlay, means of financing, projected financial
statements, viability and profitability, break-even point analysis, sensitivity analysis and risk analysis.
Cash flow statement is the basis for financial analysis. In the initial period there is a negative cash flow because
of investment in capital assets, but after the project takes off, the cash flow becomes positive due to the increased
income.
Investment is generally required in the initial years, which is a cash outflow for the project. In the operational
phase, there is inflow from the business, which results in positive cash flow till the project is wound up. In the last
year, the inflow is higher due to the residual value adding to the cash inflow.
The period from start of the project till its winding up is known as project life and will vary from project to project.
Generally, projects with more than 20 years life are analyzed for financial cost and benefits for 20 years only, as
the benefits accruing after that have a negligible present value.
(a) Measures of Financial Viability NPV, BCR and IRR
Financial viability is measured by net present value, benefit cost ratio, internal rate of return and debt service
coverage ratios.
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Net Present Value (NPV) representing wealth creation by the Project, is calculated by taking the discounted sum
of the stream of cash flows during the project life. In symbolic terms we can express NPV of a project as under:
n
1
2
...
Invst.
NPV = (1 r )
(1 r )3
(1 r )n
Where C = Cash Flows for different periods, r = Discount Rate and Invest. = Initial Investment
In other words, NPV represents the difference between the present value of the cost and benefit streams.
A project is considered viable if the NPV is positive at a given discount rate and vice-versa. When two or more
mutually exclusive projects are being appraised, the project with the highest NPV should be selected. Among
the discounted techniques, NPV is considered the most important parameter for assessing viability.
(i) Benefit Cost Ratio (BCR):BCR is the ratio of discounted value of benefit and discount value of cost. It
can be expressed as under:BCR =
Summation of discounted value of Benefits

Summation of discounted value of Costs
The project is viable when BCR is one or more than one and is unviable when it is less than one.
(ii) Internal Rate of Return (IRR):IRR represents the returns internally generated by the project. This is
also the rate which makes the net present value equal to 0. The calculation of IRR is a process of trial
and error. Normally, the process starts with the minimum discount rate and as the discount rate is
increased the NPV will come down and becomes 0 or negative. If NPV is positive at one rate and
negative at the immediate next rate (for example if NPV is positive at 20% discount rate and is negative
at 25%), Interpolation Method could be used for finding out the exact IRR by the following formula.
Exact IRR by interpolation method =
L + (H L) (NPV at L)
{(NPV at L) (NPV at H)}
Where, IRR = Internal Rate of Return; L = Lower discount rate where NPV was positive; H = Higher
discount rate at which NPV was negative.
The project is considered viable if the IRR is more than the acceptable rate for the entrepreneur which
could be the opportunity cost for his funds. In case of agricultural and rural development projects generally
the prescribed IRR for viability is 15% in India and other developing countries.
(b) Sensitivity Analysis
Projects are sensitive to fluctuation in values of critical variables like costs of inputs and prices of outputs. It is
important to examine how sensitive is the project to fluctuations in the values of these variables because the
basic assumptions taken for projections of balance sheet, cash flow statements for future years have an element
of uncertainty. Different projects may, however, get affected differently from changes in the assumption of cost
and return items. Sensitivity analysis helps us in finding out that how sensitive is the project to these fluctuations.
Sensitivity analysis involves identification of crucial variable relating to costs and returns, specification of alternative
values of the crucial variables and re-computation of the NPV and IRR by using the alternative values. A project,
which is highly sensitive to even small fluctuations in cost and price, is a risky project for financing.
(c) Scenario Analysis
Sensitivity analysis takes care of only one or two variable which is at times inadequate. This limitation is partially
overcome by what is known as scenario analysis, where scenario of certain prices, cost and other variables are
created and the financial parameters are computed.
Lesson 6
(d) Risk Analysis

Even though through sensitivity analysis and scenario analysis techniques, some of the uncertainties in the
project are taken care, both these types of analysis have limitation that they have deterministic values for the
variables. In a significant improvement over these methods, under risk analysis, probabilistic analysis is done by
identification of key risk variables, finding out values of each risk variable, assigning probabilities for each value
to each of the risk variables, using these values for risk analysis and finding out the probability of negative
outcome of the project, i.e. what is the probability that the NPV of the project will be negative.
The risk analysis adds valuable information to the project analysis and it is an important tool in this respect but
to take up investment or not depends on the risk taking capacity of the entrepreneur which will vary from person
to person. Therefore, it is judgmental in nature.
C. Economic Appraisal
The objective of economic appraisal is to examine the project from the entire economys point of view to determine
whether the project will improve the economic welfare of the country. Economic appraisal is traditionally not
conducted in banks or financial institutions. It is generally conducted by agencies like the World Bank and the
development agencies of the Government for the projects having huge investment and profound implication for
the economy. Examples of the projects where economic analysis is conducted are big dams, forestry projects
and big industrial projects.
D. Social/distributive Appraisal
For an analysis of a project to be complete, it should include not only the financial and economic but also social
appraisal. The social analysis consists of two parts: measurement of the distribution of the income due to the
project and identification of the impact on the basic needs objectives of the society.
The steps involved in social appraisal are: conducting financial analysis, economic analysis and appraisal of
distributional effect of the net benefits (externalities) of the project. Here, the affected parties like farmers, dealers
of the goods, existing operators and Government are to be identified. One party (like farmers whose lands will
be irrigated in the case of a dam) is a gainer but the other (like those who are displaced due to the dam) is a
loser.
After social and distributive analysis it may emerge that a project is financially unviable but socially and
economically is viable. In such situations the decisions to undertake the project would depend upon the goals of
the Government. If the Government believes that the positive externalities are worth the negative financial cash
flow, it may decide to implement the project.
E. Environmental Aspects
Developing countries including India are now becoming increasingly aware of the urgency to integrate
environmental concerns into their project formulations and appraisal. This has led to the increased importance
being attached to the environmental aspects in the projects and now most of the banks and financial institutions
insist on what is known as Environmental Impact Assessment (EIA). The essence of EIA is a prediction of the
consequences to the natural environment from development projects.
The emphasis in EIA is on those consequences of the projects which are relatively well known and whose
magnitudes can be easily estimated. Conditional, uncertain or probabilistic aspects of the impacts are not
considered. Another elaborate analysis called Environmental risk Assessment (ERA) is used to differentiate a
new and additional analysis in which the probabilistic element is explicitly addressed.
In India, the consciousness has already come at the policy level. A separate ministry has been formed and
Environment (Protection) Act, 1986 was passed by the Government of India. Further, Central Pollution Control
Board (CPCB) has been formed for ensuring proper implementation of the provisions of the Act. Most of the
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industries are covered by the Act and therefore such industries have to seek clearance not only before setting
up of industries but also on a regular basis from the state level PCBs. State level PCBs implement the standards
set by CPCB. Reserve Bank of India has also directed the banks not to extend certain credit facilities to industries
which have deleterious effects on the environment. Thus, environmental aspects of the projects are becoming
very important in project appraisal.
F. Organizational and Managerial Aspects

The organizational and managerial aspects evaluate the managerial capacity of the organization or the
entrepreneur, responsible for implementing the project. Even if very good technology is chosen for the project,
it may fail due to lack of or inadequate managerial capability. In small agricultural and other projects the
entrepreneur is responsible for taking care of all these aspects. It is important for the banker to judge the
borrowers managerial capability and also his financial capability (worth). In case of cost escalation he should be
in a position to meet the additional financial requirement for the project.
G. Commercial Aspects Including Marketing

Commercial aspects of a project include arrangement for supply of inputs for the initiation and operation of the
project and marketing of outputs. Some experts prefer to have a separate marketing module and would treat it
as the most important aspect of appraisal.
LENDING POLICIES AND APPRAISAL NORMS BY FINANCIAL INSTITUTIONS AND BANKS

Lending policy and appraisal norms by banks are decided by the Reserve Bank of India. RBI has issued a
master circular i.e. Master Circular DBOD. No. Dir. BC. 6/13.03.00/2010-11 dated July 1, 2011 suitably updated
by the instructions issued up to June 30, 2012. Banks determine their lending policies on the basis of RBI
circulars/instructions and government policies.
To lend, banks depend largely on deposits from the public. Banks act as custodian of public deposits. Since the
depositors require safety and security of their deposits, want to withdraw deposits whenever they need and also
adequate return, bank lending must necessarily be based on principles that reflect these concerns of the
depositors.
These principles include: safety, liquidity, profitability, and risk diversion.
(1) Safety
Banks need to ensure that advances are safe and money lent out by them will come back. Since the repayment
of loans depends on the borrowers capacity to pay, the banker must be satisfied before lending that the business
for which money is sought is a sound one. In addition, bankers many times insist on security against the loan,
which they fall back on if things go wrong for the business. The security must be adequate, readily marketable
and free of encumbrances.
(2) Liquidity
To maintain liquidity, banks have to ensure that money lent out by them is not locked up for long time by
designing the loan maturity period appropriately. Further, money must comeback as per the repayment schedule.
If loans become excessively illiquid, it may not be possible for bankers to meet their obligations vis--vis depositors.
(3) Profitability
To remain viable, a bank must earn adequate profit on its investment. This calls for adequate margin between
deposit rates and lending rates. In this respect, appropriate fixing of interest rates on both advances and deposits
is critical. Unless interest rates are competitively fixed and margins are adequate, banks may lose customers to
their competitors and become unprofitable.
Lesson 6
(4) Risk diversification

To mitigate risk, banks should lend to a diversified customer base. Diversification should be in terms of geographic
location, nature of business etc. If, for example, all the borrowers of a bank are concentrated in one region and
that region gets affected by a natural disaster, the banks profitability can be seriously affected.
LOAN POLICY
Based on the general principles of lending stated above, the Lending Policy Committee (LPC) of individual
banks prepares the basic Lending policy of the Bank, which has to be approved by the Banks Board of Directors.
The loan policy outlines lending guidelines and establishes operating procedures in all aspects of Lending
management including standards for presentation of Lending proposals, financial covenants, rating standards
and benchmarks, delegation of Lending approving powers, prudential limits on large Lending exposures, asset
concentrations, portfolio management, loan review mechanism, risk monitoring and evaluation, pricing of loans,
provisioning for bad debts, regulatory/ legal compliance etc. The lending guidelines reflect the specific banks
lending strategy (both at the macro level and individual borrower level) and have to be in conformity with RBI
guidelines. The loan policy typically lays down lending guidelines in the following areas:
Level of Lending-deposit ratio
Targeted portfolio mix
Hurdle ratings
Loan pricing
Collateral security
1. Lending Deposit (CD) Ratio

A bank can lend out only a certain proportion of its deposits, since some part of deposits have to be statutorily
maintained as Cash Reserve Ratio (CRR) deposits, and an additional part has to be used for making investment
in prescribed securities (Statutory Liquidity Ratio or SLR requirement). It may be noted that these are minimum
requirements. Banks have the option of having more cash reserves than CRR requirement and invest more in
SLR securities than they are required to. Further, banks also have the option to invest in non-SLR securities.
Therefore, the CPC has to lay down the quantum of Lending that can be granted by the bank as a percentage
of deposits available. Currently, the average CD ratio of the entire banking industry is around 70 percent, though
it differs across banks. It is rarely observed that banks lend out of their borrowings.
2. Targeted Portfolio Mix

The LPC aims at a targeted portfolio mix keeping in view both risk and return. Toward this end, it lays down
guidelines on choosing the preferred areas of lending (such as sunrise sectors and profitable sectors) as well as
the sectors to avoid. Banks typically monitor all major sectors of the economy. They target a portfolio mix in the
light of forecasts for growth and profitability for each sector. If a bank perceives economic weakness in a sector,
it would restrict new exposures to that segment and similarly, growing and profitable sectors of the economy
prompt banks to increase new exposures to those sectors. This entails active portfolio management. Further,
the bank also has to decide which sectors to avoid. For example, the LPC of a bank may be of the view that the
bank is already overextended in a particular industry and no more loans should be provided in that sector. It may
also like to avoid certain kinds of loans keeping in mind general Lending discipline, say loans for speculative
purposes, unsecured loans, etc.
3. Hurdle ratings
There are a number of diverse risk factors associated with borrowers. Banks should have a comprehensive risk
176 PP-FT&FM
rating system that serves as a single point indicator of diverse risk factors of a borrower. This helps taking
Lending decisions in a consistent manner. To facilitate this, a substantial degree of standardisation is required in
ratings across borrowers. The risk rating system should be so designed as to reveal the overall risk of lending.
For new borrowers, a bank usually lays down guidelines regarding minimum rating to be achieved by the borrower
to become eligible for the loan. This is also known as the hurdle rating criterion to be achieved by a new
borrower.
4. Pricing of loans
Risk-return trade-off is a fundamental aspect of risk management. Borrowers with weak financial position and,
hence, placed in higher risk category are provided Lending facilities at a higher price (that is, at higher interest).
The higher the Lending risk of a borrower the higher would be his cost of borrowing. To price Lending risks,
banks devise appropriate systems, which usually allow flexibility for revising the price (risk premium) due to
changes in rating. In other words, if the risk rating of a borrower deteriorates, his cost of borrowing should rise
and vice versa. At the macro level, loan pricing for a bank is dependent upon a number of its cost factors such
as cost of raising resources, cost of administration and overheads, cost of reserve assets like CRR and SLR,
cost of maintaining capital, percentage of bad debt, etc. Loan pricing is also dependent upon competition.
5. Collateral security
As part of a prudent lending policy, banks usually advance loans against some security. The loan policy provides
guidelines for this. In the case of term loans and working capital assets, banks take as primary security the
property or goods against which loans are granted. In addition to this, banks often ask for additional security or
collateral security in the form of both physical and financial assets to further bind the borrower. This reduces the
risk for the bank. Sometimes, loans are extended as clean loans for which only personal guarantee of the
borrower is taken.
6. Compliance with RBI guidelines

The Lending policy of a bank should be conformant with RBI guidelines; some of the important guidelines of the
RBI relating to bank Lending are discussed below.
7. Directed Lending stipulations

The RBI lays down guidelines regarding minimum advances to be made for priority sector advances, export
Lending finance, etc. These guidelines need to be kept in mind while formulating Lending policies for the Bank.
CAPITAL ADEQUACY
If a bank creates assets-loans or investment-they are required to be backed up by bank capital; the amount of
capital they have to be backed up by depends on the risk of individual assets that the bank acquires. The riskier the
asset, the larger would be the capital it has to be backed up by. This is so, because bank capital provides a cushion
against unexpected losses of banks and riskier assets would require larger amounts of capital to act as cushion.
The Basel Committee for Bank Supervision (BCBS) has prescribed a set of norms for the capital requirement for
the banks for all countries to follow. These norms ensure that capital should be adequate to absorb unexpected
losses. In addition, all countries, including India, establish their own guidelines for risk based capital framework
known as Capital Adequacy Norms. These norms have to be at least as stringent as the norms set by the Basel
committee. A key norm of the Basel committee is the Capital Adequacy Ratio (CAR), also known as Capital Risk
Weighted Assets Ratio, is a simple measure of the soundness of a bank. The ratio is the capital with the bank as a
percentage of its risk-weighted assets. Given the level of capital available with an individual bank, this ratio determines
the maximum extent to which the bank can lend. The Basel committee specifies a CAR of at least 8% for banks.
This means that the capital funds of a bank must be at least 8 percent of the banks risk weighted assets. In India,
the RBI has specified a minimum of 9%, which is more stringent than the international norm.
Lesson 6
The RBI also provides guidelines about how much risk weights banks should assign to different classes of
assets (such as loans). The riskier the asset class, the higher would be the risk weight. Thus, the real estate
assets, for example, are given very high risk weights. This regulatory requirement that each individual bank has
to maintain a minimum level of capital, which is commensurate with the risk profile of the banks assets, plays a
critical role in the safety and soundness of individual banks and the banking system.
LENDING EXPOSURE LIMITS

As a prudential measure aimed at better risk management and avoidance of concentration of Lending risks, the
Reserve Bank has fixed limits on bank exposure to the capital market as well as to individual and group borrowers
with reference to a banks capital. Limits on inter-bank exposures have also been placed. Banks are further
encouraged to place internal caps on their sectoral exposures, their exposure to commercial real estate and to
unsecured exposures. These exposures are closely monitored by the Reserve Bank. Prudential norms on
banks exposures to NBFCs and to related entities are also in place.
Exposure norms for Commercial banks in India

Exposure to
1. Single Borrower
Limit
15 per cent of capital fund (Additional
5 percent on infrastructure exposure)
2. Group Borrower
40 percent of capital fund (Additional

10 percent on infrastructure exposure)
3. NBFC
10 percent of capital fund
4. NBFC - AFC
15 percent of capital fund
5. Indian Joint Venture/Wholly owned
20 percent of capital fund subsidiaries abroad/ Overseas

step down subsidiaries of Indian corporates
6. Capital Market Exposure

(a) Banks' holding of shares in any
The lesser of 30 percent of paid-up share company capital

of the company or 30 percent of the paid-up capital of banks
(b) Banks' aggregate exposure to
40 percent of its net worth capital market (solo basis)
(c) Banks' aggregate exposure to
40 percent of its consolidated net worth capital market

(group basis)
(d) Banks' direct exposure to capital
20 percent of net worth market (solo basis)
(e) Banks' direct exposure to capital
20 percent of consolidated net worth market (group basis)
7. Gross Holding of capital among
10 per cent of capital fund banks / financial institutions
Some of the categories of the above table are discussed below:

1. Individual Borrowers: A banks Lending exposure to individual borrowers must not exceed 15 % of the
Banks capital funds. Lending exposure to individual borrowers may exceed the exposure norm of 15 %
of capital funds by an additional 5 % (i.e. up to 20 %) provided the additional Lending exposure is on
account of infrastructure financing.
2. Group Borrowers: A banks exposure to a group of companies under the same management control
must not exceed 40% of the Banks capital funds unless the exposure is in respect of an infrastructure
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project. In that case, the exposure to a group of companies under the same management control may
be up to 50% of the Banks capital funds.
3. Aggregate exposure to capital market: A banks aggregate exposure to the capital market, including
both fund based and non-fund based exposure to capital market, in all forms should not exceed 40
percent of its net worth as on March 31 of the previous year.
In addition to ensuring compliance with the above guidelines laid down by RBI, a Bank may fix its own Lending
exposure limits for mitigating Lending risk. The bank may, for example, set upper caps on exposures to sensitive
sectors like commodity sector, real estate sector and capital markets. Banks also may lay down guidelines
regarding exposure limits to unsecured loans.
Lending Rates
Banks are free to determine their own lending rates on all kinds of advances except a few such as export
finance; interest rates on these exceptional categories of advances are regulated by the RBI. It may be noted
that the Section 21A of the BR Act provides that the rate of interest charged by a bank shall not be reopened by
any court on the ground that the rate of interest charged is excessive. The concept of benchmark prime lending
rate (BPLR) was however introduced in November 2003 for pricing of loans by commercial banks with the
objective of enhancing transparency in the pricing of their loan products. Each bank must declare its benchmark
prime lending rate (BPLR) as approved by its Board of Directors. A banks BPLR is the interest rate to be
charged to its best clients; that is, clients with the lowest Lending risk. Each bank is also required to indicate the
maximum spread over the BPLR for various Lending exposures. However, BPLR lost its relevance over time as
a meaningful reference rate, as the bulk of loans were advanced below BPLR. Further, this also impedes the
smooth transmission of monetary signals by the RBI.
LOAN DOCUMENTATION
Term lending by the Financial Institutions is a high risk business and is therefore important for them to satisfy
themselves that no legal lacuna or formality is omitted as might expose the Financial Institutions to the danger
of losing the money lent. The relationship between the Lender and the Borrower is a legal relationship which
results in mutual rights, duties and liabilities and commercial prudence demands that these should be well
expressed and be fool proof as far as possible. Loan documentation is one of the most important aspects of
banking and banks are very cautious in documentation for a project financing
Procedure for execution of documents has been standardized in most of the cases. Sometimes delay takes
place in providing certain documents required in connection with the execution of the loan documents. The
Company Secretary of the Borrower should therefore in consultation with Legal Department of the financial
institution and the Companys advocate arrange to have:
(a) Inspection and investigation of the Title Deeds of the Borrower in respect of its properties by the Lenders
and/or by the advocates chosen by the Borrower from the panel maintained by the Lenders to establish
a clear and marketable title in favour of the Borrower to its properties.
(b) Approval of the shareholders of the company for mortgaging/charging companys properties in favour of
the Financial Institutions as required under Section 293(1)(a) of the Companies Act, 1956;
(c) Shareholders Authority to the Board of directors of the company to borrow in excess of the limits
of its paid-up capital and free reserves as required under Section 293(1)(a) of Companies Act,
1956;
(d) Resolution of the Board of directors of the Company accepting the terms and conditions of the Sanction
Letter or Letter of Intent issued by the Financial institution sanctioning the term loan and execution of
Loan Agreement and Deed of Hypothecation.
Lesson 6
(e) Normally the Lending Institution obtains several undertakings from the borrower on stamp papers. These
are:
(i) Undertakings from the Promoters Group regarding non-disposal of their shares in the Company
without prior approval of the Lender;
(ii) Undertaking by the Promoters to meet the over-run in the cost of the project without having recourse
to the Institutions and agreeing not to withdraw the unsecured loans and deposits brought in by the
Promoters/their Group for financing the project;
(iii) Undertaking to complete the pending formalities given in the Sanction Letter within a stipulated
period and also to create the Mortgage (if not completed) within a stipulated period.
(f) The Institution in the case of bridge loan gets a Demand Promissory Note signed by the authorized
Director.
(g) The Institution also obtains a No-lien letter from the Companys Bank to which the sanctioned loan
amount is to be credited. Format of this No-lien letter is provided by the Lending institution.
(h) Permission of the Income-tax authorities under Section 281 of ITA.
(i) Letter of Confirmation under Section 9A of IDBI Act that none of its Directors are interested in the project
being financed.
(j) Permission/exemption under Urban Land Ceiling Act, wherever required.
As such before signing the Loan Documents with the Financial Institutions, the Company secretary should,
besides keeping the aforementioned documents/paper, constantly liaise with the lenders to ascertain if any
further compliance is required to enable disbursement of the loan amount as soon as the documentation gets
completed.
The importance of the Loan Agreement and its main terms and conditions are discussed hereunder.
Loan Agreement of Financial Institutions

The Loan agreement is an agreement expressed in writing and entered into between the borrower and the
lender bank, institution or other creditors. It envisages a relationship taking into account the commitment made
at that time and the conduct of the parties carrying legal sanctions.
A company, as a borrower, delivers power to borrow under the Memorandum of Association and Articles of
Association read with the provision of the Companies Act, 1956. The agreement as such is required to be on
behalf of the company under its express or implied authority and may in the same manner be varied or discharged.
Loan agreement for borrowing money from financial institutions can be executed under the authority of the
Board authorization and authorizing affixation of the common seal of the company on the documents at the time
of its execution. An agreement, thus executed, binds the company and is valid in the eyes of law.
Usual conditions in Loan Agreement

(1) Loan Agreement Terms
The loan agreement begins with the date of execution and description of the parties to the agreement. The
main terms used in the loan agreement are defined and a brief description of project and financing plan is
given.
The Terms of Loan
(a) Under the terms of the loan, the exact amount of the loan the company agreed to borrow is specified.
(b) After mention of the loan agreement amount, another important clause in the loan agreement is interest
180 PP-FT&FM
which contains the exact rate of interest applicable to the loan and mode of its payment which is quarterly
installments falling due on specified dates. In the eventuality of default in payment of instalment of
interest, the clause contains provisions of compound interest being reckoned with rests taken or made
quarterly. There is provision for interest on defaulted installments of principal. Again liquidation damages
are to be paid on such defaulted sums at the rate settled by the financial institutions. The clause also
describes the mode of computation of interest and other charges.
(c) Another important clause in the Loan Agreement is the conversion of the option into Equity. In line with
the Governments policy, mandatory conversion option has been done away with. Institutions shall,
however, have a right to convert loan into equity in the event of default and assistance granted for
rehabilitation of the borrower concern or to meet a part of the cost of over-run. In case of conversion of
loan into equity is applicable to a particular loan it is so stated under the clause conversion right. The
institutions reserve a right to convert at par the entire outstanding amount into equity and in the case of
conversion option attached to over-run cost of the project upto 20% of the additional assistance sanctioned
by the institutions. The consequence of conversion is that the portion of the loan so converted would
cease to carry interest as from the date of conversion and the loan stands correspondingly reduced.
Upon partial conversion, the instalment of loan payable after the date of conversion stands reduced
proportionately by the amount of the loan so converted into equity shares of the company. On such
conversion, the lender becomes the equity holder.
(d) Disbursement of the loan amount is another important aspect. The loan agreement describes the terms
of disbursement. The basic idea is that the loan amount is required to be used by the borrower company
as per the schedule of expenditure submitted by it and all expenditure is to be adhered to as per the
schedule. The institutions want that the amount so disbursed by them should be used for the purpose of
project implementation only. With this end in view, the draw-down schedule of the loan amount is drawn
and mode of disbursement for the loan is also specified in the agreement.
(e) Another important term of the loan agreement is the repayment of loan. The borrower has to repay the
principal amount of the loan in quarterly instalments to the lender institution from a particular date
depending upon the moratorium allowed as per the information furnished in the application for the
financial assistance. The repayment clause contains provisions to exercise right by the lending institution
to vary or alter the repayment schedule wherever cash inflow/profitability position so warrants. The
company shall not make premature repayment of loan without prior permission of the lenders, and on
such request being made by the company, the lenders reserve the right to impose such conditions to
accept premature repayment. Generally, lenders stipulate payment of premium with such premature
repayments. However, premature repayment of foreign currency loan is not possible and only in very
special case the Institutions recommend such premature repayment after obtaining the approval of the
Ministry of Finance and of the Reserve Bank of India.
(2) The Security for loan
The security clause is an important clause in the loan agreement. The borrower company has to execute security
documents in favour of the lender on the basis of the provisions made in the agreement.
Loan Agreement stipulates security for the loan in the forms of mortgage of immovable properties, hypothecation
of movable assets and personal guarantee of the promoters/directors of the borrowing company. The security
clause stipulates first mortgage over the borrowers immovable and movable properties including its movable
machinery, spares, tools, and accessories, present and future, and also a first charge on all the remaining
assets of the borrower, present and future, (save and except book debts in the case of hypothecation), subject
to prior charges created and/to be created in favour of the borrowers bankers on the borrowers stocks of the
raw materials, semi-finished goods and finished goods, consumable stores and book debts and such other
movables as may be agreed to by the lenders for securing borrowing for working capital requirements in the
Lesson 6
ordinary course of the business. Where there are more than one mending institution involved, the mortgage and
charge are to be created on pari-passu basis in favour of such institutions.
The provision of personal guarantee of Promoter/Directors made in the security clause is discretionary. The
institutions in some cases obtain pledge of unencumbered shares held by the promoter as security for the loan.
In these cases, it is to be ensured that the shares are not subject to lock-in-period or the intention to create the
pledge is discussed in the prospectus.
(3) Borrowers Warranties
Under this clause the borrower ensures the lenders of the accurate description of the project in the Loan
Application, on the basis of which the borrower has been granted the loan followed by execution of the agreement.
The borrower also undertakes to furnish correct information relating to the project to the lender in future also.
Besides, this clause requires the borrower to disclose any material affecting the project in future also. Such
changes may cover scope of the projects, the location of its factory, the processes to be used for the manufacture
of its products, the line of activity, the specifications of machinery and equipment required for the project, buying
and selling arrangements, the management set-up, the arrangements entered into with collaborators, machinery
suppliers and technical consultants etc. except as approved by the lenders from time to time.
Warranties clause also cover assurance by the borrower for a good title to its properties. The assurance specifies
that there has been no changes or encumbrances on the property or the assets of the borrower; that the
properties are not involved in any litigation of title or ownership; that there is no defect in the property affecting
its title, of ownership; that there is no infringement of public law, or no default in payment of demands of
Municipalities or other statutory authorities etc. Further, warranty also covers that the properties are not affected
by any public schemes like widening of public roads etc.
In addition to the above, the warranties clause covers briefly about the selling and purchasing arrangements;
management agreements; financial position; auditors certificates, permissions under FEMA; various consents/
licence from Government of India or State Agencies; Agreement with technical consultants/collaborators;
agreements with machinery suppliers; construction schedules; cash budgets; supply of power, water, raw material,
arrangements for working capital and arrangements for meeting short fall in the resources for completion of the
project. Compliance of provisions of the Companies Act, 1956 in relation to borrowing like passing of requisite
resolutions under Sections 293(1)(a) and 293(1)(d); adequacy of technical, financial and executive staff;
resolving conflict in Memorandum of Association and Articles of Association exist in loan agreement. This list
of warranties is not complete or exhaustive but only illustrative. Additional conditions befitting the circumstances
are appended whenever the Institution deems them fit.
(4) Condition Precedent to Disbursement of the Loan
To safeguard the interest of the financial institutions, the borrower is required to comply with the following
matters incorporated under this clause in the Loan Agreement:
(a) The borrower shall have share capital paid-up to the required extent as stipulated in the loan agreement;
(b) The borrowers shall have created security in favour of lenders having proved to the satisfaction of the
lenders about the borrowers clear and marketable title over its properties;
(c) The borrower shall have complied with the provisions of the Companies Act, 1956, viz. under Section
293(1)(a) as applicable;
(d) The borrower shall have entered into arrangements with other financial institutions and banks where so
required for the balance portion of the funds required for completion of the project;
(e) The borrower has furnished tax clearance certificate under Section 230A of the Income-tax Act, 1961;
(whenever applicable)
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(f) That there are no legal proceedings pending against the borrower company involving any claim on its
properties;
(g) There has been no default discharge of its obligations to the financial institutions;
(h) The borrower shall satisfy the lender of the utilisation of earlier disbursed amount of the loan.
Here, also additional conditions precedent to disbursement could be added depending upon the circumstances
of each case as the Institution may deem fit. Similarly, some of the above conditions could even be deleted
where the circumstances so warrant when compliance of such conditions in a particular case is not required.
(5) Concurrent Covenants
The affirmative covenants and terms as given in the Loan Agreement which apply during the currency of the
Loan Agreement cover the following subject matter:
(a) Project implementation;
(b) Utilisation of loan;
(c) Loan amount to be kept in separate Bank Account;
(d) Insurance of the mortgaged assets and insurance policies to be furnished to the lenders endorsing the
Lenders as Mortgages;
(e) To report to the lender any changes in project;
(f) To report to the lender any adverse changes in the production and profitability projections;
(g) To report to the lender the changes in different contractors/agreements as covered in the loan agreement
specially those made with machinery suppliers/collaborators/technicians or technical consultants and
suppliers of raw materials;
(h) Borrower to ensure proper maintenance of the property;
(i) Borrower to inform the lender of the notices received by it about the winding up proceedings and other
legal process instituted against the company;
(j) Borrower to inform the lenders of the causes of delay in completion of the project;
(k) Borrower to inform any loss-damages the borrower suffers due to any unforeseen circumstances;
(l) On happening of certain events proportionate repayment of the loan is required to be made by the
borrower. These, events may include payment being made to other lenders covered under the loan
syndication arrangements without making proportionate payments to all i.e. preference being made in
payment of dues by paying one over the other;
(m) The borrower to reimburse and pay costs/charges and expenses to lenders e.g. travelling expenses of
lenders inspection team etc.
(n) Furnish to lenders the documents executed in favour of banks and other institutions;
(o) Make alterations in memorandum of association and articles of association as desired by the lenders;
(p) Pass necessary resolutions to entitle lenders to rights shares/bonus shares where a right of conversion
of loan into equity has been exercised by the lenders;
(q) Furnish details of additional property, movable or immovable acquired by the company subsequent to
the creation of mortgage;
(r) Borrower shall facilitate the appointment of the lenders nominee directors;
Lesson 6
(s) Borrower to agree to the lenders right to depute observers at meetings of the Board of directors or
General Meeting of the Borrower Company.
(t) Borrower to place before its Board of Directors for consideration of all important matters and also those
matters which the lenders may desire;
(u) Borrower to uphold lenders rights to appoint Technical/Management consultants and chartered
accountants as and when the lender may so decide.
Negative Covenants
In addition to the above positive covenants, there are certain negative covenants in the agreement which is
required to be performed by the borrower. These negative covenants restrict the company (1) to pay commission
to promoters, directors, managers or other persons for furnishing guarantee or indemnity or for undertaking any
other liability in connection with any financial assistance obtained and/or to be obtained by the borrower for the
purpose of the project; (2) to pay dividend to the equity share holders if default has been committed in payment
of interest or repayment of installments of principal to the lenders; (3) to create charge or lien on its assets; (4)
to enter into any partnership, profit-sharing or royalty agreements or enter into any similar arrangements whereby
the business or operations of the company are affected; (5) to create any subsidiary or become subsidiary to
any other existing concern; (6) to recognize or register any transfer of shares in the borrowers share capital by
the promoter directors, their relatives and associates who are required to furnish Undertaking for non-disposal
of shares to the Financial Institutions; (7) to permit withdrawal of unsecured loans and deposits brought in or
to be brought in by the Promoter Directors Group or Associates to finance capital cost of the project and to meet
the working capital needs unless such withdrawal or payment of interest on such unsecured loan and deposit is
permitted by the lenders.
The various other aspects covered under the negative covenants include not to carry out (1) the amendment of
the memorandum of association and articles of association or alteration in the capital structure of the Company
i.e. borrower (2) transfer of undertaking, trading activity other than the activities permitted by the Lenders (3)
payment of directors remuneration, in addition to what has been approved by the Central Government and
the Institution. Negative covenants also relate to (1) Mergers/consolidation etc. utilisation of funds, donations,
new project, change of registered office and location of factory, not to raise loans or debentures or invest funds
in other concerns etc. without the prior approval of the Lenders.
(6) Reporting System and Inspections
The borrower company is required to submit to the lender the quarterly/half-yearly progress reports during the
period when project implementation is in progress. Once the project is completed and production is commenced
the borrower company is required to submit quarterly progress reports of production, sales, gross profits and
other important details having a bearing on the operational performance of the company. Besides, the audited
annual accounts of the company are also required to be submitted by the company to the lenders.
In addition to above and obtaining the information through periodical reports, the loan agreement contains
provision for having the inspection of the borrower concern carried out periodically by the lenders to verify
project expenditure, Books of Accounts and records; technical-cum-financial-cum-legal inspections through the
Institutional Inspection team of experts in different areas. This practice continues till the entire amount of the
loan is repaid. The cost of such inspection is borne and paid by the company on demand and until payment; the
same shall carry interest at the same rate as on defaulted sums under the loan agreement.
(7) Remedies for the Breach
The main remedy of the lender against the borrower is to call back the loan amount with interest and other dues.
The clause for remedies specifies those circumstances in which the lender can take recourse to such remedies.
These circumstances, inter alia, are default in payment of principal sum of the loan; interest and arrears of
interest, non-performance of covenants and conditions; supply of misleading information to the tenders relating
184 PP-FT&FM
to the projects, its promoters or relating to its operations; refusal to disburse loan by other Financial Institutions;
sales, disposal or removal of Assets of the Company without lenders approval etc. etc.
(8) Cancellation, Suspension and Termination of Loan
The lender may cancel any part of the loan by giving notice to the borrower if such loan amount remains
unavailed of by the borrower company. Any portion of the loan may be suspended or terminated for non-compliance
of the terms and conditions of the loan agreement by the borrower or on emergence of any extraordinary
situation. Such suspension shall continue till the default is remedied.
PROJECT REVIEW AND CONTROL

Project review is a very important aspect of entire project life.
Even projects that are well designed, comprehensively planned, fully resourced and meticulously executed
will face challenges. These challenges can take place at any point in the life of the project and the project
team must work to continually revisit the design, planning and implementation of the project to confirm they
are valid and to determine whether corrective actions need to be taken when the projects performance
deviates significantly from its design and its plan. This is the purpose of the Project Monitoring, Evaluation
and Control Phase.
Not surprisingly, the three principle categories of activities taking place during the Monitoring, Evaluation and
Control Phase are:
Project Monitoring
Project Evaluation
Project Control
These activities are intended to occur continuously and continually, taking place through the entire life of the
project. For example, the earliest iterations of the project indicators are already being developed during the
Project Identification and Design Phase; the Monitoring Plan is developed during the Planning Phase; monitoring
visits are conducted during the implementation phase, and many evaluation activities are undertaken during the
End of Project Transition Phase.
Differentiating Monitoring, Evaluation and Control

Before examining each of the three categories of activities in the Project Monitoring, Evaluation and Control
Phase in detail, it is first important to differentiate between them.
Progress Monitoring tracks the operational work of the project. It answers questions like Have activities been
completed as planned? Have outputs been produced as anticipated? Is the work of the project progressing
as projected? At a fundamental level it is a passive process, it changes nothing. Instead, it tells the project
manager where the project performance is in terms of money, time, risk, quality, and other areas of project
progress. At its core, the goal objectives, timing and activities of project progress monitoring are perhaps best
identified via the following table:
The What, Why, When and How of Monitoring
What
A continuous review of project progress at the activity and outputs levels Identify necessary
corrective action
Why
Analyze current situationIdentify issues and find solutionsDiscover trends and patternsKeep
project activities on scheduleMeasure progress against outputsMake decisions about human,
financial and material resources
Lesson 6
When
How
Continuous
Field VisitsRecordsReports
Examples of Monitoring Indicators
Agriculture Example
Microfinance Example
Water Example
Outputs The
tangible
products or
services
Number of farmer groups

created - competence
of trainees
Number of clients
receiving and correctly
using credit
Number of clients participating in

savings programs
Number of new water

systems installed and
functioning properly
Activities
Tasks or
actions taken
to implement
project
interventions
Number of staff visits to

farming communities
Number of training
sessions organized
Number of staff visits

to villages
Number of bank training
sessions - competence
of trainees
Number of communities organized

for water system installation
Project Evaluation tends to focus on tracking progress at the higher levels of the logical framework i.e.
project outcomes. Evaluations tend to explore questions like, Is the project successful at achieving its outcomes?
Is the project contributing to its ultimate goal? Evaluation data is collected and analyzed less frequently and
often requires a more formal intervention (often by technical advisors or external evaluators) to show project
results.
Examples of Evaluation Indicators
Agriculture Example
Microfinance Example
Water Example
Goals Are the

project outcomes
contributing to a
larger impact within
the target
communities?
% of families who produce

enough food to cover
lean periodsDecreased %
of malnourished children
Increase in net household Reduced morbidity and

income
mortality from water related
Positive change in
diseases
household consumption
patterns
Outcomes Are
the project outputs
resulting in the
desired project
outcomes?
% of families adopting
improved techniques
% of hectares covered
with improved techniques
% of households with
increased working
capital
% of households using safe

water supplyIncrease in per
capita consumption of water
*Note While projects are expected to contribute to the achievement of the goal level indicators, it is NOT the
responsibility of the project to achieve (or to monitor) the goals.
Project Control involves establishing the systems and decision-making process to manage variances between
the project plans (in terms of scope, cost, schedule, etc.) and the realities of project implementation. It also
involves establishing how project variances and changes are managed, documented and communicated with
stakeholders.
186 PP-FT&FM
The Project Monitoring and Evaluation Plan
Connecting the Logical Framework and the Monitoring and Evaluation Plan
Project Management is Iterative!
As discussed, the Monitoring, Evaluation and Control Phase extends

through the entire life of the project. The project logical framework is
the first step in developing the full monitoring and evaluation plan for
the project. The indicators and means of verification that are included
for the logical framework will ultimately become the building blocks
for the full monitoring and evaluation plan of the project.
A crucial element of a comprehensive implementation plan is a monitoring and evaluation plan which identifies
the system for tracking and measuring project progress, performance and impact. The appropriate time to
develop the formal Monitoring and Evaluation plan is after the project is approved for funding but before the
start-up of project activities. However, the preparatory work that contributes to that plan will start long before this
point.
Strong project design makes it easier to create and align comprehensive monitoring and evaluation systems.
The Monitoring and Evaluation Plan expands on the initial progress indicators provided in the logical framework
and the project proposal; and provides additional details for each of the levels of the project logical framework.
While the format of project monitoring and evaluation plans varies, the plan usually includes the following
information:
What indicators are being monitored and evaluated?
What information is needed to track the indicator?
What are the sources of the information?
What data collection methods are appropriate?
Who will collect the information?
How often will it be collected?
Who will receive and use the results?
While there are many considerations (budget, resources, donor requirements, etc.) to keep in mind when
identifying what data to collect in the Project Monitoring and Evaluation Plan, the most important consideration
should be the usefulness of the data. When identifying indicators, the project team should always ask What will
this information tell us? and What are the expected improvements in decision-making resulting from this data?
Monitoring Project Progress AND Project Risk
Project Management is Comprehensive!
While the attention of the monitoring and evaluation plan is

focused on tracking the projects progress against the indicators
at each of the levels of the project logframe, the project team
must also track the project risk throughout the life of the project.
Risk monitoring, in comparison to progress monitoring, involves
continuously surveying the project horizon and anticipating the
possibility that something may go wrong, or not turn out as
planned. The project manager needs to continually and
comprehensively survey the risks which have the potential to
threaten project success and actively manage these threats
throughout the life of the project.
Lesson 6
SOCIAL COST AND BENEFIT ANALYSIS OF PROJECT

Social cost-benefit analysis is a systematic and cohesive method to survey all the impacts caused by a project.
It comprises not just the financial effects (investment costs, direct benefits like tax and fees, etc), but all the
social effects, like: pollution, safety, indirect (labour) market, legal aspects, etc. The main aim of a social costbenefit analysis is to attach a price to as many effects as possible in order to uniformly weigh the abovementioned heterogeneous effects. As a result, these prices reflect the value a society attaches to the caused
effects, enabling the decision maker to form a statement about the net social welfare effects of a project.
Major advantages of a social cost-benefit analysis are that it enables investors to systematically and cohesively
compare different project alternatives. Hence, these alternatives will not just be compared intrinsically, but will
also be set against the null alter-native hypothesis. This hypothesis describes the most likely scenario
development in case a project will not be executed. Put differently, investments on a smaller scale will be
included in the null alternative hypothesis in order to make a realistic comparison in a situation without huge
investments.
The social cost-benefit analysis calculates the direct (primary), indirect (secondary) and external effects:
(a) Direct effects are the costs and benefits that can be directly linked to the owners/users of the project
properties (e.g., the users and the owner of a building or highway).
(b) Indirect effects are the costs and benefits that are passed on to the producers and consumers outside
the market with which the project is involved (e.g., the owner of a bakery nearby the new building, or a
business company located near the newly planned highway).
(c) External effects are the costs and benefits that cannot be passed on to any existing markets because
they relate to issues like the environment (noise, emission of CO2, etc.), safety (traffic, external security)
and nature (biodiversity, dehydration, etc.).
The results of a social cost-benefit analysis are:
1. An integrated way of comparing the different effects: All relevant costs and benefits of the different
project implementations (alternatives) are identified and monetized as far as possible. Effects that cannot
be monetized are described and quantified as much as possible.
2. Attention for the distribution of costs and benefits: The benefits of a project do not always get to the
groups bearing the costs. A social cost-benefit analysis gives insight in who bears the costs and who
derives the benefits.
3. Comparison of the project alternatives: A social cost-benefit analysis is a good method to show the
differences between project alternatives and provides information to make a well informed decision.
4. Presentation of the uncertainties and risks: A social cost-benefit analysis has several methods to
take economic risks and uncertainties into account. The policy decision should be based on calculated
risk.
Two approaches for SCBA

UNIDO Approach: - This approach is mainly based on publication of UNIDO (United Nation Industrial
Development Organisations) named Guide to Practical Project Appraisal in 1978.
L-M Approach :- IMD Little and J.A. Mireless approach for analysis of Social Cost Benefit in Manual of
Industrial Project Analysis in Developing countries and project Appraisal and planning for Developing
Countries.
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UNIDO Approach of Social Cost benefit Analysis

The UNIDO guidelines provide a comprehensive framework for appraisal of projects and examine their desirability
and merit by using different yardsticks in a step-wise manner. The desirability is examined from various angles,
such as the impact on
(a) Financial profitability of utilization of domestic resources,
(b) Savings and consumption pattern,
(c) Income distribution, and
(d) Production of merit and demerit goods.
These different aspects are examined in five stages, each stage leading towards a social benefit-cost of the
project.
Stage one: measures financial profitability from detailed integrated standard analytical tables enumerating various
costs and benefits at the market price and examines profit viability from investors point of view.
Stage two: adjusts the financial costs and benefits to various distortions introduced by market imperfections by
valuing costs and benefits or net benefits in terms of economic efficiency or shadow prices. For shadow prices,
it categorizes project inputs and outputs into traded, tradable and non-traded. For traded and tradable, the
guidelines use the border prices (f.o.b/c.i.f)as the relevant shadow prices, whereas non-traded inputs and outputs
are broken down into their components and each tradable subcomponent is valued at border prices, and so on.
The residual non-traded components of commodities are valued at domestic willingness to pay criterion and the
labour is valued at shadow wage rate.
Stage three: This stage designed to examine the impact of projects on savings and consumption which are of vital
consideration in the choice of alternative investments in labour-intensive and capital-intensive projects. If saving is
assigned great importance, as should be the case in capital-scarce countries, this stage recommends the rate for
adjustment for savings by which the social value of a rupee/dollar investment exceeds its consumption value.
Stage four: This is important for those countries that regard income redistribution in favor of weaker sections
and backward regions as desirable objectives. The guidelines suggest weighting net benefits to various income
groups or regions that reflect the judgment of politicians or the planners.
Stage five: Finally, in stage five, the UNIDO analysis suggests a methodology for necessary adjustment of the
deviations in economic and social values and difference between the efficiency and social value of project
output, say, between good and bad or merit and demerit goods. It has been claimed that the analysis of merit
and demerit goods is not designed for purists in economics who think that economics should be devoid of
political or subjective judgements
Little Mirrlees (L-M) Approach

The seminal work of Little and Mirrlees on benefit-cost analysis systematically develops a theoretical basis for
the analysis and its underlying assumptions and lays down step-wise procedure for undertaking benefit-cost
studies of public projects. The mathematical formulation is identical to the UNIDO method except for differences
in assigning value to discount rates and accounting for imperfections and other market failures and social
considerations.
Like UNIDO guidelines, the Little-Mirrlees method also suggests valuation of project investment at opportunity
cost (shadow prices) of resources to correct distortions due to market imperfections. Both methods make use of
border prices to correct distortions but with a major difference.
While Little and Mirrlees express the numeraire in terms of border prices in foreign currencies, the guidelines
recommend that foreign exchange values be calculated in terms of domestic currency.
Lesson 6
Little and Mirrlees have also suggested an elaborate methodology for calculating shadow prices of non-tradables.
Use of detailed input-output tables is suggested with a view to tracing down the chain of all non-traded and
traded inputs that go into their production. However, in the case of non-availability of detailed input/output tables,
a conversion factor based on the ratio of domestic costs of representative items to world prices of these items
could be used for approximation of shadow prices of non-traded resources. Little and Mirrlees believe that in all
less developed countries, one of the major criteria for the choice of a project should be its ability to generate
savings and, hence, the Little-Mirrlees method suggests the use of accounting rate of interests to calculate
present worth of future annuities of savings and consumption. Guidelines, on the other hand, do not make any
adjustment for consumption and saving impact of project investment. Unlike the five stages of UNIDO, the Little
and Mirrlees procedure is relatively more practical, although, unlike guidelines, it does not provide sufficient
insights by examining project investment from different angles.
Difference between UNIDO and L-M Approach

UNIDO
L-M
Domestic currency is used as Nemeraire
International price is used as Nemeraire
Consumption is the measurement base
Uncommitted social income is the measurement base
SCBA objectives are met through stage by stage
At one place all SCBA objectives are fulfilled.
DIFFERENT SOURCES OF FINANCE

Term Loans from Financial Institutions and Banks
Term loan is a long term secured debt extended by banks or financial institutions to the corporate sector for
carrying out their long term projects maturing between 5 to 10 Years which is normally repaid in monthly or
quarterly equal instalment. They are external source of finance paid in instalments governed by loan agreement
and covenants.
All the capital requirements cannot be fulfilled by the promoters or equity share issues and that is where the term
loans come into picture. Term loan or project finance is a long term source of finance for a company normally
extended by financial institutions or banks for a period of more than 5 years to a maximum of around 10 years.
One common feature which helps management in relatively substituting equity by term loans is the longer term
of the loan.
Term loan is a type of funding which is most suitable for projects involving very heavy investment which is not
possible by an individual or promoters. Big projects cannot be concluded in a year or two. To yield return from
them, long term perspective is required. Such big ventures are normally financed by big banks and financial
institutions. If the investment is too large, several banks come together and finance it. Such type of term loan
funding is also called as consortium loan
Term loan is acquired for new projects, diversification of business, expansion projects, or for modernization or
technology upgradation. Here also, the underlying fact is that the investment in these projects is normally very
huge. Lack of option of funding from other sources such as equity etc for any reason also directs a company to
go for term loan.
Financial Leverage and Term Loan

At times, important reason for selecting term loan is financial leverage. By opting for debt finance like term loan,
a company tries to magnify the returns to their equity shareholders. This help management of a company
achieve the core objective of wealth maximization for its shareholders and also preserve the control and share
of existing shareholders.
190 PP-FT&FM
Features of a Term Loan:

1. Loan in any Currency: These loans are provided both in home or foreign currency. Home currency loans are
offered normally for purchase of fixed assets such as land, building, plant and machineries, preliminary and
preoperative expenses, technical know-how, working capital etc. On the other hand, foreign currency loans are
offered for import of certain plant or machinery, payment of foreign consulting fee etc.
2. Secured Loan: Term loans come under secured category of loans. Two kinds of securities are there
primary and collateral. Primary security is the asset which is purchased using the loan amount and collateral
security is the charge on other assets of the borrower.
3. Loan Instalments: Repayment of loan is done in instalments. These instalments cover both principal and
interest. Normally, loan instalments are decided by banks based the borrowers cash flow capacity. There may
be instalments paid monthly, quarterly, biannually, or even annually. Instalments are normally equal but they
may be structured based on the borrowers business. Moratorium or grace period is also given by banks in
which no instalment or very low instalment is asked from the borrower. Sometimes, small instalments are kept in
the initial year or two and then the remaining loan is split into the remaining maturity period making the later
instalments higher than the initial ones.
4. Maturity: Normally a term loan is ranging between 5 to 10 years. Forecasting for more than 10 years in the
current changing business environment is very difficult.
5. Loan Agreement: An agreement is drafted between the borrower and the bank regarding the terms and
conditions of the loans which is signed by the borrower and is preserved with bank.
6. Loan Covenant: Covenants are a part of loan agreement. They are certain statements in the agreement
which states certain dos and donts for the company. They are normally related to use of assets, creation of
liabilities, cash flow, and control of the management. They are positive / affirmative or negative in nature.
Leasing and hire purchase are currently a supplementary form of debt finance.
LEASE FINANCE
A lease represents a contractual arrangement whereby the lessor grants the lessee the right to use an asset in
return for periodic lease rental payments. While leasing of land, buildings, and animals has been known from
times immemorial, the leasing of industrial equipments is a relatively recent phenomenon, particularly on the
Indian scene.
There are two broad types of lease: finance lease and operating lease.
Finance Lease
A finance lease or capital lease is essentially a form of borrowing. Its salient features are:
1. It is an intermediate term to a long-term non-cancellable arrangement. During the initial lease period,
referred to as the primary lease period. Which is usually three years or five years or eight years, the
lease cannot be cancelled.
2. The lease is more or less fully amortised during the primary lease period. This means that during this
period, the lessor recovers, through the lease rentals, his investment in the equipment along with an
acceptable rate of return. Thus, a finance lease transfers substantially all the risks and rewards incident
to ownership to the lessee.
3. The lessee is responsible for maintenance, insurance, and taxes.
Lesson 6
4. The lessee usually enjoys the option for renewing the lease for further periods at substantially reduced
lease rentals.
Operating Lease
An operating lease can be defined as any lease other than a finance lease. The salient features of an operating
lease are:
1. The lease term is significantly less than the economic life of the equipment.
2. The lessee enjoys the right to terminate the lease at a short notice without any significant penalty.
3. The lessor usually provides the operating know-how and the related services and undertakes the
responsibility of insuring and maintaining the equipment. Such an operating lease is called a wet lease.
An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment
is called a dry lease.
From the above features of an operating lease it is evident that this form of a lease does not result in a substantial
transfer of the risks and rewards of ownership from the lessor to the lessee. The lessor structuring an operating
lease transaction has to depend upon multiple leases or on the realisation of a substantial resale value (on
expiry of the first lease) to recover the investment cost plus a reasonable rate of return thereon. Therefore,
specialising in operating lease calls for an in-depth knowledge of the equipments and the secondary (resale)
market for such equipments. Of course, the prerequisite is the existence of a resale market. Given the fact that
the resale market for most of the used capital equipments in our country lacks breadth, operating leases are not
in popular use. In recent years there have been attempts to structure car lease and computer lease transactions
in the operating lease format.
The key features of lease finance in India:
Most leases in India are finance leases not operating leases
Lease finance is available for identifiable performing assets
Lease finance is available in small volume
There is a great deal of flexibility in structuring lease finance
Lease of immovable assets is not possible by banks
Lease tenors up to eight years is available
HIRE-PURCHASE
Hire Purchase is a loan or contract that involves an initial deposit, linked to a specific purchase, which is a way
of obtaining the use of an asset before payment is completed. The payments of the HP are in monthly instalments,
plus interest within which at the end of the agreement. Finance companies usually offer the facility of leasing as
well as hire-purchase to its clients.
The main features of a hire-purchase arrangement are as follows:
The hiree (the counterpart of lessor) purchases the asset and gives it on hire to the hirer (the counterpart
of lessee).
The hirer pays regular hire-purchase instalments over a specified period of time. These instalments
cover interest as well as principal repayment. When the hirer pays the last instalment, the title of the
asset is transferred from the hiree to the hirer.
The hiree charges interest on a flat basis. This means that a certain rate of interest, usually around 8
percent, is charged on the initial investment (made by the hiree) and not on the diminishing balance.
192 PP-FT&FM
The total interest collected by the hiree is allocated over various years. For this purpose, the sum of the
years digits method is commonly employed.
The following differences between leasing and hire-purchase, from the point of view of the lessee (hirer), may
be noted.
Leasing
Hire-Purchase
The lessee cannot claim depreciation.
The hirer is entitled to claim depreciation.
The entire lease rental is a tax-deductible

expense for the lessee.
Only the interest component of the hire-purchase

instalment is a tax-deductible expense for the hirer.
The lessee, not being the owner of the asset,

does not enjoy the salvage value of the asset.
The hirer, being the owner of the asset, enjoys the

salvage value of the asset.
VENTURE CAPITAL
Venture capital is a source of financing for new businesses. Venture capital funds pool investors cash and loan
it to startup firms and small businesses with perceived, long-term growth potential. This is a very important
source of funding startups that do not have access to other capital and it typically entails high risk (and potentially
high returns) for the investor.
Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If
an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works,
turnaround or revitalise a company, venture capital could help do this. Obtaining venture capital is substantially
different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment
of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an
equity stake in the business. As a shareholder, the venture capitalists return is dependent on the growth and
profitability of the business. This return is generally earned when the venture capitalist exits by selling its
shareholding when the business is sold to another owner.
Venture capitalist prefers to invest in entrepreneurial businesses. This does not necessarily mean small or
new businesses. Rather, it is more about the investments aspirations and potential for growth, rather than by
current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a
business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a
venture capital firm. Venture capital investors are only interested in companies with high growth prospects,
which are managed by experienced and ambitious teams who are capable of turning their business plan into
reality.
Venture capital firms usually look to retain their investment for between three and seven years or more. The term
of the investment is often linked to the growth profile of the business. Investments in more mature businesses,
where the business performance can be improved quicker and easier, are often sold sooner than investments in
early-stage or technology companies where it takes time to develop the business model.
Just as management teams compete for finance, so do venture capital firms. They raise their funds from several
sources. To obtain their funds, venture capital firms have to demonstrate a good track record and the prospect
of producing returns greater than can be achieved through fixed interest or quoted equity investments. Most UK
venture capital firms raise their funds for investment from external sources, mainly institutional investors, such
as pension funds and insurance companies.
PRIVATE EQUITY
Private equity is essentially a way to invest in some assets that isnt publicly traded, or to invest in a publicly
traded asset with the intention of taking it private. Unlike stocks, mutual funds, and bonds, private equity funds
Lesson 6
usually invest in more illiquid assets, i.e. companies. By purchasing companies, the firms gain access to those
assets and revenue sources of the company, which can lead to very high returns on investments. Another
feature of private equity transactions is their extensive use of debt in the form of high-yield bonds. By using debt
to finance acquisitions, private equity firms can substantially increase their financial returns.
Private equity consists of investors and funds that make investments directly into private companies or conduct
buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from
retail and institutional investors, and can be used to fund new technologies, expand working capital within an
owned company, make acquisitions, or to strengthen a balance sheet. Generally, the private equity fund raise
money from investors like Angel investors, Institutions with diversified investment portfolio like pension funds,
insurance companies, banks, funds of funds etc.
Types of Private Equity

Private equity investments can be divided into the following categories:
Leveraged Buyout (LBO): This refers to a strategy of making equity investments as part of a transaction in
which a company, business unit or business assets is acquired from the current shareholders typically with the
use of financial leverage. The companies involved in these transactions are typically more mature and generate
operating cash flows.
Venture Capital: It is a broad sub-category of private equity that refers to equity investments made, typically in
less mature companies, for the launch, early development, or expansion of a business.
Growth Capital: This refers to equity investments, most often minority investments, in companies that are
looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without
a change of control of the business.
Structure of Private Equity

Huss (2005) describes that investing in private equity can be done in two ways: a direct investment or an
investment through a fund. A direct investor participates in privately placed offerings and is responsible for the
investment process. Such an investment is not only very time consuming and costly, but it requires a certain
know-how and experience in the private equity market. When investing through a fund, one can be faced with
problems due to asymmetric information between investors and entrepreneurs. These entrepreneurs have a
better knowledge about the real conditions of the firm, the market and potential risk factors.
Characteristics of Private Equity

The structure of private equity funds is a fixed limited partnership; therefore early withdrawals are not possible.
Moreover, there is often a sales restriction that underlies private equity investments. Private equity investments
generally are liquid, because when there is a possibility of a secondary sale of fund shares, investors can expect
a substantial discount on the net asset value if selling in the secondary market.
When participating in a limited partnership, the investor needs a minimum amount of capital commitment. This
minimum differs from fund to fund, but it is a small fraction of the wealth of an investor. So, the potential for
diversification is highly restricted. The private equity market is not transparent. One of the key characteristics in
this market is that there is little publicly available information. The lacking of transparency is seen as a necessity
for achieving the results, because substantial part of the returns, private equity experiences, is due to the ability
to exploit inside information.
DEFERRED PAYMENT ARRANGEMENTS

A deferred payments arrangement is one of the sources of finance to industry. Machinery suppliers in India or
overseas where machinery is proposed to be imported may agree to accept payment in a scheduled manner in
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instalments in the period ahead of delivery. This is known as deferred payment arrangement with the machinery
suppliers. The machinery suppliers in India or abroad may agree to above arrangement on security which is
procured in the form of guarantee from financial institutions and banks of repute relied upon by the machinery
suppliers.
Guarantee for deferred payments are offered by All India Institution viz, IFCI, IDBI, ICICI to foreign machinery
supplier and also to indigenous machinery supplier against the request of the company for financing project cost
of the company. The application made by the borrower for facility of guarantee is processed in the same manner
as applicable for loan. However, the borrower company to be able to avail the facility should be in possession of
requisite import licence where the guarantee is required for import of machinery from abroad or should have tied
up the foreign currency loan from the foreign institution with the approval of the Government of India where the
guarantee for such loans is required to be given to such foreign lending institution.
INTERNATIONAL FINANCE AND SYNDICATION OF LOANS

International finance plays a very important role in financing the cost of capital of projects of the corporate
sector.
In international financial market the borrower from one country may seek lenders in other countries in specific
currency which need not be of the participant country. In international financial market, the availability of foreign
currency is assured under four main systems:
(a) Euro currency market; (b) Export credit facilities; (c) Bond issues; and (d) Financial institutions.
Euro currency marketHere funds are made available as loans through syndicated Euro credits/instruments
known as Floating Rate Notes FRNS. Interest rates vary every 3 to 6 months based on LondonInterbank
offeredRate. Syndicated Euro Currency bank loan has developed into one of the most important instruments
for international lending. Syndicated Euro credit is available through instruments viz. Term loan and Revolving
Line facility.
Export Credit Facilities are made available by several countries through an institutional frame work in which
EXIM Banks play a prominent role. EXIM Bank of India is playing a significant role in financing exports and other
off shore deals.
International Bond Market provides facilities to raise long term funds by using different types of instruments. The
bond market is generally known as Euro bond market.
UN Agency financial institutions viz. IMF of World Bank and its allied agencies, IFC (W), ADB, etc. provide
finance in foreign currency.
New International Instruments

Swap is the international finance market instrument for managing funds. The basic concept involved in swaps is
matching of difference between spot exchange rate for a currency and the forward rate. The swap rate is the
cost of exchanging one currency into another for a specified period of time. The swap will represent an increase
in the value of the forward exchange rate (premium of a decrease discount). There are three main types of
swaps (a) interest swap; (b) currency swap; (c) combination of both.
Syndicated Euro Currency Loans

The Eurocurrency market refers to the availability of a particular currency in the international financial market
outside the home country of that currency. For example, the Eurodollar market refers to the financial market for
US dollars in England, France, West Germany, Hong Kong and other financial centres outside the US. The
Eurodollar borrowing may be evidenced by issue of commercial paper in the form of promissory notes, or by
subscription to bond/debentures or it may be syndicated loans type.
Lesson 6
Main Objectives of Syndication (Borrowers point of view)

(a) Large sums are arranged without delay and at least cost.
(b) Gets better introduction to enter into international loan market without much difficulty.
(c) Funds are made available easily for meeting balance of payment deficit and for financing large industrial
projects.
(d) The borrower is allowed to select the length of the roll over period and in choosing different currencies
to repay or cancel agreements after a short notice period without penalty.
Lenders point of view

(1) It helps the bank to share large credits with other banks, to finance many borrowers.
(2) Different size banks can participate.
(3) It provides more profitability to banks as costs are relatively low.
(4) Syndicated loan is under-written by a small group banks which resell portions of the commitments to
other banks.
CORPORATE TAXATION AND THE IMPACT ON CORPORATE FINANCING

Corporate Finance is the field of finance dealing with financial decision that business enterprises make and the
tool and analysis used to make the decisions. There are three methods used in corporate financing, these are
borrowings, Issue of shares and retained earnings. Corporate taxations play a vital role in taking decision of
corporate financing. The provisions of tax laws have wider impact on Capital investment decisions that deal with
which project to invest in, whether it is feasible to fund the investment with debt or equity, as well as the time
when dividend should be paid to the shareholders.
The deductibility of interest paid on debt reduces the tax liability of the company therefore the companies preferred
to fund the new project out of borrowed capital. However, the Companies with low expected marginal tax rates
on their interest deductions are less likely to finance new investment with debt. Availability of deductions under
the tax laws will reduce the taxable income which will lower the average tax rate and ultimately minimize the tax
benefit on interest paid on borrowings. The companies have to pay tax first on the earned profits and secondly
when it declares dividend. The companies have to pay Corporate Dividend Tax on the declared dividend.
In tax laws, there are certain types of deductions, tax incentives available to the corporates which need to be
considered while taking financial decisions.
The deductions & incentives available to the industry are summed up as below:
1. Deduction of profits & gains derived by 100% Export Oriented Undertaking.
2. Deduction of profits & gains derived from the export of articles or things or services by an undertaking
established in Special Economic Zone.
3. Deductions u/s 80IA of Income Tax Act, 1962 in respect of profits and gains from industrial undertakings
or enterprises engaged in infrastructure development etc.
4. Deductions in respect of profits and gains by an undertaking or enterprise engaged in development of
Special Economic Zone.
5. Deduction in respect of Profits and gains from certain industrial undertakings other than infrastructure
development undertakings.
6. Deduction in respect of certain undertakings or enterprises in certain special category States.
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7. Deduction in respect of profits and gains from business of hotels and convention centers in specified
areas.
8. Allowability of revenue expenditure and capital expenditure (except on land) incurred on scientific
research.
9. Capital expenditure incurred on acquisition of patent rights or copy rights (before 1st day of April 1998)
is also allowed to be amortised in equal instalments over a period of 14 years.
10. Deduction of capital expenditure incurred on specified business under section 35AD of Income Tax Act,
1962.
11. Expenditure for obtaining license to operate telecommunication services in equal installments over the
period for which the license remains in force.
12 Amortisation of preliminary expenses such as feasibility report or project report expense are allowed in
5 equal installments.
FINANCING COST ESCALATION

Cost escalation results in the increase in project cost for many reasons viz. Delay in implementation of project
and inflationary pressure on corporate purchasing.
Financing cost escalation will depend upon the corporate arrangements as to how the project cost has originally
been financed. There may be two different aspects to treat the financing of cost escalation as discussed below:
1. Firstly, financing cost escalation in the case when he project is new and financed by owner fund only. In
such cases, the raising of equity is costly but issue of right shares to existing shareholder could be
planned and this cost be met out.
There may be another situation when the company is existing company and project cost is being financed
by its internal funds. In this case the company can capitalise its reserves and surplus and use the
amount in financing cost escalation.
2. In the second situation where the company has been using borrowed sums in addition to equity capital
for financing the project cost, it can always make request of additional funds to the lending institutions to
meet the cost escalations or over runs in the project cost. In case the cost escalation is of greater
magnitude then the company will have to go to raise funds from equity holders besides raising loans
from the institutions so as to maintain the debt equity ratio tin the existing balanced and planned
proportions.
LESSON ROUND UP
Project decisions are taken by the management with basic objective to maximize returns on the
investment being made in a project.
Project report is a working plan for implementation of project proposal after investment decision by a
company has been taken.
Project appraisal should be analyzed for determining the project objects, accuracy of method and
measurement, objective of the proposal, reliability of data and project statements.
A careful balance has to be stuck between debt and equity. A debt equity ratio of 1:1 is considered
ideal but it is relaxed up to 1.5:1 in suitable cases.
Lesson 6
Economic Rate of Return is a rate of discount which equates the real economic cost of project outlay
to its economic benefits during the life of the project.
Domestic Resource Cost measures the resource cost of manufacturing a product as against the cost
of importing/exporting it. The output from any project adds to domestic availability implying a notional
reduction in imports to the extent of output of the project or an addition to exports if the product is being
exported.
Effective Rate of Protection attempts to measure the net protection provided to a particular stage of
manufacturing
The Loan agreement is an agreement expressed in writing and entered into between the borrower and
the lender bank, institution or other creditors. It envisages a relationship taking into account the
commitment made at that time and the conduct of the parties carrying legal sanctions.
Loan syndication involves obtaining commitment for term loans from the financial institutions and
banks to finance the project. Basically it refers to the services rendered by merchant bankers in arranging
and procuring credit from financial institutions, banks and other lending and investment organization
or financing the client project cost or working capital requirements
In Social Cost-Benefit Analysis, a project is analyzed from the point of view of the benefit it will generate
for the society as a whole.
SELF TEST QUESTIONS

1. What is Project report? Why is it necessary to prepare project report? Sketch a formal for project report
to be submitted to a financial institution.
2. Discuss the important covenant incorporated in a long term loan agreement. Also state its relevance.
3. How the financial institutions monitor the projects financed by them.
4. Narrate the steps taken by financial institutions while appraising a project.
5. Write short notes:
(i) Promoters contribution
(ii) Social Cost benefit analysis
(iii) Viability tests
(iv) Economic aspects of project appraisal
(v) Borrowers warranties in loan agreement
(vi) Social Cost Benefit Analysis.
6. Discuss various techniques of economic appraisal followed by the lending institutions.
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Lesson 7
Dividend Policy
LESSON OUTLINE
Lesson 7
Divident Policy 199
LEARNING OBJECTIVES
Dividend is the part of EAT (Earning left after

paying tax) which is paid to the shareholders.
There is no stipulation in the legislations about
dividend policy of an organisation. Dividend
policy of an organisation depends on multiple
factors. A finance manager should be aware
about the different aspects affecting the dividend
policy of an organisation.The object of the
lesson is to enable the student to understand:
Introduction
Determinants and Constraints of Dividend
Policy
Type/ Forms of Dividend
Dividend Policy
Different Dividend Theories
Types of the Dividend Policy
(a) Walters Model
Residual Theory of Dividend Policy
(b) Gordons Model
Relevance of Dividend Walter formula
(c) Modigliani-Miller Hypothesis of

Dividend Irrelevance Dividend Policy
Dividend Growth Model

Irrelevance of Dividend Modigliani
Miller formula
Practical and Legal Constraints
Marginal Analysis and Residual Theory
Corporate Dividend Practices in India
Determinants of Dividend Policy
Case Studies
Cooperate Dividend Practices in India
LESSON ROUND UP
SELF TEST QUESTIONS
Dividend decision is one of the crucial parts of the financial manager, as it determines the amount
available for financing the organisation long term growth and it plays very important part in the
financial management
199
200 PP-FT&FM
INTRODUCTION
Dividend policy determines what portion of earnings will be paid out to stock holders and what portion will be
retained in the business to finance long-term growth. Dividend constitutes the cash flow that accrues to equity
holders whereas retained earnings are one of the most significant sources of funds for financing the corporate
growth. Both dividend and growth are desirable but are conflicting goals to each other. Higher dividend means
less retained earnings and vice versa. This position is quite challenging for the finance manager and necessitate
the need to establish a dividend policy in the firm which will evolve a pattern of dividend payments having no
adverse effects on future actions of the firm.
The formulation of the dividend policy poses many problems. On the one hand theory would seem to dictate that
the firm should retain all funds which can be employed at a higher rate than the capitalization rate; on the other
hand, stock-holders preference must be considered.
Two important considerations evolve from the above, firstly, whether owners needs are more important than the
needs of the firm. It is not easy to ascertain the extent to which shareholders best interest or desires affect
dividend policy because of the following difficulties: (1) in determining the dividend needs of the stock-holders,
as related to tax position, capital gains, current incomes; it is also difficult to locate exactly what more affects the
interest of the shareholders current income requirements or alternative use of funds, or tax considerations. (2)
Existing conflict of interest amongst shareholders dividend policy may be advantageous to one and not to other.
Nevertheless, investors expectations of dividend are mainly based on three factors viz., (a) reduction of uncertainty
due to current earnings by way of dividend. (b) Indication of companys strength and sound position that reposes
confidence in investors. (c) To meet the need of current income.
Secondly, need of the firm are easier to determine which the centre of attention is for the policy makers. Firmoriented matters relating to dividend policy can be grouped under the following six categories, affecting directly
or indirectly the determination and the appropriateness of the policy:
(1) Firms contractual obligations, restrictions in loan agreement and/or legal limitations/considerations;
and insufficiency of cash to pay dividends.
(2) Liquidity, credit standing and working capital requirement and considerations. Ability to borrow, nature
of stockholders, degree of control, timing of investment opportunities, inflation and need to repay debt.
(3) Need for expansion-availability of external finance, financial position of promoters, relative cost of external
funds, the ratio of debt to equity.
(4) Business cycle considerations.
(5) Factors relating to future financing.
(6) Past dividend policies and stockholders relationship.
The above factors affect the different firms or industry in different manner in different situations.

There are basically 4 types of dividend policy. Let us discuss them on by one:
(1) Regular dividend policy: in this type of dividend policy the investors get dividend at usual rate. Here the
investors are generally retired persons or weaker section of the society who want to get regular income. This
type of dividend payment can be maintained only if the company has regular earning.
Merits of Regular Dividend Policy:
It helps in creating confidence among the shareholders.
Lesson 7
Divident Policy 201
It stabilizes the market value of shares.

It helps in marinating the goodwill of the company.
It helps in giving regular income to the shareholders.
(2) Stable dividend policy: here the payment of certain sum of money is regularly paid to the shareholders. It
is of three types:
(a) Constant dividend per share: here reserve fund is created to pay fixed amount of dividend in the year
when the earning of the company is not enough. It is suitable for the firms having stable earning.
(b) Constant payout ratio: it means the payment of fixed percentage of earning as dividend every year.
(c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share constantly +
extra dividend in the year when the company earns high profit.
Merits of stable dividend policy:
It helps in creating confidence among the shareholders.
It stabilizes the market value of shares.
It helps in marinating the goodwill of the company.
It helps in giving regular income to the shareholders.
(3) Irregular dividend: as the name suggests here the company does not pay regular dividend to the shareholders.
The company uses this practice due to following reasons:
Due to uncertain earning of the company.
Due to lack of liquid resources.
The company sometime afraid of giving regular dividend.
Due to not so much successful business.
(4) No dividend: the company may use this type of dividend policy due to requirement of funds for the growth of
the company or for the working capital requirement
DETERMINANTS/CONSTRAINTS OF DIVIDEND POLICY

In the company organisation, dividend policy is determined by the Board of directors having taken into consideration
a number of factors which include legal restrictions imposed by the Government to safeguard the interests of
various parties or the constituents of the company.
The main considerations are as follows:
(1) Legal: As regards cash dividend policy several legal constraints bear upon it a firm may not pay a
dividend which will impair capital. Dividend must be paid out of firms earnings/current earnings. Contract/
Agreements for bonds/loans may restrict dividend payments. The purpose of legal restriction is to ensure
that the payment of dividend may not cause insolvency.
(2) Financial: There are financial constraints to Dividend Policy. A firm can pay dividend only to the extent
that it has cash to disburse; a firm cant pay dividend when its earnings are in accounts receivables or
firm does not have adequate liquidity.
(3) Economic Constraints: Besides, there are economic constraints also. The question arise, does the
value of dividend affects the value of the firm. If the answer to it is yes then there must be some optimum
level of dividend, which maximises the market price of the firms stock.
202 PP-FT&FM
(4) Nature of Business Conducted by a Company: A company having a business of the nature which
gives regular earnings may like to have a stable and consistent dividend policy. Industries manufacturing
consumer/consumer durable items have a stable dividend policy.
(5) Existence of the Company: The length of existence of the company affects dividend policy. With their
long standing experience, the company may have a better dividend policy than the new companies.
(6) Type of Company Organisation: The type of company organisation whether a private limited company
or a public limited company affects dividend decisions. In a closely held company, a view may be taken
for acquiescence and conservative policy may be followed but for a public limited company with wide
spread of shareholder, a more progressive and promising dividend policy will be the better decision.
(7) Financial Needs of the Company: Needs of the Company for additional capital affects the dividend
policy. The extent to which the profits are required to be invested in the company for business growth is
the main consideration in dividend decisions. Working capital position of a company is an important
condition that affects the dividend policy as no company would declare a dividend to undermine its
financial strength and threaten its solvency.
(8) Market Conditions: Business cycles, boom and depression, affects dividend decisions. In a depressed
market, higher dividend declaration are used to market securities for creating a better image of the
company. During the boom the company may like to save more, create reserves for growth and expansion
or meeting its working capital requirements.
(9) Financial Arrangement: In case of financial arrangements being entered into or being planned like
merger or amalgamation with another company, liberal policy of dividend distribution is followed to
make the share stock more attractive.
(10) Change in Government Policies: Changes in Government Policies particularly those affecting earnings
of the company are also taken into consideration in settling dividend decisions. For example, higher rate
of taxation will definitely affect company earnings and carry impact on dividend decisions. Besides,
fiscal, industrial, labour, industrial policies do affect in different magnitude the dividend decisions of
individual corporate enterprises.
TYPES OF DIVIDEND/FORM OF DIVIDEND

Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified
into:
Dividend
Cash dividend
Bond dividend
Stock dividend
Property Divided
(1) Cash Dividend

If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid periodically out
the business concerns EAIT (Earnings after interest and tax). Cash dividends are common and popular types
followed by majority of the business concerns.
Lesson 7
Divident Policy 203
(2) Stock Dividend

Stock dividend is paid in the form of the company stock due to raising of more finance. Under this type, cash is
retained by the business concern. Stock dividend may be bonus issue. This issue is given only to the existing
shareholders of the business concern.
(3) Bond Dividend

Bond dividend is also known as script dividend. If the company does not have sufficient funds to pay cash
dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond or
notes.
(4) Property Dividend

Property dividends are paid in the form of some assets other than cash. It will distribute under the exceptional
circumstance. This type of dividend is not published in India.
THEORIES OF DIVIDEND
Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines
the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings
for financing its long term growth. Hence, dividend decision plays very important part in the financial management.
Dividend decision consists of two important concepts which are based on the relationship between dividend
decision and value of the firm.
Theories of Dividend
Irrelevance of dividend
Solomon
Approach
M.M.
Approach
Relevance of Dividend
Walters
Model
Gordons
Model
(a) Residual Theory of Dividend Policy

According to Ezra Solomon, dividend policy is strictly a financing decision; the payment of cash dividend is a
passive residual. The amount of dividend payout will fluctuate from period to period in keeping with fluctuations
in the amount of acceptable investment opportunities available to the firm. If the opportunities abound, percentage
of payout is likely to be zero; on the other hand, if the firm is unable to find out profitable investment opportunities,
payout will be 100 per cent. The theory implies that investors prefer to have the firm retain and reinvest earnings
rather than pay them out in dividends if the return on re-invested earnings exceeds the rate of return the investors
could themselves obtain on other investments of comparable risks.
(b) Irrelevance of Dividend

Professor Modigliani and Miller in their article, Dividend Policy, Growth and the Valuation of Shares advanced
204 PP-FT&FM
most comprehensive arguments to hold that investors are indifferent to dividends and capital gains and so
dividends have no effect on the wealth of shareholders. They argue that the value of the firm is determined by
the earning power of firms assets or its investment policy. The manner is which earnings are divided into dividends
and retained earnings does not affect this value. These conclusions of MM thesis are based on certain assumptions
viz. Existence of perfect market with rational investors, no floatation cost on issue of shares, no taxes, investment
policy of firm not subject to change, perfect certainty by every investors as to future investments and profits of
the firm (this is dropped by MM later). With these assumptions, the market price of a share at the beginning of
the period is defined as equal to the present value of dividend paid at the end of the period plus the market price
at the end of the period. Thus,
P0
1
1 p
(D1 P1)
P0 = market price per share at 0 time

P = capitalisation rate for firm in that risk class (assumed constant throughout)
D1 = dividend per share at time 1
P1 = market price per share at time 1.
Suppose a share is expected to sell at Rs. 100/- one year from now, and is to pay a dividend of Rs. 5/- one year
from now, the current value of stock is Rs. 105/- discounted by the appropriate rate p. A firm committed to equity
financing may retain earnings and forego selling additional shares or it may pay dividend and sell shares. According
to MM, the discounted value per share before and after a dividend payment (with an accompanying sale of shares)
will be the same as if earnings had been retained (with no accompanying sale of shares). Let n share be outstanding
at period t0 and let ?n be number of new shares sold at t1 at a price of P1, the new equation will be written as:
nP0
1
[nD1 (n
(1 p)
n)P1
nP1]
The total value of new shares to be sold ( nP1) will depend on the volume of new Investment I, the net income
earned Y during the period and the dividend paid on outstanding shares (nD1) will be:
nP1 I (Y nD1)
Substituting the above into main equation above we have:
nP0
1
(1 p)
[(n
n)P1 I Y ]
Since D1 does not appear in the above equation MM concludes that P0 is not a function of D1, the other variable
n, n, P1, I, Y are assumed to be independent of D1.
Question
In the light of above, consider the following data:
p = .12
P0 = 10
D1 = .40
Shares outstanding 5,00,000
Solution
P0
1
1 p
(D1 P1)
Lesson 7
Divident Policy 205
P0 (1 p) D1 P1
= 10 (1.12) .40 = 10
P1=10.80
If no dividend is paid, then the share price is 10(1.12) 0 = 11.20.

If the company earns ` 1/- per share next year, new investment of Rs. 10,00,000 are expected and company
pays dividend then new shares to be issued are as under:
nP1 I (Y nD1)
n(10.80) 10,00,000 (5,00,000 2,00,000)
n
7,00,000
10.80
64,815 shares.
If no dividend is paid by the company the new share to be issued are:
n(1120
. ) 10,00,000 5,00,000
n
5,00,000
1120
.
44,643
The discounted value per share before and after a dividend payment will be the same as if earnings had been
retained. Further, the total value of new shares to be sold will depend on the volume of new investment I, the net
income earned during the period Y and the dividend paid on outstanding shares nD1 which established that P0 is
not function of D1 and all the variables in the equation are independent of D1.
However, the unrealistic assumptions of MM thesis render the hypothesis unrealistic and insignificant.
(c) Marginal Analysis and Residuary Theory

Besides the above approaches, the current thinking contributes to the significance of marginal analysis in the
explanation of the residuary theory of the dividend policy. Every firm has some optimum debt ratio, new financing
is done partly by equity and partly by debt which is a cheaper source of funds as compared to equity. Debt and
equity forms the capital and gives the average cost of capital as long as firm finances at the optimum point using
an optimum amount of equity and providing that it uses only internal earning as equity. Its marginal cost of
capital (MCC) is equal to the average cost of capital.
If the firm turns up for more common stock than the retained earnings, it will be from outside and expensive. At
the point where new stock must be sold the cost of equity and consequently the MCC rises. This concept is
depicted below in Fig. 1:
Cost of Capital (%)
Y = 13
X = 10
MCC
Earnings
New Debt
Rs. 50 m.
Rs. 100 m.
Fig. 1
Capital
Raised
206 PP-FT&FM
Suppose the firm has Rs. 50 million of retained earnings and a 50% optimum debt ratio. It can invest Rs. 100
million, its marginal cost is constant at 10% for upto Rs. 100 m. of capital; beyond Rs. 100 million, MCC rises to
13% as firm begins to use more expensive new capital.
In case the investment opportunities are ranked in terms of their rate of return (IRR) as bad, normal and good as
respectively shown by IRR1, IRR2 and IRR3 in the Fig.2 then IRR1 shows that firm can invest more money at
higher rates of return than it can in other given situations.
Investment Rate of Return
IRR1
IRR2
IRR3
Investment in million rupees

Fig. 2
If the above investment opportunities are combined with the cost of capital, the point where the investment
opportunity curve cuts the cost of capital curve, defines the proper level of new investment. Where investment
opportunities are relatively poor, the optimum level of investment is Rs. 25 million. Where it is normal, it is Rs. 75
million and when good, it is Rs. 125 million. (See the Fig. 3)
96
IRR2
IRR1
IRR3
Inter-relation of cost
of capital, investment
opportunities and new
investment.
O
Rs. 25
Rs. 75
Rs. 100 Rs. 125
New Investment (Rs. million)

Fig. 3
An explanation to the above could be added. Consider the situation where firm can invest Rs. 100 million. It has
Rs. 50 million debt and Rs. 50 million earnings so it can finance Rs. 100 million. If it pays part of the earnings as
dividend, then it will have to use new stock and then cost curve will jump. This suggests that under this condition,
Lesson 7
Divident Policy 207
its pay-out ratio is zero %. Under IRR2 condition it can invest only Rs. 75 million by raising Rs. 25 million debt but
the 50:50 ratio will change. To retain this, it should have 37.5 million equity and the same amount of debt. If it has
Rs. 50 million in total earnings and decides to retain and reinvest Rs. 37.5 million, it must pay Rs. 12.5 million
dividends. In this case pay out ratio is 25% (12.5/50). In the third situation it should invest only Rs. 25 million as
it has Rs. 50 million earnings it could finance entire Rs. 25 million out of retained earnings and still have Rs. 25
million available for dividends. But this decision is not good, it will move it away from the target debt-equity ratio.
The firm must retain Rs. 12.5 million and sell Rs. 12.5 million debt that is Rs. 50 million minus Rs. 12.5 million is
equal to Rs. 37.5 million residual that should be paid out as dividend then pay out ratio is 75%.
The above theory cant be applied in fully. Flexibility may moderately be introduced.
An appropriate dividend policy must be evaluated in the light of the objectives of the firm, viz. Choose a policy
that will maximise the value of the firm to its shareholders. Shareholders wealth includes not only the market
price of stock but also current dividends which may be in the form of cash dividend or stock dividends. Payment
of stock dividends does not fundamentally affect the value of the firm or influence the volume of financing
available to the firm. But cash distributions, may effect the value of this firm or clearly influence the volume of
funds available to the firm.
(d) Walter Formula

Professor James E. Walter has developed a theoretical model which shows the relationship between dividend
policies and common stock prices. The basic premise underlying the formulation is that prices reflect the present
value of expected dividend in the long run. The model operates on the objective of maximising common
stockholders wealth. In general, if a firm is able to earn a higher return on earnings retained than the stockholder
is able to earn on a like investment then it would appear beneficial to retain these earnings all other things being
equal. Walters model is as under:
D
P
Ra
(E D)
Rc
Rc
Where:
P : market price per share of common stock
D : dividend per share
E : earnings per share
Ra : return on investment
Rc : market capitalization rate.
Example: To illustrate the above formula suppose
Ra = return on investment is given as 0.12
Rc = market capitalization rate is as 0.10
E = earnings per share is Rs. 4/D = dividend per share is Rs. 2/Then, the market price per share would be:
2 (0.12 0.10)(4 2)
0.10
208 PP-FT&FM
= Rs. 44/The optimal payout ratio is determined by varying D until we obtain the maximum market price per share.
According to Walter the dividend payout ratio should be zero if Ra is greater than Rc. This will maximise the
market price of the share. In the instant case, we have P = Rs. 48 as calculated under:
2 (0.12 0.10)(4 0)
0.10
= Rs. 48/-
So, with payout ratio 0, the market price is maximised and comes to Rs. 48/-. Similarly, if Ra is less than Rc the
optimal payout ratio should be 100%. This point can be exemplified if Ra = 0.8 instead of 0.12 and other figures
remain unchanged as in the above example, then we have market price of share as under:
2 (0.8 0.10)(4 2)
0.10
= Rs. 36/However, with Dividend payout ratio at 100%, we have:
4 (0.8 0.10)(4 4)
0.10
= Rs. 40/Thus, market price per share can be maximised with complete distribution of earnings. If Ra is equal Rc, then
market price per share is insensitive to payout ratio. To sum up Walters conclusions, the firm should distribute
all the earnings in dividends if it has no profitable opportunities to invest.
(e) Dividend Growth Model

Besides Walters formula there is a continuing Dividend Growth Model which gives the following formula for
calculating the value of a firms stock with dividend declaration:
E(1 b)
Ke br
Where, P = price of share

E = earning per share
b = Retention ratio or percentage of earnings retained
(1 - b) = dividend payout ratio, i.e., percentage of earnings distributed as dividend
Ke = Capitalisation rate/cost of capital
br = growth rate in r, i.e., rate of return on investment of an all equity firm.
The model is also referred to as the dividend capitalization model. Grahm and Dodd Myron Gordon and
others worked on the model which considers capitalization of dividends and earnings. The model is also referred
to as the dividend growth model. The model considers the growth rate of the firm to be the product of its retention
ratio and its rate of return.
The capitalization model projects that the dividend decision has a bearing on the market price of the share. In
situations where the rate of return on investment (r) is greater than the capitalization rate (ke), the market price
of share increases with decrease in dividend payout ratio. If r is less than Ke, market price of share declines with
decrease in dividend payout ratio. If r is equal to ke, the dividend payout ratio has no effect on the market price
of the security.
Lesson 7
Divident Policy 209
The dividend growth model thus, provides an additional measure of the intrinsic value of shares and may be
used to supplement other valuation methods.
Example
Determine the market price of a share of LMN Ltd., given
ke = 11%
E = Rs. 20
R = (i) 12%; (ii) 11%; and (iii) 10%
The market price be determined if
(a) b = 90%
(b) b = 60% and
(c) b = 30%
Solution
E(1 b)
Ke br
(i) r = 12%
(a) b = 90%
br = .9 Rs. .12 = 0.108
P=
Rs. 20 (1 0.9)
= Rs. 100
.11 .108
(b) b = 60%
br = .6 Rs. .12 = 0.072
P=
Rs. 20 (1 0.6)
= Rs. 210.52
.11 .072
(c) b = 30%
br = .3 .12 = 0.036
P=
Rs. 20 (1 0.3)
= Rs. 189.19
.11 .036
(ii) r = 11%
(a) b = 90%
br = .9 Rs. .11 = 0.099
P=
Rs. 20 (1 0.9)
.11 0.099 = Rs. 181.82
(b) b = 60%
br = .6 .11 = 0.066
P=
Rs. 20 (1 0.6)
.11 0.066 = Rs. 181.82
210 PP-FT&FM
(c) b = 30%
br = .3 Rs. .11 = 0.033
P=
Rs. 20 (1 0.3)
= Rs. 181.82
.11 .033
(i) r = 10%
(a) b = 90%
br = .9 Rs. .10 = 0.090
P=
Rs. 20 (1 0.9)
.11 0.090 = Rs. 100
(b) b = 60%
br = .6 Rs. .10 = 0.060
P=
Rs. 20 (1 0.6)
= Rs. 160
.11 .060
(c) b = 30%
br = .3 Rs. .10 = 0.030
P=
Rs. 20 (1 0.3)
= Rs. 175
.11 .030
The impact of dividend growth model can thus be analysed in three situations:
(1) When normal capitalization rate is less than the actual capitalization rate: CDnorm < CRact
In such a situation, the shareholder gains more earnings by investing in the company than he expects as a
norm. The shareholder would want the firm to retain more than to pay as dividend. If dividend payout is enhanced
it will lower the intrinsic value as it lowers the growth rate of a highly profitable company.
(2) Another situation could be where normal capitalization rate equals the actual capitalization rate: CDnorm = CRact
This situation represents that the company is doing well and shareholders are indifferent as to the level of
dividend. If dividend is declared, it would be reinvested in the companies. Thus the dividend payout ratio does
not effect the intrinsic value of the company.
(3) Where normal capitalization rate is more than actual capitalization rate i.e., CDnorm > CRact :
This situation represents the opposite side of (1) above. Here, the company is not doing well as expected, the
shareholders would like to invest elsewhere in more profitable avenues, so dividend payout has to be higher and
intrinsic value of shares accordingly gets enhanced.
The dividend growth model, thus an additional measure of the intrinsic value of shares that may be used to
supplement other valuation methods.
LEGAL ASPECTS OF DIVIDENDS

The Companies Act, 1956 makes the following provision for payment of dividends:
1. Dividends to be paid only out of profits:
It is necessary for a company to declare and pay dividend only out of profits for that year arrived at after providing
Lesson 7
Divident Policy 211
for depreciation in accordance with the provisions of Section 205(2) of the Act. Alternatively, Dividend could be
declared out of profits of the company for any previous financial year or years arrived at after providing for
depreciation in accordance with those provisions and remaining undistributed. The dividend can also be declared
out of moneys provided by the Central Government or a State Government for the payment of dividend in
pursuance of guarantee given by that government.
In this regard, three things are more important viz.
(a) to provide for depreciation before declaring dividend for the particular financial year;
(b) to set-off the amount of loss of previous financial year against the profit of the company in that year as
per the provisions of the Companies Act, 1956.
(c) Central Government may allow company to declare or pay dividend for any financial year out of the
profits of the company for that year or any previous financial year without providing for depreciation.
The company is required to transfer to the reserves such percentage of its profits for that year not exceeding ten
percent in addition to providing for depreciation as required under Section 205(2A) of the Act. The company has
the freedom to transfer voluntarily any amount of its profits or the higher percentage of its profits to the reserves
in accordance with the rules as prescribed by the Government from time to time. The intention of the law is to
restrict a company not to pay dividend out of capital.
It has been held in number of cases by Supreme Court that when a dividend is declared it becomes a debt of the
company and a shareholder is entitled to sue for recovery of the same. Jurisdiction for such suit is at the place
where the dividend is to be sent. (See AIR 1971 SC 206 Hanuman Prasad Gupta v. Hiralal).
(
2) Unpaid Dividend to be transferred to Special Dividend account:
Dividends are to be paid within 30 days from the date of the declaration. If they are not paid the company is
required to transfer the unpaid dividend to Unpaid Dividend account within seven days of the expiry of the period
of thirty days. The company is required to open this account in any scheduled bank as required under Section
205-A of the Companies Act, 1956 and deposit the amount of dividend within 5 days.
(3) Dividend is to be paid only to registered shareholders or to their order or their bankers because Section 206
places the restriction for dividend not to be paid to any other person excepting those named above. This provision
has been made to prevent misuse of the funds and the litigation.
TRANSFER OF UNPAID/UNCLAIMED DIVIDEND TO INVESTOR EDUCATION AND PROTECTION

FUND
The Companies (Amendment) Act, 1999 amended the provisions relating to the transfer of unpaid dividend
account to the Central Government.
According to amended provisions, any money transferred to the unpaid dividend account of a company in
pursuance of Section 205A(2) which remains unpaid or unclaimed for a period of seven years from the date of
such transfer to unpaid dividend account, shall be transferred by the company to the Investor Education and
Protection Fund established under Sub-section (1) of Section 205C.
The company shall file the statements and deposit the money of unpaid dividend account as mentioned above
to such authority or Committee as the Central Government may appoint. The company shall be entitled to a
receipt from the authority or committee for any money transferred by it to the fund and such a receipt shall be an
effectual discharge of the company in respect thereof. For this purpose Central Government has prescribed the
Investor Education and Protection Fund (Awareness and Protection of Investor) Rules, 2001. Now a person can
claim upto seven years from the date of transfer to unpaid dividend account, and thereafter the money will be
transferred to the fund and the shareholder cannot claim dividend therefrom.
To curb the practice of companies declaring interim dividend and not paying the same promptly to the shareholders,
212 PP-FT&FM
the definition of dividend includes interim dividend and Sub-section (1A) of Section 205 stipulates that the Board
of Directors may declare interim dividend and the amount of dividend including interim dividend is to be deposited
in a separate bank account within five days from the date of declaration of such dividend and the amount of
dividend including interim dividend so deposited under Sub-section (1A) shall be used for payment of interim
dividend.
Section 207 stipulates that where a dividend has been declared by a company but has not been paid or the
warrant in respect thereof has not been posted, within 30 days from the date of declaration, to any shareholder
entitled to the payment of dividend, every director of the company, shall, if knowingly a party to the default, be
punishable with simple imprisonment for a term which may extend to three years and shall also be liable to a
fine of one thousand rupees for everyday during which such default continues and the company shall be
liable to pay simple interest at the rate of eighteen percent per annum during the period for which such default
continues.
CORPORATE DIVIDEND PRACTICES IN INDIA

Capital in the corporate sector is contributed by the investors with the main objective of earning a good return on
their savings either as a regular annual income by way of dividend or the capital enhancement in the value of the
shares. Corporate management has got to honour this legitimate expectation of the investors. Dividend makes
equity investment attractive. Limitations of any nature put on the distribution of dividend by corporate sector has
to bear upon the dis-incentive to savings and investment and thus to discourage economic growth. With this
point in view, Public Companies (Limitation of Dividend) Act was allowed by the Government to lapse at the end
of March, 1950 within a period of less than two years. But again, the government had promulgated Companies
(Temporary Restrictions on Dividends) Ordinance on July 6,1974 which became an Act but was subsequently
withdrawn on July 6, 1976.
The main drawback that is reflected in the context of dividend practice is the Government direct taxation. Dividend
income is taxed twice, once at the hands of the company and once in the hands of the recipient shareholders.
Despite representations from different segments particularly the corporate sector and the representative bodies
of investors, Government has not done away with the existing practices. The large shareholders are not interested
in receiving dividend in cash but are interested in long-term growth of the company on the basis of utilization of
retained earnings so that they escape the liability to pay tax on dividend income.
Corporate dividend practices, besides the above facts, are based on conservative management policies.
Companies mostly prefer to depend for expansion, modification/renovation on the retained earnings rather than
raising fresh equity or raising loans from financial institutions or banks. Governments credit policy also encourages
the corporate units to declare dividend at lower rates and increase their retained earnings or free reserves so as
to attain self-sufficiency of funds for utilisation in the implementation of modernisation schemes etc. With the
higher profitability of certain companies, the shareholders have the grievances for not being paid higher dividend.
Therefore, certain companies have now started paying higher dividend. This has in many cases raised the
market, price of the share and provided opportunity to investors to encash their gains. Lower dividend keeps the
market price general low unless special circumstances exist due to companys efforts for growth by way of
expansion or modernisation or diversification to boost investors sentiments.
SOME CASE STUDIES

Exercise No. 1
1. X Company Ltd., has 1,00,000 shares outstanding the current market price of the shares Rs. 15 each. The
company expects the net profit of Rs. 2,00,000 during the year and it belongs to a rich class for which the
appropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50
per share for the current year. What will be the price of the share at the end of the year (i) if the dividend is paid
and (ii) if the dividend is not paid?
Lesson 7
Divident Policy 213
Solution

ke = capitalisation rate for firm in that risk class (assumed constant throughout)
(i) If the dividend is paid
Po = Rs.15
Ke = 20%
D1 = 2.50
P1 = ?
2.50 + P1 = 15 1.2
P1 = 18 2.50
P1 = Rs. 15.50
(ii) If the dividend is not paid
Po = 15
Ke = 20%
D1 = 0
P1 =?
0 + P1 = 151.20
P1 = Rs. 18.
Exercise No. 2
Ram Company belongs to a risk class for which the appropriate capitalization rate is 12%. It currently has
outstanding 30000 shares selling at Rs. 100 each. The firm is contemplating the declaration of dividend of Rs. 6
per share at the end of the current financial year. The company expects to have a net income of Rs. 3,00,000
and a proposal for making new investments of Rs. 6,00,000. Show that under the MM assumptions, the payment
of dividend does not affect the value of the firm. How many new shares issued and what is the market value at
the end of the year?
Solution
214 PP-FT&FM
ke = capitalisation rate for firm in that risk class (assumed constant throughout)
In the given problem
Po = 100
D1 = Rs. 6
P1 =?
Ke = 12%
6 + P1 = 112
P1 = 112 6
P1 = Rs. 106
If Dividend is not declared
Ke = 12%, Po = 100, D1 = 0, P1 =?
112= P1
Calculation of number of new shares to be issued/ Market Value of Firm
Dividends is Paid
Dividends is not Paid
Net Income
3,00,000
3,00,000
Total Divided
1,80,000
Nil
Retained earning
1,20,000
3,00,000
Investment required
6,00,000
6,00,000
Amount to be raised from new shares (A)
4,80,000
3,00,000
Relevant Market Price (B)
106
112
No. of shares to be issued (A/B)
4,528
2,679
Total number of shares at the end of the year
30,000
30,000
Total Number of Shares
34,528
32,679
Market Price per share
106
112
Market Value for Shares
36,60,000
36,60,000
There is no change in the total market value of shares whether dividends are distributed or not distributed.
Exercise No 3:
A company has 10,000 shares of Rs 100 each. The capitalisation rate is 12%. Income before tax is Rs 1,50,000.
Tax rate is 30%. Dividend pay-out ratio is 60%. The company has to take up a project costing Rs 4,00,000. Find
MPS at the end of the current year and the number of shares to be issued for financing the new project if (a)
dividend is paid, and (b) if dividend is not paid. Base the answer on M-M approach.
Lesson 7
Divident Policy 215
Solution
Net income = Rs 1,50,000(1 0.30) = Rs 1,05,000
Dividend = Rs 1,05,000 0.6 = Rs 63,000
Dividend per share = Rs 63,000/10,000 = Rs 6.30
MPS1 when dividend is paid= Rs (100 1.12) 6.30 = Rs 105.70
Additional investment required = Rs 4,00,000 Rs 1,05,000 Rs 63,000 = Rs 2,32,000
No. of shares to be issued additionally = Rs 2,32,000/105.70 = 2,195
MPS1 when dividend is not paid= Rs 105.70 + 6.30 = Rs 112
Additional investment required = Rs 4,00,000 1,05,000 = Rs 2,95,000
No. of shares to be issued additionally = Rs 2,95,000/112 = 2,634
Exercise No. 4
From the following information supplied to you, determine the theoretical market value of equity shares of a
company as per Walters model:
Earnings of the company
Rs 5,00,000
Dividends paid
Rs. 3,00,000
Number of shares outstanding
Rs. 1,00,000
Price earnings ratio
Rate of return on investment
0.15
Are you satisfied with the current dividend policy of the firm? If not, what should be the optimal dividend payout
ratio in this case?
Solution
Solution
D
r
E D Rs 3 0.15 Rs 5 Rs 3
ke
0.125
Rs 43.20
ke
0.125
No, we are not satisfied with the current dividend policy.

The optimal dividend payout ratio, given the facts of the case, should be zero.
No, we are not satisfied with the current dividnent policy.
The optimal dividend payout ratio, given the facts of the case, should be zero.
Working Notes
(i) ke is the reciprocal of P/E ratio = 1/8 = 12.5 per cent
(ii) E = Total earnings Number of shares outstanding
(iii) D = Total dividends Number of shares outstanding
Exercise No. 5
X company earns Rs 5 per share, is capitalised at a rate of 10 per cent and has a rate of return on investment of
18 per cent. According to Walters model, what should be the price per share at 25 per cent dividend payout
ratio? Is this the optimum payout ratio according to Walter?
216 PP-FT&FM
Solution
Solution
D
(a) P
r
E D Rs 1.25 0.18 Rs 5.0 - Rs 1.25
ke
0.10
Rs 80
ke
0.10
This is not the optimum dividend payout ratio because Walter suggests a zero per cent dividend payout ratio in
situations where r > ke to maximise the value of the firm. At this ratio, the value of the share would be maximum,
that is, Rs 90.
Exercise No. 6
A company has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = Rs.10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.
Solution:
Case A:
D/P ratio = 50%
When EPS = Rs.10 and D/P ratio is 50%, D = 10 x 50% = $5
Rs. 5
Case B:
D/P ratio = 25%
When EPS = Rs.10 and D/P ratio is 25%, D = 10 x 25% = Rs. 2.5
Exercise No. 7: Determination of value of shares, given the following data:

Case A
Case B
D/P Ratio
40
30
Retention Ratio
60
70
Cost of capital
17%
18%
12%
12%
EPS
Rs.20
Rs.20
Solution
P
Rs.20 (1 - 0.60)
0.17 (0.60 x 0.12)
=>
Rs.81.63 (Case A)
Lesson 7
P
Rs.20 (1 - 0.70)
0.18 (0.70 x 0.12)
=>
Divident Policy 217
Rs. 62.50 (Case B)
Gordons model thus asserts that the dividend decision has a bearing on the market price of the shares and that
the market price of the share is favorably affected with more dividends.
LESSON ROUND-UP
Dividend Policy determines what portion of earnings will be paid out to stockholders and what portion
will be retained in the business to finance long term growth.
The amount of dividend payout fluctuates from period to period in keeping with fluctuations in the
amount of acceptable investment opportunities available to the firm. If the opportunities abound,
percentage of payout is likely to be zero; on the other hand, if the firm is unable to find out profitable
investment opportunities, payout will be 100 per cent.
Walter formula: Prices reflect the present value of expected dividend in the long run. A firm is able to earn
a higher return on earnings retained than the stockholder is able to earn on a like investment then it
would appear beneficial to retain these earnings all other things being equal. Walters model is as under:
D
P
Ra
(E D)
Rc
Rc
Dividend Capitalization model projects that dividend decision has a bearing on the market price of the
share.
E(1 b)
Ke br
Modigliani Miller Approach: According to MM, the discounted value per share before and after a dividend
payment will be same as if earnings had been retained.
P
nP0
1
[nD1 (n n)P1 nP1]
(1 p)
Dividend Policy is determined by the Board of Directors having taken into consideration a number of
factors which include legal restrictions imported by the Government to safeguard the interest of various
parties or the constituents of the company.
An appropriate dividend policy must be evaluated in the light of the objectives of the firm.
Section 205 (2) of the Companies Act provides that dividend could be declared out of profit of the
company for any previous financial year or years arrived at after providing for depreciation in accordance
with those provision and remaining undistributed.
Dividend is also paid in the form of shares of stock and this is referred as stock dividend or bonus shares.
SELF-TEST QUESTIONS
What do you understand by dividend policy? What are the main determinants of dividend policy in a
corporate enterprise?
Do you feel that a dividend decision is backed by a theoretical framework? What are different dividend
theories? Describe each of them precisely.
218 PP-FT&FM
What steps as a corporate executive would you suggest to the management for following an appropriate
dividend policy for your company that may be appreciated by the investors in general? Give reasons
for your recommendations.
What are the legal constraints on payment of dividends? Discuss in the light of statutory framework
existing in India.
How would you justify elimination of dividend entirely as a policy of your company to your shareholders?
Under what circumstances a company should follow such a dividend policy?
Write short notes on the following:
(1) Steady Dividend Policy.
(2) Fluctuating Dividend Policy.
Lesson 8
Working Capital
LESSON OUTLINE
Lesson 8
Working Captial 219
LEARNING OBJECTIVES
Meaning, Types, Determinants and

Assessment of W orking Capital
Requirements,
W orking capital is very important for an

organisation. It is called the blood of the
organisation. As without proper blood circulation
in the body, body is to face various diseases,
similarly proper circulation of working capital is
vital for the proper and smooth functioning of
an organisation. Seeing the importance of
working capital management, it is very
necessary for a corporate professional to know
about management of different constituents of
working capital.
Negative Working Capital

Operating Cycle Concept and
Applications of Quantitative Techniques
Management of Working Capital - Cash,
Receivables, Inventories
Financing of Working Capital; Banking
Norms and Macro Aspects

to understand:
Concept of Working Capital
Factoring and Forfeiting
Case Studies
Current Assets and Fixed Assets

Financing
LESSON ROUND UP
Operating Circle
SELF TEST QUESTIONS
Application of Quantitative Techniques

Techniques for Allocation and control of
Working Capital
Banking Norms and Macro Aspect of
Working Capital Management
Cash Management
Inventory Management
Receivable Management
All companies should focus on the proper management of working capital. Inventory, accounts
receivable, and accounts payable are of specific importance since they can be influenced most
directly by operational management and here starts the role of Management.
219
220 PP-FT&FM
MEANING OF WORKING CAPITAL -THE BASIC CONCEPT

The capital which is required to finance current assets is called working capital. That is in operating daily business
of the firm effectively, some resources are needed and the capital which are needed to finance, these resources
is called working capital
Working capital may be defined as all the short term assets used in daily operationJohn. J Harpton.
Short term assets of a firm means cash money, short-term securities, inventory, Bill receivable, note receivable,
Debtors etc. In operating daily business, fixed assets are also needed in addition to current assets. Though
some fixed assets help on the daily operation of a firm, these cant be told as working capital, because these
cant be converted into cash in this current accounting period. So, the assets which can be converted into Raw
Material from cashR/MFinished GoodsB/RCash and helps in operating daily business of the firm, is
called working Capital. Working capital is also called Trading Capital, Circulating capital/Short term capital /
Short /Current Assets management.
Working capital is defined varyingly keeping in view the objectives and purposes. To businessmen, working
capital comprises current assets of business whereas to the accountant/creditors/investment analysts working
capital is understood as the difference of current assets minus current liabilities. This is also called the Net
Working Capital. There is operative aspects of working capital i.e. current assets (which is known as funds
also) employed in the business process form the gross working capital. Current assets comprise: cash, receivables,
inventories, marketable securities held as short-term investment and other items near cash or equivalent to
cash. This is also known as going-concern concept of working capital.
TYPES OF WORKING CAPITAL

The working capital in certain enterprise may be classified into the following kinds.
1. Initial working capital: The capital, which is required at the time of the commencement of business, is called
initial working capital. These are the promotion expenses incurred at the earliest stage of formation of the
enterprise which include the incorporation fees. Attorneys fees, office expenses and other preliminary expenses.
2. Regular working capital: This type of working capital remains always in the enterprise for the successful
operation. It supplies the funds necessary to meet the current working expenses i.e. for purchasing raw material
and supplies, payment of wages, salaries and other sundry expenses.
3. Fluctuating working capital: This capital is needed to meet the seasonal requirements of the business. It is
used to raise the volume of production by improvement or extension of machinery. It may be secured from any
financial institution which can, of course, be met with short term capital. It is also called variable working capital.
4. Reserve margin working capital: It represents the amount utilized at the time of contingencies. These
unpleasant events may occur at any time in the running life of the business such as inflation, depression, slump,
flood, fire, earthquakes, strike, lay off and unavoidable competition etc. In this case greater amount of capital is
required for maintenance of the business.
5. Permanent and Temporary Working Capital: The Operating Cycle creates the need for Current Assets
(Working Capital).However the need does not come to an end once the cycle is completed. It continues to exist.
To explain the continuing need of current assets, a distinction should be drawn between temporary and permanent
working capital.
Business Activity does not come to an end after the realization of cash from customers. For a company, the
process is continuing, and hence, the need for regular supply of working capital. However, the, magnitude of
Working Capital required is not constant but fluctuating. To carry on a business, a certain minimum level of
working capital is necessary on a continuous and uninterrupted basis. For all practical purposes, this requirement
Lesson 8
Working Captial 221
has to be met permanently as with other fixed assets. This requirement is referred to as permanent or fixed
working capital.
Any amount over and above the permanent level of working capital is temporary, fluctuating or variable working
capital. The position of the required working capital is needed to meet fluctuations in demand consequent upon
changes in production and sales as a result of seasonal changes.
Both kinds of working capital are necessary to facilitate the sales proceeds through the Operating Cycle.
6. Long Term working capital: The long-term working capital represents the amount of funds needed to keep
a company running in order to satisfy demand at lowest point. There may be many situations where Demand
may fluctuate considerably. It is not possible to retrench the work force or instantly sell all the inventories whenever
demand declines Due to temporary reasons. Therefore the value, which represents the long-term working capital,
stays with the business process all the time. It is for all practical purpose as permanent as fixed assets. In other
words, it consists of the minimum current assets to be maintained at all times. The size of the permanent
working capital varies directly with the size of Operation of a firm.
7. Short term working capital: Short-term capital varies directly with the level of activity achieved by a company.
The Volume of Operation decides the quantum of Short-term working capital. It also changes from one firm to
another; from cash to inventory from inventory to debtors and from debtors back to cash. It may not always be
gain fully employed. Temporary Working capital should be obtained from such sources, which will allow its return
when it is not in use.
8. Gross Working Capital: Gross working capital refers to the firms investment in current assets. Current
assets are those assets which can be converted in to cash with in an accounting year and includes cash short
term securities, debtors bills receivable and stock.
9. Net Working Capital: Net working capital refers to the difference between current asset and Current liabilities.
Current liabilities are those claims of outsiders, which are expected to mature for payment within accounting
year and include creditors, bills payable and outstanding expenses. Net Working capital can be positive or
negative. A positive net working capital will arise when current assets exceed current liabilities.
The Gross working capital concept focuses attention on two aspect of current assets management.
(a) How to optimize investment in current assets?
(b) How should current assets be finance?
Both the question is the most decision making action of the management. It should be give due consideration
before taking decision.
Both Net and Gross working capital is important and they have equal significance from management point of
view.

Working capital is constantly affected by the criss-crossing economic currents flowing about a business. The
nature of firms activities, the industrial health of the country, the availability of material, the ease or tightness of
the money markets are all part of these shifting forces. It is difficult to rank them because the influence in
individual items rises and wanes over the years as a companys internal policies and environment in which it
operates change.
The following factors are however important.
1. Nature of Business: A companys working capital requirements are directly related to the kind of business it
conducts. A company that sells a service primarily on a cash basis does not have the pressure of keeping
considerable amounts of inventories or of carrying customers receivables. On the other hand, a manufacturing
222 PP-FT&FM
enterprise ordinarily finances its own customers, requires large amounts to pay its own bills, and uses inventories
of direct materials for conversion into end products. These conditions augment the working capital requirements.
2. Degree of Seasonality: Companies that experience strong seasonal movements have special working capital
problems in controlling the internal financial savings that may take place. Aggrevating this difficulty is the fact
that no matter how clearly defined a pattern may be, it is never certain. Unusual circumstances may distort
ordinary relationships. Although seasonality may pull financial manager from the security of fixed programmes
to meet recurring requirements, flexible arrangements are preferable to guard against unforeseen contingencies.
An inability to cope with sharp working capital swings is one of the factors that encourages companies to
undertake diversification programmes.
3. Production Policies: Depending upon the kind of items manufactured, by adjusting its production schedules
a company may be able to offset the effect of seasonal fluctuations upon working capital, at least to some
degree, even without seeking a balancing diversified line. Thus in one year, in order to avoid burdensome
inventories, firm may curtail activity when a seasonal upswing normally takes place. As a matter of policy, the
choice will rest on the one hand, and maintaining a steady rate of production and permitting stocks of inventories
to build up during off season periods, on the other. In the first instance, inventories are kept to minimum levels
but the production manager must shoulder the burden of constantly adjusting his working staff; in the second,
the uniform manufacturing rate avoids fluctuations of production schedules, but enlarged inventory stocks create
special risks and costs. Because the purchase of inventories is often financed by suppliers, the mere fact that a
company carries bigger amounts does not necessarily mean that its cash problem is more serious.
4. Growth Stage of Business : As a company expands, it is logical to expect that larger amounts of working
capital will be required to avoid interruptions to the production sequence. Although this is true it is hard to draw
up firm rules for the relationship between the growth in the volume of a companys business and the growth of its
working capital. A major reason for this is managements increasing sophistication in handling the current assets,
besides other factors operating simultaneously.
5. Position of the Business Cycle: In addition to the long-term secular trend, the recurring movements of the
business cycle influence working capital changes. As business recedes, companies tend to defer capital
replacement programmes and deflect depreciations to liquid balances rather than fixed assets. Similarly, curtailed
sales reduce amounts receivable and modify inventory purchases, thereby contributing further to the accumulation
of cash balances. Conversely, the sales, capital, and inventory expansions that accompany a boom produce a
greater concentration of credit items in the balance sheet.
The tendency for companies to become cash-poor as the tide of economic prosperity rises and cash-rich as it
runs out is well known economic phenomenon. The pressure on company finances during boom years is reflected
in the business drive for loans and the high interest rate of these years as compared with a reversal of such
conditions during the periods of economic decline. The financial implications of these movements may be
deceptive. A weakening of the cash position in favourable economic environment may suggest the need or
difficulty of raising capital for the further expansion rather than a shortage of funds to take care of current needs.
On the other hand, a strong cash position when the economic outlook is bleak may be the forerunner of actual
financial difficulties. The financial manager must learn to look behind the obvious significance of the standard
test of corporate liquidity interpret their meaning in the light of his knowledge of the companys position in the
industry, the prospects of new business and the availability of external sources for supplying additional capital.
6. Competitive Conditions: A corporation that dominates the market may relax its working capital standard
because failing to meet customers requirements promptly does not necessarily lead to a loss of business. When
competition is keen, there is more pressure to stock varied lines of inventory to satisfy customers demands and
to grant more generous credit terms, thereby causing an expansion in receivables.
7. Production Collection Time Period: Closely related to a companys competitive status are the credit terms,
it must grant. These arrangements may be result of tradition, policy within the industry, or even carelessness in
Lesson 8
Working Captial 223
failing to carry out announced principles. And the arrangements, in turn, are part of the overall production
collection time sequence, that is, the time intervening between the actual production of goods and the eventual
collection of receivables, flowing from sales. The length of this period is influenced by various factors.
Purchases may be on a cash basis, but the manufacturing cycle may be prolonged and sales terms generous,
causing a wide gap between cash expenditure and receipt and possibly placing heavy financing pressure on the
firm. The pressure may be eased, despite long manufacturing cycle, if the company can persuade its suppliers
to bear a large part of its financing burden or the manufacturing cycle may be short, and get the pressures heavy
because suppliers do not bear a large part of financial burden. The financing requirements of the company may
always be traceable to the relation between purchasing and sales credit volume and terms of operations.
8. Dividend Policy: A desire to maintain an established dividend policy may affect the volume of working
capital, or changes in working capital may bring about an adjustment of dividend policy. In either event, the
relationship between dividend policy and working capital is well established, and very few companies ever
declare a dividend without giving consideration to its effect on cash and their needs for cash.
9. Size of Business: The amount needed may be relatively large per unit of output for a small company subject
to higher overhead costs, less favourable buying terms, and higher interest rates. Small though growing companies
tend to be hard pressed in financing their working capital needs because they seldom have access to the open
market as do large established business firms have.
10. Sales Policies: Working capital needs vary on the basis of sales policy of the same industry. A department
store which caters to the carries trade by carrying a quality line of merchandise and offering extensive charge
accounts will usually have a slower turnover of assets, a higher margin on sales, and relatively larger accounts
receivable than many of its non-carriage, trade competitors. Another department store which stresses cash and
carry operations will usually have a rapid turnover, a low margin on sales, and small or no accounts receivable.
11. Risk Factor: The greater the uncertainty of receipt and expenditure, more the need for working capital. A
business firm producing an item which sells for a small unit price and which necessitates repeat buying, such as
canned foods or staple dry goods etc., would be subject to less risk than a firm producing a luxury item which
sells for a relatively high price and is purchased once over a period of years, such as furniture, automobiles etc.
FACTORS INFLUENCING THE AMOUNT OF CASH, RECEIVABLES AND INVENTORIES

Factors affecting holding of cash in an organisation
In all enterprises, cash holding is maintained for three motives viz. transaction, precautionary and speculative. Cash
held for transaction purposes meets the normal day to day cash needs of the business. The size of precautionary
cash balance is directly related to the companys ability to assume risk. The companys motive for holding cash
balance for speculative purpose is understood when the objective is to take advantage of profitable opportunities.
Factors which influence cash balance include the credit position of the firm, status of the firms receivables and
inventory accounts, the nature of business enterprise, the managements attitude towards risk.
For managing the cash balances cash budget is used as a planning device which determines the size of cash
holdings. The budget could be prepared for a week, quarter of a month, monthly, bi-monthly, and so on. Excess
cash or shortage of cash can be sorted out through cash budgets.
Factors affecting the invstment in receivables

Factors influencing investment in receivables are mainly the cost and time values of funds. Cost is associated
with the amount of investment in receivables and the value of each sale rupee sold on terms will be greater if it
is received in the immediate future than received at some later date. Therefore, both the cost and time value of
funds be given consideration while setting credit policy for the company. Generally, an increase in receivables
results from several causes i.e. (1) increase in sales, (2) length of credit terms, and (3) volume of delinquent
224 PP-FT&FM
accounts. Increase in sales generally requires larger investment in receivable. It is advantageous for a business
enterprise to maintain the shortest credit terms possible alongwith the lowest cost of capital. Delinquent accounts
should be avoided by expediting collections or by eliminating the delinquent customers or the cost of capital
involved in such accounts be recovered from such customers for delinquency. The firm can reduce investment
in receivables by offering cash discount to customers.
Risk is associated with receivables. The risk is related to bad debt losses to the profit margin i.e. a company can
bear more risk with great profit margin. Risk associated with receivables can be accounted for by adjusting
either (1) the discount rate used to ascertain the present value of receivables cost of capital; or (2) the cash
flow resulting from receivables. Standard deviation and co-efficient of variation are tools that may be used to
determine the degree of risk associated with cash group.
Factors affecting the investment in Inventories

There are several factors which influence the amount of funds invested in inventories at any one time. Firstly, the
amount of time needed for inventories to travel through the various processes directly affect the amount of investment.
Secondly, the cost associated with large inventories like storage costs, set-up and change over costs resulting
from short production runs, costs associated with increased ordering activity and costs resulting from spoilage and
obsolescence. Besides, there are certain costs associated with investment in inventories which cannot be measured
like opportunity cost of not being able to invest funds in more profitable ventures, costs resulting from changes in
price, or loss of sales for not having adequate inventories to satisfy demand. Therefore, the investment in inventories
is guided by minimisation of costs. The third factor affecting investment in inventories is managements ability to
predict the forces that may cause disruption in the flow of inventories like strikes or shifts in demand for the product,
etc. Fourthly, the companys accounting procedure tends to influence the size of investment in inventories.
ASSESSMENT OF WORKING CAPITAL

Working capital requirement assessment requires 1. Calculation of average value of Raw Material Inventory,
Work in Progress inventory and Finished Goods inventory 2. Calculation of Trade receivables 3. Calculation of
Cash and Cash Convertibles required for normal running of business, calculation of trade payables.
The formula which is used for assessing the working capital requirement is listed below
A. Value of Raw Material Stock
Value of Work in Progress
Value of Finished Goods Stock
XXXX
XXXX
XXX
Value of Trade Receivables
XXXX
Value of Cash Required
XXXX
Total of A
XXXXX
Less:
B. Value of Trade Payable
XXXX
Value of Bank Overdraft
XXXX
Value of Outstanding expenses
XXXX
Total of B
XXXX
Working Capital
Total of A-Total of B
NEGATIVE WORKING CAPITAL

Generally, negative working capital is a sign that the company may be facing bankruptcy or a serious financial
trouble. Under the best circumstances, poor working capital leads to financial pressure on a company, increased
Lesson 8
Working Captial 225
borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means
banks charge a higher interest rate, which can cost a corporation a lot of money over time.
In general, companies that have a lot of working capital will be more successful since they can expand and
improve their operations. Companies with negative working capital may lack the funds necessary for growth.
However, some companies can sell their inventory and generate cash so quickly that they actually have a
negative working capital. This is generally true of companies in the restaurant business (McDonalds had a
negative working capital of $698.5 million between 1999 and 2000). Amazon.com is another example. This
happens because customers pay upfront and so rapidly that the business has no problems raising cash. In
these companies, products are delivered and sold to the customer before the company even pays for them.
In order to understand how a company can have a negative working capital, let us take an example of Wal-Mart.
Suppose Wal-Mart orders 500,000 copies of a DVD to Warner Brothers and they were supposed to pay within
30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores
across the country? By the twentieth day, they may have sold all of the DVDs. Here, Wal-Mart received the
DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they
had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesnt really need to
have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they
can pay each bill as it comes due, maximizing their efficiency.
The bottom line is that a negative working capital can also be a sign of managerial efficiency in a business with
low inventory and accounts receivable (which means they operate on an almost strictly cash basis).
CURRENT ASSETS AND FIXED ASSETS FINANCING

The more of the funds of a business are invested in working capital, lesser is the return in term of profitability and
less amount is available for investing in long-term assets such as plant and machinery, etc. Therefore, the
corporate enterprise has to minimise investment in working capital and to concentrate on investment of resources
in fixed assets. Some economists argue that current assets be financed by current liabilities. But this all depends
upon economic conditions prevailing at particular time requiring a company to keep business resources liquid
so that business can take immediate advantage of knocking opportunities. In short-run, opportunity may arise
for investment in stocks to make immediate gains due to movement in prices, whereas investment in plant and
machinery may not be possible.
Current assets financing can be viewed from the working capital pool as under:
(All Current Accounts)
Marketable Securities
Accounts
Receivables
Cash
Inventory
Accounts
Payables
Working Capital Pool

Current assets usually are converted into cash within a current accounting cycle in one year. Cash is used to
purchase raw material etc., i..e. to create inventories. When inventories are sold, it gives rise to accounts
receivables. Collection of receivables brings cash into company and the process forms a circle and goes on as
depicted below:
226 PP-FT&FM
Cash
Inventories
Receivables
Thus, the current assets represent cash or near cash necessary to carry on business operations at all times. A
level of current assets is thus maintained throughout the year and this represents permanent working capital.
Additional assets are also required in business at different times during the operating year. Added inventory
must be maintained to support peak selling period when receivables also increase and must be financed. Extra
cash is needed to pay increased obligations due to spurt in activities.
Fixed assets financing is different to current assets financing. In fixed assets investment is made in building,
plant and machinery which remains blocked over a period of time and generates funds through the help of
working capital at a percentage higher than the return on investment in current assets. Working capital financing
or current assets financing is done by raising short-term loans or cash credits limits but fixed assets financing is
done by raising long-term loans or equity.
The working capital leverage and the capital structure leverage are, therefore, two different concepts. Capital
structure leverage is associated with the fixed assets, financing, with an optional mix of owners funds and
borrowed funds. Owners funds are the internal funds of the company comprised of equity holders money in the
shape of equity, retained earnings, depreciation fund and reserves. Borrowed funds are the external sources of
funds raised from banks, financial institutions, issue of debentures, stock and term deposits from public. Financing
of fixed assets with borrowed funds is cheaper than using owners funds which increases the earnings per share
and tends to increase the value of owners capital in the share market. The detailed discussion on this aspect
can not be accommodated as this topic is entirely devoted to the aspects of working capital.
OPERATING CYCLE CONCEPT AND APPLICATION OF QUANTITATIVE TECHNIQUES

The operating cycle is the length of time between the companys outlay on raw materials, wages and other
expenditures and the inflow of cash from the sale of the goods. In a manufacturing business, operating cycle is
the average time that raw material remains in stock less the period of credit taken from suppliers, plus the time
taken for producing the goods, plus the time the goods remain in finished inventory, plus the time taken by
customers to pay for the goods. Operating cycle concept is important for management of cash and management
of working capital because the longer the operating cycle the more financial resources the company needs.
Therefore, the management has to remain cautious that the operating cycle should not become too long.
The stages of operating cycle could be depicted through the diagram given next page.
Lesson 8
Working Captial 227
CASH
(Ultimate Stage)
Sundry Debtors
(Period of Credit
Taken by customers)
Stage IV
Stage I
Raw materials
(Period of Turnover
of raw-material
stocks)
Working Capital
Operating Cycle
Finished goods
(Period of Turnover
of finished goods stock)
Stage III
Stage II
Stock-in-process
(Period in
production)
The above figure would reveal that operating cycle is the time that elapses between the cash outlay and the
cash realisation by the sale of finished goods and realisation of sundry debtors. Thus cash used in productive
activity, often some time comes back from the operating cycle of the activity. The length of operating cycle of an
enterprise is the sum of these four individual stages i.e. components of time.
The operating cycle can be calculated for a period as under:
S.No. Name of Working Capital
Component
1.
Formula
Raw materials
Period of raw material stock
Average value of Raw material stock

Consumption of raw material per day
Less: Period of credit granted

by supplier
2.
Period of Production
Average value of work in progress

Average cost of production per day
3.
Period of turnover of
Stock of finished goods

Average cost of gods sold per day
finished goods stock

4.
Period of credit taken

by customers
Total operating cycle period
Average value of debtors

Average value of sales per day
Sum of Sl. Nos. 1, 2, 3, 4
Days
228 PP-FT&FM
Example No. 1
Calculate the Operating cycle from the following figures related to company X:
Particulars
Average amount
Outstanding
`
Raw Material inventory
Average value
per day (340
days assumed) `
1,80,000
Work-in-progress inventory
96,000
Finished goods inventory
1,20,000
Debtors
1,50,000
Creditors
1,00,000
Purchase of Raw Material
2,500
Cost of Sales
4,000
Sales
5,000
Solutions
Calculation of operating cycle
Days
1. Period of Raw Material Stock
Less: Credit granted by supplier
2. Period of Production
3. Turnover of Finished Goods
4. Credit taken by customers
Operating Cycle Period
180
, ,000
2500
100
, ,000
2500
96,000
4,000
120
, ,000
4000
150
, ,000
5000
72
40
32
24
30
30
116
Comments: Operating cycle is long and a number of steps could be taken to shorten this operating cycle.
Debtors could be cut by a quicker collection of accounts.
Finished goods could be turned over more rapidly, the level of raw material inventory could be reduced or the
production period shortened.
Requirement of working capital over the operating cycle period could be guessed for short-term, medium term as well
as long-term. For short term, working capital is required to support a given level of turnover to pay for the goods and
services before the cash is received from sales to customers. Effort is made that there remains no idle cash and no
shortage of money to erase liquidity within the companys working process. For this purpose sales budget could be
linked to the expected operating cycle to know working capital requirement for any given period of time or for each
month. Medium term working capital include profit and depreciation provisions. These funds are retained in business
and reduced by expenditure on capital replacements and dividend and tax payment. By preparing budget the minimum
amount required for medium term working capital can be estimated. The company can work out its working capital
needs for different periods through cash budget which is key part of working capital planning. To prepare such a
budget operating cycle parameters are of great use as estimation of future sales level, time and amount of funds
flowing into business, future expenditure and costs all can be made with least difficulty to help the main target.
Lesson 8
Working Captial 229
Then, operating cycle help in assessing the needs of working capital accurately by determining the relationship
between debtors and sales, creditors and sales and inventory and sales. Even requirement of extra working
capital can be guessed from such estimate.
Example No. 2
From the following information, you are required to estimate the net working capital:
Cost per unit (`)
Raw Material
200
Direct Labour
100
Overheads (excluding depreciation)
250
Total Cost
550
Estimated data for the forthcoming period is given as under:

Raw material in stock
average 6 weeks
Work-in-progress (assume 50% completion

stage with full material consumption)
average 2 weeks
Finished goods in stock
average 4 weeks
Credit allowed by suppliers
average 4 weeks
Credit allowed to debtors
average 6 weeks
Cash at bank is expected to be
` 75,000
Selling price
` 800 per unit
Output
52,000 units per annum
Assume that production is sustained at an even pace during the 52 weeks of the year. All sales are on credit
basis. State any other assumptions that you might have made while computing.
Answer
Computation of Net working Capital
Nature of Asset/Liabilities
Basis of Calculation
Amount
(`)
A. Current Assets
(i) Raw material stock
Average 6 weeks
52,000 200 6
52
(ii) Work-in-progress
(a) Raw Material
12,00,000
Average 2 weeks
52,000 200 2
52
4,00,000
52,000 175 2
52
3,50,000
(b) Direct labour and overhead

(50% completion stage)
230 PP-FT&FM
(iii) Finished goods stock
Average 4 weeks
52,000 550 4
52
(iv) Debtors
22,00,000
Average 6 weeks
52,000 800 6
52
(v) Cash at bank
48,00,000
75,000
Total of A
90,25,000
B. Current Liabilities
(i) Creditors
Average 4 weeks
52,000 200 4
52
C. Net Working Capital (A-B)
8,00,000
82,25,000
Note: (i) It has been assumed that the material has been introduced at the commencement of the process.
(ii) Lag in payment of overheads is nil.
(iii) There is no depreciation charge.
The company may have a budget or plan to show the expected increase in sales over the next period and by
using the relationship may determine sales and the relevant items of current assets and current liabilities. The
relationship between sales and funds required as working capital can vary at different stages of economic cycle.
Advance knowledge of actual sales is the main determinant of the working capital needs. For example, raw
material stocks are partly based on estimates of production level and work in progress and finished goods are
based on expected sales. At times of downturning in economic activity, there could be overstocking which is not
desirable and a company should adjust this level to business activity.
The above is the management oriented approach of calculating working capital. Banks and financial institutions
view the assessment of working capital from the angle as discussed in the following pages. Banks normally
provide working capital finance to hold an acceptable level of current assets viz. raw materials and stores,
stocks in progress, finished goods and sundry debtors for achieving a pre-determined level of production and
sales. The assessment of funds required to be blocked in each of these items of the working capital required by
an industry.
REQUIREMENT OF FUNDS, FOR THE VARIOUS ITEMS OF CURRENT ASSETS

1. Raw Material: Raw material, of any kind is necessarily required by an industrial unit to continue the production
process. Different raw material could be procured from different sources may be indigenous or overseas and
accordingly different treatment of procurement time is bound to be given. Mode of payment for the raw material
may also be different. Thus, affecting the credit requirements of the client, the funds blocked up in procurement
and stocking of material will have to be taken into consideration. Total materials including those in transit and for
which advance payment is made can normally be expressed in terms of number of months consumption and
requirements of funds can be assessed by multiplying the figure by the amount of monthly consumption.
2. Work in Process: The time taken by the raw material to be converted into finished product is the period of
material processing and all the expenses of the process are involved in it. Therefore, the assessment of funds
blocked in the process is made by taking into account the raw material consumption during the processing
period and the expenses incurred during such period i.e. the cost of production for the period of processing.
Lesson 8
Working Captial 231
3. Finished goods in the next stage: The funds blocked in finished goods inventories are assessed by estimating
the manufacturing cost of product.
4. Sundry Debtors: When goods sold is not realised in cash, sundry debtors are generated. The credit period
followed by a particular industrial unit in practice is generally the result of industry practices. Investment in
accounts receivable remains blocked from the time of sale till the time amount is realised from debtors. The
assessment of funds blocked should be on the basis of cost of production of the materials against which bank
extends working capital credit.
5. Expenses: One months total expenses, direct or indirect, are provided by way of cushion in assessing the
requirement of funds which may include rent, salaries, etc. depending upon the length of operating cycle.
6. Trade Credit received on purchases reduces working capital funds requirements and has to be taken into
account for correct assessment of funds.
7. Advances received alongwith purchase orders for the products also reduce the funds requirements for
working capital.
Taking into consideration the above parameters of operating cycle, the working capital for a unit can be assessed
as under:
Particular
Basis of Calculation
1. Raw material
Months consumption
100
2. Stock in process
Weeks (cost of production

for period of processing)
100
Months cost of production

required to be stocked
100
4. Sundry debtors
100
5. Expenses
One months
100
Total
500
3. Finished goods
Less: Trade credit on months purchases
` 100
Less: Advance payment on Orders received
` 100 200
Working Capital required
300
Banks do not provide the entire amount of ` 300 towards working capital. At every stage bank would insist upon
the borrowers stake in the form of margin which depends on various factors like saleable quality of product,
durability, price fluctuations, market conditions and business environment, etc. Thus the bank at every stage
would allow at the pre-determined rate the margin as noted below:
Component of Working Capital
Raw material
Less: Margin 10%
Stock in process
Less: Margin 40%
Finished goods
Less: Margin 25%
Permissible Limit (`)

100
10
90
100
40
60
100
25
75
232 PP-FT&FM
Sundry Debtors (at sale value)
100
Less: Margin 10%
10
Expenses for one month
100
100% Margin
100
90
Total permissible limit
315
Working capital requirement of the unit
500
Permissible limits (Bank loan)
315
Gap (contribution to be provided by Borrower)
185
Before sanctioning the working capital of ` 315, the bank would ensure that borrower is in a position to bring in
margin money of ` 185 by way of excess current assets over current liabilities based on projected balance
sheet.
Quantitative Techniques for Forecasting Working Capital Needs

A company very often faces fluctuations in business operations which affect the levels of current assets and
liabilities due to cyclical and seasonal fluctuations. Estimation of future needs of working capital becomes difficult
in such situations. But the data collected for past working may establish a trend relationship between the sales
per month or per week and the level of working capital. Linear regression model is used to judge the relationship
of two variables for estimating the working capital needs for the given amount of working capital needs. The
most widely used regression technique employs the method of least squares:
The linear equation technique solve the equation problem as under:
y = a + b (x)
When x
the independent variable i.e. sales
the dependent variable i.e. working capital level
intercept of the least square line with the vertical axis
the slope of the line. With the help of such model, linear equation could be solved.
Working capital = a + b (prior months sales).

Linear regression can be solved in assisting the analyst in making estimates but it must be used with care. A
straight line can be fitted to any data, some additional statistical technique would be needed to see how well the
regression line actually describes the relationship between four variables. In those events where the relationship
is not linear, more sophisticated analytical tools would be needed to express it accurately. The degree of accuracy
will depend upon the skill and expertise of the analyst in using the information and making forecasting.
To forecast the working capital requirement for the next period, the following may also be used:
O. C.
Number of working days in the period
Where, C
Cash balance required
O.C.
Operating cycle
C.G.S.
Estimated cost of goods sold.
C
. S.
C.G.S
Lesson 8
Working Captial 233
Techniques for Allocation of Working Capital

There are some mathematical techniques like Linear Programming for giving a basis for allocation of funds
between individual current assets items from which a company can derive benefit in items when funds are
scarce. This technique is not used in uncertain conditions that exist in India today where it is impossible to
assess correctly all the variables from which the equation can be developed.

Sources of financing of working capital differ as per the classification of working capital into permanent working
capital and variable working capital.
1. Sources of permanent working capital are the following:
(a) Owners funds are the main source. Sale of equity stock or preference stock could provide a permanent
working capital to the business with no burden of repayment particularly during short period. These
funds can be retained in the business permanently. Permanent working capital provides more strength
to the business.
(b) Another source of permanent working capital is bond financing but it has a fixed maturity period and
ultimately repayment has to be made. For repayment of this source, company provides sinking funds for
retirement of bonds issued for permanent working capital.
(c) Term loan from banks or financial institutions has the same characteristics as the bond financing of
permanent working capital.
(d) Short-term borrowing is also a source of working capital finance on permanent basis.
2. Source of variable working capital
Working capital required for limited period of time may be secured from temporary sources as discussed below:
(a) Trade Creditors: Trade credit provide a quite effective source of financing variable working capital for
the period falling between the point goods are purchased and the point when payment is made. The
longer this period, the more advantageous it becomes for the firm to avoid efforts of seeking finance for
holding inventories or receivables.
(b) Bank loan: Bank loan is used for variable or temporary working capital. Such loans run from 30 days to
several months with renewals being very common. These loans are granted by bank on the goodwill
and credit worthiness of the borrower, and collateral may include goods, accounts/notes receivable or
Government obligations or other marketable securities, commodities and equipments.
(c) Commercial Paper: It can be defined as a short term money market instrument, issued in the form of
promissory notes for a fixed maturity. It will be totally unsecured and will have a maturity period ranging
from 90 days to 180 days. It will meet the short term finance requirements of the companies and will be
good short term investment for parking temporary surpluses by corporate bodies.
(d) Depreciation as a source of working capital: Increase in working capital results form the difference in
the amount of depreciation allowance deducted from earnings and new investment made in fixed assets.
Usually, the entire amount deducted towards depreciation on fixed assets is not invested in the acquisition
of fixed assets and is saved and utilised in business as working capital. This is also a temporary source
of working capital so long as the acquisition of fixed asset is deferred.
(e) Tax liabilities: Deferred payment of taxes is also a source of working capital. Taxes are not paid from day-today, but estimated liability for taxes is indicated in Balance Sheet. Besides, business organisations collect
taxes by way of income tax payable on salaries of staff deducted at source, old age retirement benefits,
excise taxes, sales taxes, etc. and retain them for some period in business to be used as working capital.
234 PP-FT&FM
(f) Other miscellaneous sources are Dealer Deposits, Customer advances etc.
Working Capital A Policy Decision

In formulating a Firms Working Capital Policy, an important consideration is the trade-off between profitability
and risk. In other words, the level of a firms Net Working Capital (Current Assets Current Liabilities) has a
bearing on its profitability as well as risk. The term profitability here means profits after expenses. The term risk
is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its
obligations when they become due for payment.
The risk of becoming technically insolvent is measured using net working capital. It is assumed that the greater
the amount of Net Working Capital, the less risky the firm is, and vice-versa. The relationship between liquidity,
Net Working Capital and risk is such that if either net working capital or liquidity increases, the firms risk decreases.
What proportion of current assets should be financed by current liabilities and how much by long term sources
will depend, apart from liquidity profitability trade off, on the risk perception of the management. Two broad
policy alternatives, in this respect, are:
(a) A conservative current Asset financing policy: It relies less on short term bank financing and more on
long term sources.
No doubt it reduces the risk that the firm will be unable to repay its short term debt periodically, but
enhances the cost of financing.
(b) An aggressive current Asset Financing Policy: It relies heavily on short term bank finance and seeks to
reduce dependence on long term financing. It exposes the firm to a higher degree of risk, but reduces
the average cost of financing thereby resulting in higher profits.
The relationship between current assets and sales under different current asset policies is shown in the following
figure:
Sales
Aggressive
Conservative
Current Assets
To explain, an aggressive current asset policy aims at minimising the investment in current assets corresponding
to increase in sales thereby exposing the firm to greater risk but at the result of higher expected profitability. On
the other hand conservative policy aims at reducing the risk by having higher investment in current assets and
thereby depressing the expected profitability. In between these two, lies a moderate current asset policy.
Lesson 8
Working Captial 235

The direct approach to working capital control is to develop effective policies for the control of each of the
components of working capital. Since deviations occur in actual operations, indirect control techniques are
needed by management to reduce its working capital requirements. Control of cash, receivables and inventories
be maintained in a synchronized way so that a matching balance in all parameters of working capital could be
obtained.

Working capital leverage may refer to the way in which a companys profitability is affected in part by its working
capital management. Profitability of a business enterprise is affected when working capital is varied relative to
sales but not in the same proportion. If the flow of funds created by the movements of working capital through
the various business processes is interrupted, the turnover of working capital is decreased as is the rate of
return on investment. Working capital management should enhance the productivity of the current assets deployed
in business. This correlates the working capital with Return-on-Investment (ROI). ROI is product of two factors
assets turnover and profits margin. If either of these ratios can be increased, ROI will be increased to a great
degree. DU Pont Chart illustrates this position as under:
If profit margins is 6% and Asset
By increasing profit margin
By increasing assets turnover
Turnover is 3 times then ROI would
by 1%, ROI increases by 3%
by 1, ROI increases by 6%
be 18%
i.e. 6 + 1 = 7 x 3 = 21%
6% x 4 = 24
Assets turnover side of ROI computation may also reflect the working capital management.
Current assets reflect the funds position of a company and is known as Gross Working Capital. Working
Capital leverage is nothing but current assets leverage which refers to the asset turnover aspect of ROI. This
reflects companys degree of efficiency in employing current assets. In other words, the ability of the company
to guarantee large volume of sales with small current asset base is a measure of companys operating efficiency.
This phenomenon is asset turnover which is a real tool in the hands of finance manager in a company
to monitor the employment of fund on a cumulative basis to result into high degree of working capital
leverage.
Short-term loans or cash credit raised by the company to meet the requirements of working capital i.e. to finance
the current assets, add to the profitability of the companys turnover of current assets in comparison to the cost
associated in terms of interest charges on such loans. This is the exact measure of working capital leverage.
However, the concept of working capital leverage has not been much in use in academic discussions and its real
importance is also to be understood by the business enterprises. To maximise profits, finance managers
unanimously view the investment in current assets be kept to the minimum and should be financed from the
funds such as current liabilities or low cost funds.
Ways to Improve Working Capital Position

With interest rates continuing to rise, oil and commodity costs mounting and ever-increasing pressures from
Wall Street to increase shareholder value, its surprising that some companies are not taking more measured
steps to drive effective cash management and increase free cash flow.
Working capital is a highly effective barometer of a companys operational and financial efficiency and
effectiveness. The better its condition, the better positioned a company is to focus on developing its core business.
By addressing the drivers of working capital, in fact, a company is sure to reap significant operating cost and
customer service improvement.
236 PP-FT&FM
According to an analysis of financial results from the 2,000 largest companies in the U.S. and Europe performed
in 2005 by Hackett-REL, U.S. and European companies have reduced working capital by 12 percent and 17
percent, respectively, over the past three years. This strongly indicates that awareness of the benefits of
working capital and cash management improvement has been elevated beyond the treasury to the office of
the CEO.
But while corporate profits may be soaring, corporations are still overlooking billions in cash a staggering
$460 billion in the U.S. and some $570 million in Europe. This enormous sum is literally stuck in transit, a
result of inefficient receivables, payables and inventory practices that could be reclaimed with relatively little investment.
Liberating the billions in cash trapped on the balance sheet is easier than one may think. Dell Inc., for instance
a lauded for overall strong corporate management and working capital performance builds a computer only
when it has received payment for an order, and doesnt pay its own suppliers for an agreed-upon period of time
thereafter. As a result, Dell enjoys negative working capital and, the more it grows, the more its suppliers finance
its growth.
Not all companies can operate like Dell, but most can improve their working capital position by at least 20
percent over time if they pay attention to the following list of cash management dos and donts:
(1) Get educated. There is more to working capital management than simply forcing debtors to pay as quickly
as possible, delay paying suppliers as long as possible and keep stock levels as lean as possible. A properly
conceived and executed improvement program will certainly focus on optimizing each of these components, but
also, it will deliver additional benefits that extend far beyond operational rewards. All this underscores the need
for ambitious executives to integrate working capital management into their strategic and tactical thinking, rather
than view it as an extraneous added bonus.
(2) Institute dispute management protocols. Consider a case where a companys working capital is deteriorating
due to an increase in past-due accounts receivable (A/R). A review of the past-due A/R illustrates a high level of
customer disputes, which are taking on average of 30 days to resolve and consuming significant amounts of
sales, order-entry and cash collectors time.
By tackling the root cause of the disputes in this case, poor adherence to pricing policies the company can
eliminate the disputes, thereby improving customer service. Established dispute-management protocols
free up time for sales, order-entry and cash collections personnel to be more effective at their designated
roles, and they also will increase productivity, reduce operating costs and potentially boost sales. And finally,
days payable outstanding (DPO) and working capital will improve, as customers wont have reason to hold
payment.
This example illustrates how working capital is one of the best indicators of underlying inefficiency within an
organization and why it is critical that senior executives remain focused on addressing the primary causes of
working capital excesses to control operating costs and remain competitive.
(3) Facilitate collaborative customer management. One of the most important cash management and
working capital strategies that executives CFOs and treasurers, as well as CEOs can employ is to avoid
thinking linearly and concerning themselves solely with their own companys needs. If it is feasible to collaborate
with customers to help them plan their inventory requirements more efficiently, it may be possible to match
your production to their consumption, efficiently and cost-effectively, and replicate this collaboration with your
suppliers.
The resulting implications for inventory levels can be massive. By aligning ordering, production and distribution
processes, companies can increase inherent efficiency and achieve direct cost savings almost instantly. At this
point, payment terms can be most effectively negotiated.
Lesson 8
Working Captial 237
(4) Educate personnel, customers and suppliers. A business imperative should be to educate staff to consider
the trade-offs between various working capital assets when negotiating with customers and suppliers. Depending
on the usage pattern of a raw material, there may be more to gain from negotiating consignment stock with a
supplier instead of pushing for extended terms - particularly in cases of long lead-time items or those that
require high minimum-order quantities.
The same can hold true for customers. Would vendor-managed inventory at a customer site provide you the
insight into true usage to better plan your own production? It is important to remember, however, that this is not
the solution for all products, and it should be evaluated on a case-by-case basis.
(5) Agree to formal terms with suppliers and customers and document carefully. This step cannot be
stressed enough. Terms must be kept up to date and communicated to employees throughout the organization,
especially to those involved in the customer-to-cash and purchase-to-pay processes; this includes your sales
organization.
Avoid prolific new product introductions without first establishing a clear product-range management strategy.
Whether in the consumer products or aluminium extrusions business, many companies rely heavily on new
products to maintain and grow market share. However, poor product-range management creates inefficiency in
the supply chain, as companies must support old products with inventory and manufacturing capability. This
increases operating costs and exposes the company to obsolete inventory.
(6) Dont forget to collect your cash. This may sound obvious, but many businesses fail to implement effective
ongoing collection procedures to prevent excess overdue funds or build-up of old debts. Customers should be
asked if invoices have been received and are clear to pay and, if not, to identify the problems preventing timely
payment. Confirm and reconfirm the credit terms. Often, credit terms get lost in the translation of general payment
terms and whats on the payables ledger in front of the payables clerk.
(7) Steer clear of arbitrary top-down targets. Too many companies, for example, impose a 10 percent
reduction in working capital for each division that fails to take into account the realistic reduction opportunities
within each division. This can result in goals that de-motivate employees by establishing impossible targets,
creating severe unintended consequences. Instead, try to balance top-down with bottom-up intelligence when
setting objectives.
(8) Establish targets that foster desired behaviours. Many companies will incentivise collections staff to
minimize A/R over 60 days outstanding when, in fact, they should reward those who collect A/R within the
agreed-upon time period. After all, what would stop someone from delaying collections activities until after 60
days when they can expect to be rewarded? Likewise, a purchasing manager may be driven by the purchase
price and rewarded for buying when prices are low, but this provides no incentive to manage lot sizes and order
frequency to minimize inventory.
(9) Do not assume all answers can be found externally. Before approaching existing customers and
suppliers to discuss cash management goals, fully understand your own process gaps so you can credibly
discuss poor payment processes. Approximately 75 percent of the issues that impact cash flow are internally
generated.
(10) Treat suppliers as you would like customers to treat you. Far greater cash flow benefits can be realized
by strategically leveraging your relationship with suppliers and customers. A supplier is more likely to support
you in the case of emergency if you have treated them fairly, and, likewise, a customer will be willing to forgive
a mistake if you have a strong working relationship.
That said, also realize that each customer is unique. Utilize segmentation tactics to split your customers and
suppliers into similar groups. For customers, segmentation may be based on criteria including, profitability,
238 PP-FT&FM
sales, A/R size, past-due debt, average order size and frequency. Once segmentation is complete, it is important
to define strategies for each segment based around the segmentation criteria and your strategic goals.
For example, you should minimize the management cost for low-margin customers by changing service levels,
automating interaction, etc. Finally, allocate your resources according to the segmentation, with the aim of
maximizing value.

The direct approach to working capital control is to develop effective policies for the control of each of the
components of working capital. Since deviations occur in actual operations, indirect control techniques are
needed by management to reduce its working capital requirements. Control of cash, receivables and inventories
be maintained in a synchronized way so that a matching balance in all parameters of working capital could be
obtained.
CASH MANAGEMENT
By cash management, we mean the management of cash in currency form, bank balances and readily marketable
securities. Cash is the most important component of working capital of a firm. It is also the terminal conversion
point for other constituents. Each firm holds cash to some extent at any point of time. Source of this cash may be
the working capital operating cycle or capital inflows. Similarly the outflow of cash from the cash reservoir of a
firm can be either to the operating cycle or for capital repayment.
Motives for holding cash

At the basic level, a firm like individuals, has three motives for holding cash. These are as under:
(a) Transactional motive
(b) Speculative motive
(c) Contingency motive
(a) Transactional Motive
This is the most essential motive for holding cash because cash is the medium through which all the transactions
of the firm are carried out. Some examples of transactions of a manufacturing firm are given below:
Purchase of Capital Goods like plant and machinery
Purchase of raw material and components
Payment of rent and wages
Payment for utilities like water, power and telephone
Payment for service like freight and courier
These transactions are paid for from the cash pool or cash reservoir which is all the time being supplemented by
inflows. These inflows are of the following kinds:
Capital inflows from promoters capital and borrowed funds
Sales proceeds of finished goods
Capital gains from investments
Lesson 8
Working Captial 239
The size of the cash pool depends upon the overall operations of the firm. Ideally, for transaction purposes, the
working capital inflows should be more than the working capital outflows at any point of time. The non-working
capital inflows should be utilized for similar outflows such as purchase of fixed assets together with the surplus
of working capital inflows.
(b) Speculative Motive
Since cash is the most liquid current asset, it has the maximum potential of value addition to a firms business.
The value addition can come in two forms. First, as the originating and terminal point of the operating cycle, cash
is invaluable. But cash has an opportunity cost also and if cash is kept idle, it becomes a liability rather than an
asset. Therefore, efficient firms seek to deploy surplus cash in short term investments to get better returns. It is
here that the second form of value addition from cash can be had. Since this deployment of cash needs to be
done skillfully, not all the firms hold cash for speculative motive. Further the amount of cash held for speculative
motive should not cause any strain upon the operating cycle.
(c) Contingency Motive
This motive of holding cash takes into account the element of uncertainty associated with any form of business.
The uncertainty can result in prolongation of the working capital operating cycle or even its disruption. It is
possible that cost of raw materials or components might go up or the time taken for conversion of raw materials
into finished goods might increase. For such contingencies, some amount of cash is kept by every firm.
Level of cash holding

The level of cash holding of a firm depends upon a number of factors. Prominent among these factors are the
nature of the firms business, the extent and reach of the business. The level of cash is measured as a percentage
of turnover of the firm.
1. Nature of the business
If the firm is engaged in cash purchase of raw material from a number of sources, its requirement of cash would
be more than that a firm which buys on credit. Also a firm having cash purchase and cash sale would need to
maintain more cash balance than a firm which buys on credit and sells on credit. A firm buying in cash and
selling on credit is likely to have strained cash flows. On the other hand, a firm buying on credit and selling in
cash has comfortable cash balances.
2. Extent and reach of the business
A multi location firm having a number of large and small branches has more cash requirement than a single
location firm. Also the problems associated with moving cash between the branches and maintaining liquidity
are much more in a multi location firm.
For illustration, let us assume the amount of cash and bank balances maintained by the firm:
240 PP-FT&FM
(` in crores)
Firm A
Firm B
Firm C
2012
2013
2012
2013
2012
2013
Income
3,031.76
3,322.44
10,948.86
11,353.68
1,381.91
1,882.61
Cash and Bank Balances
27.95
27.49
522.08
913.16
315.21
1,089.34
Cash balance as Percentage

of Income
0.92
.082
4.77
8.04
22.81
57.86
Firm A is a large cement manufacturer, Firm B is a FMCG giant and firm C is a leading soft ware company. Out
of the above three firms, firm A has been holding the minimum quantum of cash and bank balances as percentage
of total income while firm C has the maximum quantum. On the face of it, the first impression that one is likely to
get is that firm A is the most efficient user of cash and bank balances while firm C is the most inefficient user. But
that would be a hasty conclusion. We have to move further and probe into the status of cash and bank balances
vis--vis other current assets:
Current Assetsincl. Loans
Firm A
Firm B
Firm C
and Adv.
2012
2013
2012
2013
2012
2013
Inventories
312.60
30.12
1182.10
1240.03
Sundry Debtors
247.63
216.50
264.51
424.78
375.22
395.61
Cash and Bank Balances
27.95
27.49
522.08
913.16
151.74
1098.34
Other Current Assets
12.81
6.02
48.53
50.61
Loans and Advances
306.29
351.42
744.09
798.19
147.68
129.26
Total Current Assets
907.48
901.55
2761.32
3426.76
674.64
1623.1
Cash & Bank Balance as %

of Total current Assets
3.08
3.05
18.90
26.65
22.49
67.66
From the above table we note that Firm a holds just around 3% of its current assets as cash balances, i.e. its
operating cycle has an extended and large span requiring conversion into Loans and Advances, Inventories,
Sundry Debtors before re-conversion into cash. Firm B is engaged in manufacture and trading of consumer
non-durables having a relatively shorter operating cycle. As such, holding of cash by this firm as a percentage of
total current assets is larger. Firm C has 22.49% of the current assets in cash and bank balances in 2012 while
the figure has gone up to 67.66% in 2013. The abnormal rise is due to the fact that out of the cash and bank
balances of ` 1098.34 lacs represented unutilised proceeds of the capital issue made by the firm. Ignoring this
figure, the cash and bank balances are ` 666.84 lacs, still 56.43% of the current assets. The implication of this
is that the firm C, being in the services sector as a software exports, has a short operating cycle. The inventory
holding is nil and current assets and generally held either as cash or receivables. So, the level of cash and bank
balances viewed per se, is no indicator of the efficiency of cash management. We have to analyse the various
components of cash holding to arrive at a more accurate conclusion.
Components of cash and bank balances

Cash and bank balances are held by the firms in three major forms, i.e. cash and cheques on hand, balances
with banks and investment in liquid securities.
1. Cash and Cheques on hand
This is the most liquid and readily accessible component of cash. The cash is held to meet day-to-day payments
Lesson 8
Working Captial 241
of small amounts. It is generated from counter cash receipts of the firm, if any, and from cash withdrawals from
the bank. The volume of cash on hand maintained by the firm again depends upon the nature of operations of
the firm. In case of major portion of the sales being in cash, firm is left with large amounts of end of day cash
which needs to be taken care of safely. This entails security and custody arrangements for the cash before it is
deposited in the bank. Moreover, since receipt and payment of cash is a primary level transaction which is
culminated with the handing over of the cash, special care is required while handling cash.
Cheques on hand are clubbed with cash in a categorization because a cheque is a secondary form of cash and
is equivalent to holding cash. The care and precaution required for holding cheques is much less than required
for cash because almost all the cheques are account payee cheques which can be credited to the account of
the firm only. The cheques in hand need to be deposited carefully and expeditiously into the bank in order to get
credit to the correct account well in time. Attention also needs to be paid to those cheques which are dishonoured
at the time of presentation to the payee banks since the drawer of the cheques has to be contacted for obtaining
rectified cheque.
2. Bank Balances
Bank balances represent the amount held with banks in savings, current or deposit accounts. In the case of
firms, balances are not held in savings accounts. A firm has at least one main current account with a bank
through which the transactions are carried out. All the excess cash is deposited into this account together with
the cheques. Payments to employees, creditors and suppliers are made by way of cheques drawn on this
account. Being a current account, no interest is payable to the firm on the balance maintained in this account.
Therefore the firm seeks to keep just sufficient balance in the current account for meeting immediate payment
liabilities. After accounting for these liabilities, the surplus is transferred either to an interest bearing deposit
account or invested in short term liquid instruments. In case the firm has borrowed funds for working capital, the
surplus cash and cheques are credited to those accounts, thereby reducing the liability of the company.
Nature of Bank Balances

On a superficial reading of the Balance sheet of a firm, a large amount held by the company in bank deposits
portrays a comfortable and liquid position of finances of the company. It is not always true. Let us take a look at
break-up of the bank balances of some firms :
(` in crores)
Firm A
Firm B
Firm C
2012
2013
2012
2013
2012
2013
Total Bank Balance
27.41
26.30
520.61
911.74
151.57
1,098.17
Bal. in Current Accounts
15.15
7.86
147.56
222.9
149.28
275.55
Bal. in Deposit Accounts
0.59
0.75
373.05
689.45
0.72
820.55
Bal. in Earmarked Current A/c
1.03
2.32
0.00
0.00
1.57
2.07
Remittances in Transit
10.64
15.36
We can note that while firm B has a substantial portion of the cash in deposit accounts, firms A and C have
comparatively much larger portion in current accounts. In the case of firm A, it appears that the cash inflows are
quickly followed by cash outflows so that it does not have surpluses available for keeping in bank deposits.
Firms B and C have comparatively comfortable cash position evidenced by the amounts kept in deposit accounts.
It means that the firms have less pressure for cash outflows. Further, firm A has substantial amount outstanding
as Remittance in Transit, i.e. remittance sent from other centers and cheques sent under collection. Such
remittance need to be translated into bank balances at the earliest or else the firm can not make much use of
242 PP-FT&FM
this cash. There are certain deposits which have been earmarked for a specific purpose, for example margin
money for bank guarantees or letters of credit. Such earmarked deposits can not be used for other purposes
and to that extent, the cash balances are deemed to have been converted into other assets.
Strategy for effective cash management

The strategy for effective cash management in any firm has a core component of ensuring uninterrupted supply
of cash to the operating cycle. This cash is ideally generated from the cycle itself but under certain circumstances
infusion of cash from outside the cycle also takes place. Examples of such circumstances are:
(a) when the firm has been newly set up and the cycle has yet to commence;
(b) when due to disruption in the cycle, cash gets stuck in other current assets and outside cash infusion in
the form of promoters lenders contribution is done.
Essential elements of a successful cash management strategy:
Realistic cash forecasting
Speeding up collections
Spreading out payments
(1) Realistic cash forecasting
By realistic cash forecasting we mean that a cash forecast for the entire next year should be prepared at its
commencement. The cash forecast has two partsone is the forecast of cash flows from the operating cycle
and the second part is the capital flows. The first part originates from the sales forecast for the year while the
second part originates from the capital budget. The surplus of cash generated from the operating cycle in called
the internal accruals of the firm and it is used to fund the capital outlays together with bank borrowings.
For a realistic cash forecast, the sales projections and capital budget have to be drawn up after extensive
deliberations in the management committee of the firm. Such a forecast carries a cushion for normal contingences
like sudden spurt or shrinkage in demand for which mid-term modifications in the forecast are made. Involvement
of operational level people, both from production and sales areas, is essential for a realistic cash forecast.
(2) Speeding up Collections
After the cash forecast has been prepared, the firm should ensure that in day to day operations cash (including
cheques) should be collected speedily. Towards this end, a schedule of receivables should be prepared and
kept updated. Before due date of each payment, the debtor should be reminded for it. When the cheques are
received on due dates, these should be credited to the bank account expeditiously. For a multi-locational firm,
arrangements should be made with the bank for on-line transfer of funds to the main account. Similarly facilities
like drop boxes can be provided by firms having a large user base whereby customers can drop their payments
in boxes placed at vantage locations.
(3) Spreading out Payments
Simultaneously with speeding up collection, the firm should spread out payments as far as possible. It means
that if credit period is available in some payments, it should be utilized fully. Bunching of payments should be
avoided. For outstation customers, arrangement can be made with the bank for making at par payment.
INVENTORY MANAGEMENT
Inventory Management is the second important segment of working capital management Inventory is the second
step in the operating cycle wherein cash in converted into various items of the inventory. Inventory has the
following major components:
Lesson 8
Working Captial 243
(a) Raw Material

(b) Work in Process
(c) Finished Goods
Inventories form a link between production and sale of a product. A manufacturing company must maintain a
certain amount of inventory during production, the inventory known as work in process (WIP). Although other
types of inventory namely, raw materials and finished goods are not necessary in the strictest sense, they
allow the company to be flexible. Raw materials inventory gives the firm flexibility in its purchasing. Finished
goods inventory allows the firm flexibility in its production scheduling and in its marketing. Production does not
need to be geared directly to sales. Large inventories also allow efficient servicing of customer demands. If a
product is temporarily out of stock, present as well as future sales may be lost. Thus, there is an incentive to
maintain large stocks of all three types of inventory.
Benefits versus Costs

The advantages of increased inventories are several. The firm can effect economies of production and purchasing
and can fill orders more quickly. In short, the firm is more flexible. The obvious disadvantages are the total cost
of holding the inventory, including storage and handling costs, and the required return on capital tied up in
inventory. An additional disadvantage is the danger of obsolescence. Because of the benefits, however, the
sales manager and production manager are biased toward relatively large inventories. Moreover, the purchasing
manager often can achieve quantity discounts with large orders, and there may be a bias here as well. It falls on
the financial manager to dampen the temptation for large inventories. This is done by forcing consideration of
the cost of funds necessary to carry inventories as well as perhaps the handling and storage costs.
Inventories should be increased as long as the resulting savings exceed the total cost of estimates of holding
the added inventory. The balance finally reached depends on the estimates of actual savings, the cost of carrying
additional inventory, and the efficiency of inventory control. Obviously, this balance requires coordination of the
production, marketing, and finance areas of the firm in keeping with an overall objective. Our purpose is to
examine various principles of inventory control by which an appropriate balance might be achieved.
Extent and Quantum of Inventory Management

Let us take a look at the extent and quantum of inventory in real life examples taken up for consideration by us
for working capital management.
(` in crores)
Firm A
Firm B
Firm C
2012
2013
2012
2013
2012
2013
907.48
901.55
2,761.32
3,426.78
674.64
1,623.21
Inventories
312.8
300.12
1182.10
1424.04
Sundry Debtors
247.63
216.50
264.51
424.78
375.22
395.61
Cash and Bank Balance
27.95
27.49
522.08
913.16
151.75
1,098.34
Other Current Assets
12.51
60.2
48.53
50.61
Loans and advances
306.29
351.42
744.08
798.19
147.68
129.26
Inventory as % of Total
current assets
33.75
33.29
42.80
36.19
Firm A, being in the current manufacturing sector has over 30% of the current assets held in the form of inventories,
244 PP-FT&FM
while firm B, being in the FMCG manufacturing and trading sector has over 35% of the current assets in the
inventory form. Firm C, in the software export segment has obviously zero inventory holding.
Strategy for Inventory Management

A successful strategy for inventory management has at its core the objective of holding the optimum level of
inventory at the lowest cost.
The cost of holding inventory has the following three elements:
(i) Carrying Cost
This is the cost of keeping or maintaining the inventory in a usable condition. This includes the storage costs,
i.e. the cost of storing the inventory in rented premises or the opportunity cost of storing in own premises +
the wage cost of personnel assigned to storing and securing it + cost of utilities and insurance + cost of
financing.
Inventory carrying cost is directly proportional to the level of inventory assuming that the loading of carrying cost
is done pro rata to the space occupied. Thus if inventory level rises, its carrying cost also rises.
(ii) Ordering Cost
It is the cost associated with placing each individual order for supply of raw materials, stores, packing materials
etc. If these items are procured in small lots, then the ordering cost per unit of inventory would be more and vice
versa.
(iii) Stock-out Cost
It is the cost associated with procuring an inventory item, which has gone out of stock and is needed for immediate
supply. This cost includes the reduction of profit and costs accruing due to disruption in the operating cycle.
How cost of inventory can be lowered:
Cost of inventory can be lowered by
Entering into long term arrangements for supply of raw materials at market driven prices.
Arranging for direct supply of raw material at manufacturing locations.
Promoting ex-factory sales of the finished goods.
Availing quantity discounts and spot payment discounts if the carrying cost and financing cost is less
than the discounts.
Apart from these general steps, a technique called ABC analysis is also used for monitoring inventory costs.
Managing the Inventory Level

1. EOQ Model
Inventory level can be managed by adopting the Economic Order Quantity (EOQ) model. This model determines
the order size that will minimize the total inventory cost. According to this model, three parameters are fixed for
each item of the inventory:
(1) Minimum level of that inventory to be kept after accounting for usage rate of that item and time lag in
procuring that item and contingences.
(2) The level at which next order for the item must be placed to avoid possibility of a stock-out.
(3) The quantity of the item for which the re-order must be placed.
In addition to the determination of above parameters, the EOQ model is based on the following assumptions:
Lesson 8
Working Captial 245
The total usage of that particular item for a given period is known with certainty and the usage rate is
even throughout the period.
There is no time gap between placing an order and receiving supply.
The cost per order of an item is constant and the cost of carrying inventory is also fixed and is given as
a percentage of the average value of inventory.
There are only two costs associated with the inventory and these are the cost of ordering and the cost
of carrying the inventory.
Given the above assumptions, the optimum or economic order quantity is represented as:
EOQ
2AB
C
Where A = Total annual requirement for the item

B = Ordering cost per order of that item
C = Carrying cost per unit per annum.
2. ABC Analysis
This system is based on the assumption that in view of the scarcity of managerial time and efforts, more attention
should be paid to those items which account for a larger chunk of the value of consumption rather than the
quantity of consumption. Let us take an example of a firm having three major components of raw material:
Component Units Consumed
% to total
Value per unit
Total Value (Lacs)
5000
45.45
1000
50.00
22.93
4000
36.36
1200
48.00
22.00
2000
18.18
6000
120.00
55.05
11000
100.00
218.00
100.00
Thus the cost of raw material C which accounts for 55% of the total consumption value should be given priority
over item A although the number of units consumed of the latter is much more than former.
RECEIVABLES MANAGEMENT
Receivables are near the terminating point of the operating cycle. When raw material has been converted into
finished goods, the final product is sold by the firm. Some of the sales are done on spot basis while the remaining
sales are made on credit. The extent of credit sales varies from industry to industry and within an industry.
Period of credit depends upon the position of the firm in the industry. If the firm has a monopoly position, period
of credit would be very low. If the industry consists of a large number of players in keen competition with each
other, the period of credit would tend to be fairly long. Also, during periods of demand recession, even a firm in
monopoly situation might be forced to extend credit in order to promote sales.
Receivables are generally referred to by the name of Sundry Debtors in the books of account, Strictly speaking,
Sundry Debtors refer to receivables created in the course of operation of the working capital cycle, i.e. those
persons which owe payment to the firm for goods supplied or services rendered. Thus sundry debtors represent
an intermediate stage between reconversion of finished goods into cash. So long as the sundry debtors persist,
the firm is strained of cash. So, logically the firm seeks to minimize the level of sundry debtors.
The period of credit allowed to debtors also depends upon the industry practice. This period of credit has two
components. First component is a small period of week to ten days which is normally allowed in all industries
246 PP-FT&FM
and no interest is charged on the amount due. The second component is the larger one, length of which varies
from industry to industry and interest is usually charged for this period. In the alternative, the firm may charge full
invoice value for payment made after the credit period and allow discount for spot payments.
The existence of debtors in the books of a firm is a routine and normal situation. Only a firm with a commanding
market share or the one operating in a situation of acute mismatch between demand and supply can afford to
dictate terms of sale and receive full invoice value in advance. Otherwise, the firm has to maintain a balance
between promoting sales and maintaining the level of receivables within manageable limits.
Apart from the Sundry Debtors, cash flow of the firm is also affected by Loans and Advances made to suppliers,
subsidiaries and others. These advances are not exactly working capital advances but nevertheless these are
treated as current assets because these are assumed to be recoverable or converted into inventory, fixed
assets or investments within one year.
Credit policy can have a significant influence on sales. In theory, the firm should lower its quality standard for
accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables.
What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical
work of checking additional accounts, and servicing the added volume of receivables. We assume for now that
these costs are deducted from the profitability of additional sales to give a net profitability figure for computational
purpose. An other cost comes from the increased probability of bad-debt losses.
Illustration
To assess the profitability of a more liberal extension of credit, we must know the profitability of additional sales,
the added demand for products arising from the relaxed credit standards, the increased slowness of the average
collection period, and the required return on investment. Suppose a firms product sells for ` 10 a unit, of which
`8 represents variable costs before taxes, including credit department costs. The firm is operating at less than
full capacity, and an increase in sales can be accommodated without any increase in fixed costs. Therefore, the
contribution margin of an additional unit of sales is the selling price less variable costs involved in producing the
unit, or `10 `8 = `2.
At present, annual credit sales are running at a level of `2.4 million, and there is no underlying trend in such
sales. The firm may liberalize credit, which will result in an average collection experience of new customers of
2 months. Existing customers are not expected to alter their payment habits and continue to pay in 1 month.
The relaxation in credit standards is expected to produce a 25 percent increase in sales, to `3 million annually.
This `6,00,000 increase represents 60,000 additional units if we assume that the price per unit stays the
same. Finally, assume that the opportunity cost of carrying additional receivables is 20 percent before taxes.
This information reduces our evaluation to a trade-off between the added profitability on the additional sales and
the opportunity cost of the increased investment in receivables. The increased investment arises solely from
new, slower paying customers; we have assumed existing customers continue to pay in 1 month. With the
additional sales of `6,00,000 and receivable turnover of 6 times a year (12 months divided by the average
collection period of 2 months), the additional receivable are ` 6,00,000 / 6 = `1,00,000. For these additional
receivables, the firm invests the variable costs tied up in them. For our example, `80 of every Re.1.00 in sales
represents variable costs. Therefore, the added investment in receivables is .80 x `1,00,000 = `80,000. In as
much as the profitability on additional sales, `1,20,000, far exceeds the required return on the additional investment
in receivables, `16,000, the firm would be well advised to relax its credit standards. An optimal credit policy
would involve extending trade credit more liberally until the marginal profitability on additional sales equals the
required return on the additional investment in receivables.
Now, we shall revert back to our sample firms and examine the level of Sundry Debtors and loans and Advances
vis-a-vis the level of operations.
Lesson 8
Working Captial 247
How do firms ensure realisations?

Timely realisation of receivables is an important element of working capital management. Practices in this respect
vary from firm to firm. Most of the firms dissuade credit sales to first time customers and gradually allow credit
after development of relationship. While giving credit, some firms obtain post dated cheques from their clients.
In other cases, firms have special staff earmarked for recovery efforts. The key elements here are the opportunity
cost of funds blocked in receivables and the net expenses of maintaining recovery infrastructure. Expenses of
maintaining recovery infrastructure include the costs associated with recovering the amount from debtors. If the
funds realised from receivables can yield better return than the interest recovered from debtors, then the firm
would be better off by promoting cash sales.
Desirable Level of receivables

Considering the under given situation, let us find out whether there is a desirable level of receivables for a firm
in relation to its turnover:
` in crores
A
2012
2013
2012
2013
2012
2013
Sundry Debtors
247.63
216.50
264.51
424.78
470.76
464.10
Loans and Advances
306.29
351.42
744.09
798.19
136.91
104.73
Sales/Services
3,031.76
3,322.44 10,603.79 10,971.90
1,381.91
1,882.61
(1) as % of (3)
8.17
6.52
2.49
3.87
34.08
24.65
(2) as % of (3)
10.10
10.57
7.02
7.27
9.91
5.56
Obviously firm B has adopted a tight and conservative policy towards debtors. It is recovering its receivables
quickly. Similarly the outgo on loans and advances is not disproportionate as compared to sales. One reason for
this is that the firm B has undertaken a qualitative analysis of loans and advances and has treated some of these
as doubtful. Such doubtful advances, including loans and advances to subsidiary companies have been charged
to the Profit and Loss Account as part of prudent accounting practice. Similar treatment has been accorded to
sundry debtors as well.
In the case of firm C, the sundry debtors are a fairly high percentage of total sales and rightly so, because the
firm has no inventory and most of the working capital is locked in receivables only. The loans and advances are,
however at around 6-10% of sales.
It is difficult to prescribe a reasonable level for loans and advances for any firm because of the percentage of
sundry debtors to sales varies widely among these firms. In case of firm A sundry debtors are between 6 to 8%
of sales while loans and advances are around 10% of sales. The loans and advances consist of various types of
deposits, pre payments and advances etc. Not all loans and advances are meant to be converted into cash.
That is why loans and advances, although considered as current assets, are not treated part of the working
capital. In fact some of the advances get converted into either capital expenditure or investments. For example
advances for supply of capital goods would ultimately get shaped into fixed assets. Advances towards share
application money or as loans to subsidiary are converted into investments. Similarly pre-paid taxes & duties are
ultimately treated as expenses. In the case of firm B, the sundry debtors are just around 3-4% of sales while
loans and advances are around 7% of sales.
If a firm is buying raw material or traded goods on credit, then ideally the level of such creditors should be more
than the level of debtors at any point of time. Benchmarking of the receivable level can also be done against
248 PP-FT&FM
historical industry trends. To guard against the receivables rising beyond tolerable levels, firms usually treat all
advances and debts over six months old as doubtful cases and, if needed, charge such amounts to the profit
and loss account.
Illustration :
Ash Ltd. follows collection policy as detailed below :
(i) 10% of the sales is collected in the same month
(ii) 20% of the sales is collected in the 2nd month
(iii) 40% of the sales is collected in the 3rd month
(iv) 30% of the sales is collected in the 4th month.
Sales of the company for the first three quarters of the year are as follows :
Month of the
Quarter
Quarter-I
Quarter-II
Quarter-Ill
15,000
7,500
22,500
15,000
15,000
15,000
15,000
22,500
7,500
Total
45,000
45,000
45,000
90
90
90
No. of working days
You are required to work out average age of receivables.

Solution: Calculation of Receivable at the end of 3rd month of quarter
Out of sale
of Month
100
(10%
100
100
2
+
Balance at the end
20%
40%)
30%
(10%
20%)
70%
(10%)
90%
Rocoverable at the end of Q-I

Month
Amount
Recoverable
Recovered
Balance
Balance
Amount
15,000
70%
30%
4,500
15,000
30%
70%
10,500
15,000
10%
90%
13,500
45,000
Average age of receivables = 28500/45000*90 = 57 days
Rocoverables at the end of Q-II
28,500
Lesson 8
Working Captial 249
Month
Amount
Recoverable
Recovered
Balance
Balance
Amount
7,500
70%
30%
2,250
15,000
30%
70%
10,500
22,500
10%
90%
20,250
45,000
33,000
Average age of receivables = 33000/45000*90 = 66 days

Rocoverables at the end of Q-III
Month
Amount
Recoverable
Recovered
Balance
Balance
Amount
22,500
70%
30%
6,750
15,000
30%
70%
10,500
7,500
10%
90%
6,750
45,000
24,000
Average age of receivables = 24,000/45,000*90 = 48 days

Recovery speed is lowest in Q-II
Control of Bad debts

Control of bad-debts is an important part of controlling the working capital or the current assets of the company.
Credit policy should be followed which may not lead to bad-debts and expedite collections. Periodical checks
should be maintained by classifying debtors as outstandings from 0-30 days, 30-60 days, 60-90 days and 90
and over. Amount due for 60 days or more should be followed seriously and collected.
BANKING NORMS AND MACRO ASPECT OF WORKING CAPITAL MANAGEMENT

The above is the management oriented approach of calculating working capital. Banks and financial institutions
view the assessment of working capital from the angle as discussed in the following pages. Banks normally
provide working capital finance to hold an acceptable level of current assets viz. raw materials and stores,
stocks in progress, finished goods and sundry debtors for achieving a pre-determined level of production and
sales. The assessment of funds required to be blocked in each of these items of the working capital required by
an industry is discussed as under:
1. Raw Material: Raw material, of any kind is necessarily required by an industrial unit to continue the production
process. Different raw material could be procured from different sources may be indigenous or overseas and
accordingly different treatment of procurement time is bound to be given. Mode of payment for the raw material
may also be different. Thus, affecting the credit requirements of the client, the funds blocked up in procurement
and stocking of material will have to be taken into consideration. Total materials including those in transit and for
which advance payment is made can normally be expressed in terms of number of months consumption and
requirements of funds can be assessed by multiplying the figure by the amount of monthly consumption.
2. Work in Process: The time taken by the raw material to be converted into finished product is the period of
material processing and all the expenses of the process are involved in it. Therefore, the assessment of funds
blocked in the process is made by taking into account the raw material consumption during the processing
period and the expenses incurred during such period i.e. the cost of production for the period of processing.
3. Finished goods in the next stage: The funds blocked in finished goods inventories are assessed by estimating
the manufacturing cost of product.
250 PP-FT&FM
4. Sundry Debtors: When goods sold is not realised in cash, sundry debtors are generated. The credit period
followed by a particular industrial unit in practice is generally the result of industry practices. Investment in
accounts receivable remains blocked from the time of sale till the time amount is realised from debtors. The
assessment of funds blocked should be on the basis of cost of production of the materials against which bank
extends working capital credit.
5. Expenses: One months total expenses, direct or indirect, are provided by way of cushion in assessing the
requirement of funds which may include rent, salaries, etc. depending upon the length of operating cycle.
6. Trade Credit received on purchases reduces working capital funds requirements and has to be taken into
account for correct assessment of funds.
7. Advances received alongwith purchase orders for the products also reduce the funds requirements for
working capital.
Taking into consideration the above parameters of operating cycle, the working capital for a unit can be assessed
as under:
S.No. Component of Working Capital Basis of Calculation
1.
Raw material
Months consumption
100
2.
Stock in process
Weeks (cost of production for period of processing)
100
3.
Finished goods
Months cost of production required to be stocked
100
4.
Sundry debtors
100
5.
Expenses
One months
100
Total
500
Less: Trade credit on months purchases
` 100
Less: Advance payment on Orders received
` 100
200
300
Banks do not provide the entire amount of ` 300 towards working capital. At every stage bank would insist upon
the borrowers stake in the form of margin which depends on various factors like saleable quality of product,
durability, price fluctuations, market conditions and business environment, etc. Thus, the bank at every stage
would allow the margin at the pre-determined rate as noted below:
Permissible Limit (`)
Raw material
Less: Margin 10%
100
10
90
Stock in process
Less: Margin 40%
100
40
60
Finished goods
Less: Margin 25%
100
25
75
Sundry Debtors (at sale value)

Less: Margin 10%
100
10
90
Expenses for one month

100% Margin
100
100
Total permissible limit
315
Lesson 8
Working Captial 251
Working capital requirement of the unit
500
Permissible limits (Bank loan)
315
Gap (contribution to be provided by Borrower)
185
Before sanctioning the working capital of ` 315, the bank would ensure that borrower is in a position to bring in margin
money of ` 185 by way of excess current assets over current liabilities based on projected balance sheet.
DIFFERENT COMMITTEE OF RBI FOR WORKING CAPITAL MANAGEMENT

Commercial banks grant working capital advances by way of cash credit limits and are the major suppliers of
working capital to trade and industry. In the past, the practices in commercial banks as revealed by the findings
of different Study Groups appointed by RBI were as follows:
1. Daheja Study Group

The current limit was related to the security offered by the clients of banks without assessing financial position of
the borrower through cash flow analysis. Short-term advances were not utilised for short-term purposes and
defeated their self liquidating objective. In large number of accounts, no credit balance existed nor was the debit
balance fully wiped out over a period of years because withdrawals were more than deposits.
To control the tendency of over-financing and the diversion of the banks funds, Daheja Study Group (National
Credit Council constituted in 1968 under the Chairmanship of V.T. Daheja) made recommendations for the
banking system to finance industry on the basis of a total study of the borrowers operations rather than on
security considerations. Further, present as well as future cash credit accounts should be distinguished as
between the hard core and the short-term components. The hard core should represent the minimum level of
raw materials, finished goods and stores which the industry required to hold in order to maintain a given level of
production, and the bank finance should be provided on strong financial basis as term loan and be subjected to
regular repayment schedule whereas short-term component of the account would represent the requirement of
funds for temporary purposes i.e. a short term increase in inventories, tax, dividends and bonus payments, etc.
the borrowing being adjsuted in a short period out of sales.
2. Tondan Committee of Daheja Study Group Counicl

Although the above recommendations were implemented but no improvement was noticed in money drain to
strong industrial groups by banks and RBI appointed another study group under the chairmanship of Shri P.L.
Tandon in August 1975. Tandon committee made certain recommendations inter alia comprising of
recommendations on norms for inventory and receivables for 15 major industries, new approach to bank lending,
style of lending credit, information system and follow up, supervision and control and norms of capital structure.
A brief appraisal of the Tandon committee recommendations would prove more enlightening as given below:
1. Norms for inventory and receivables recommended by Tandon Committee for 15 major industries, cover
about 50 per cent of industrial advances of banks. These norms were arrived at after examining the trends
reflected in the company finance studies conducted by the Reserve Bank of India and detailed discussion with
representatives and experts of the industries concerned.
2. Bank lending: The Committee introduced the concept of working capital gap. This gap arised due to the noncoverage of the current assets by the current liabilities other than bank borrowings. A certain portion of this gap
will be filled up by the borrowers own funds and long-term borrowings. The Committee developed three
alternatives for working out the maximum permissible level of bank borrowings:
1.
75% of the working capital gap will be financed by the bank i.e.
Total Current assets
Less: Current Liabilities other than Bank Borrowings
= Working Capital Gap.
Less: 25% of Working Capital gap from long-term sources.
252 PP-FT&FM
2.
Alternatively, the borrower has to provide for a minimum of 25% of the total current assets out of longterm funds and the bank will provide the balance. The total current liabilities inclusive of bank borrowings
will not exceed 75% of the current assets:
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings
= Maximum Bank Borrowing permissible.
3.
The third alternative is also the same as the second one noted above except that it excludes the permanent
portion of current assets from the total current assets to be financed out of the long-term funds, viz.
Total Current assets
Less: Permanent portion of current assets
Real Current Assets
Less: 25% of Real Current Assets
Less: Current liabilities other than Bank Borrowings
= Maximum Bank Borrowing permissible.
Thus, by following the above measures, the excessive borrowings from banks will be gradually eliminated
and the funds could be put to more productive purposes.
The above methods may be reduced to equation as under:
1st Method
PBC = 75/100 x WCG
2nd Method
PBC = TCA [(25/100 x TCA) + OCL]
3rd Method
PBC = TCA [CRA + 25/100 (TCA CRA) + OCL]
Where,
PBC stands for Permissible Bank Credit
WCG stands for Working Capital Gap
TCA stands for Total Current Assets
OCL stands for Other Current Liabilities
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.
The three alternative methods mentioned above may be illustrated by taking the following figures of a borrowers
financial position, projected at the end of next year.
ILLUSTRATION
Current Liabilities
` in lakhs
Creditors for Purchase
100
Other Current Liabilities
50
Bank Borrowings including
Current Assets
Raw materials
` in lakhs
200
150
Stock-in-process
20
200
Finished goods
90
Receivable including bills discounted
50
Other current assets
10
bill discounted with banks
350
370
Lesson 8
Working Captial 253
The core Current Assets are ` 95 lakhs.

1st Method
` in
lakhs
370
2nd Method
` in
lakhs
370
3rd Method
Less: Current Liabilities
Less: 25% of Current
Less: Core Current Assets
other than Bank
Assets from long-term
Real Current Assets
borrowings
150
Working Capital gap
220
Less: 25% of above from

Long-term sources
55
Excess borrowings
Current Ratio
278
165
200
35
1 .17 : 1
95
275
Less: 25% of above from

long-term sources
69
Less: Current liabilities other

150
than Bank borrowings
Maximum Bank
150
56
Borrowings Permissible
128
Working capital gap
Working capital gap
220
Maximum Bank borrowing
Actual Bank borrowing
200
permissible
Excess borrowings
370
206
other than Bank

borrowings
Actual borrowing from

bank
92
Less: Current liabilities
Maximum Bank borrowing

permissible
sources
` in
lakhs
72
Current Ratio
1.33 : 1
Current Ratio
1.79 : 1
220
56
Actual Bank borrowing200

Excess borrowings
144
The above approach of lending is meant to ensure reasonable relationship between current assets and current
liabilities. Conventionally a current ratio of 2 : 1 is considered satisfactory but at that time it was anticipated that
in view of the constraints the availability of long-term funds in India and lack of alternative sources, the vast
majority of borrowers would not be able to comply at present with conventional standard. Accordingly, the study
group preferred to take a realistic view in suggesting that current liabilities should not exceed the current assets
and as such it is necessary that current ratio should carry a thin margin of safety i.e. it should be slightly over 1.1.
The study group also emphasised the importance of the classification of current assets and current liabilities
which should be made as per definition in the Companies Act.
The above illustration shows that each successive method is intended to increase progressively the investment
of borrowers long-term funds (comprising borrowers own funds and long-term borrowings) to support current
assets. The Committee recommended placement of the borrower on the first method within a year and their
moving to the second and third methods in stages. Out of three methods Reserve Bank of India accepted first
two methods for being put into practice by bank and deferred implementation of third method for the time being
pending group work and detailed studies to be undertaken to work out core current assets for various industries.
First and second method are not alternative but successive stages through which borrowers will pass. A borrower
who reached 1st method will push a head to conform to second method. The borrower who already satisfy the
requirement of the second method are not allowed to slip back to the 1st method by increasing their dependence
on bank borrowings. This is to say, existing current ratio should not be impaired.
The application of first method which was the stage to be reached with in period of one year, might have required
many existing borrowers to repay excess borrowings. In such cases bank were to hold dialogue with the customers
to adjust the excess borrowing without causing any hardship to them. If adjustment was difficult, the bank could
convert the excess borrowing into Working Capital Term Loan (WCTL) for being amortised over a reasonable
254 PP-FT&FM
period taking into account the borrowers cash accruals and obligations and his capacity to raise additional
equity. Period of regularisation was to be agreed to on negotiation basis between banker and borrower at the
time of entry into the new system.
3. Style of credit: A change in the style of lending has also been suggested by the Committee so as to bifurcate
the cash credit into a loan account and demand cash credit instead of treating the entire credit limit as cash
credit for a year. This will make the credit less expensive to borrowers. The demand cash credit will meet the
seasonal requirements of industry and will be wiped out automatically at the end of the business cycle. This will
introduce a better financial discipline in the credit system and will generate better financing system in the banking
economy with numerous advantages.
4. Information system: To monitor better credit information system in the banking industry, the committee
suggested for the borrower to submit quarterly statements in the prescribed format about its operations, current
assets and current liabilities and funds flow statements with monthly stock statements and projected balance
sheets and profit and loss account at the end of financial year.
5. Follow up: The Committee also suggested a close follow up for supervision and control of the use of credit by
the banks and change in attitude of the banks from security-oriented lending to production oriented lendings/
credit.
6. Norms of Capital Structure: For examining the capital structure of the company the norms have also been
suggested by the committee for monitoring a better equity : debt relationship.
3. Chore Committee
Reserve Bank of India accepted the above recommendations of the Tandon Committee but found that the gap
between sanctioned cash credit limit and its utilisation has remained unanswered. In this context, RBI appointed
in April 1979 a working group under the Chairmanship of Mr. K.B. Chore to look into this gap between the
sanctioned limits and their utilisation.
The Chore Committee has, inter alia, recommended as follows:
(1) emphasised need for reducing the dependance of large and medium scale units on bank finance for
working capital;
(2) to supplant the cash credit system by loans and bills wherever possible; and
(3) to follow simplified information system but with penalties when such information is not forthcoming
within the specified limit.
Chore Committee also suggested that the banks should adopt henceforth Method II of the lending recommended
by the Tandon Committee so as to enhance the borrowers contribution towards working capital. The observance
of these guidelines will ensure a minimum current ratio of 1.33 : 1. Where the borrowers are not in a position to
comply with this, excess borrowings on account of adoption of Method II should be segregated and converted
into a working capital term loan (WCTL). This loan should be made repayable in half-yearly instalments over a
period not exceeding five years. WCTL may carry a rate of interest higher than the rate applicable on the relative
cash credit limit, not exceeding the ceiling with a view to encouraging an early liquidation of WCTL.
It was also suggested that banks should fix separate limits where feasible for peak level and non-peak level
requirements with periods where there is a pronounced seasonal trend. This will not apply to agro-based industries
but also to certain consumer industries like fans, refrigerators, etc. The borrower should be discouraged from
approaching banks frequently for ad hoc limits in excess of the sanctioned limits excepting those special
circumstances when such requests be considered for short duration with 1 per cent additional interest over
normal rate which could be waived in general cases on merits. Sick units may be allowed general exemptions
from the above requirements. The Committee also favoured encouragement be given to bill finance i.e. bill
Lesson 8
Working Captial 255
acceptance and bill discounting practices involving banks, buyers and sellers. The Committee suggested some
modifications and improvements in the system earlier recommended by the Tandon Committee. The modified
system includes that banks should submit half-yearly statements to RBI above credit limits of borrowers with
aggregate working capital of ` 50 lakhs and above from the banking system.
4. Marathe Committee
In 1982, it was felt that an independent review of the Credit Authorisation Scheme (CAS) which had been in
operation for several years would be useful and accordingly the Reserve Bank of India appointed a Committee
referred as Marathe Committee in November 1982 to review the working of the Credit Authorisation Scheme.
The Committee submitted its report in July 1983.
The Marathe Committee which was given terms of reference to examine the Credit Authorisation Scheme from
the point of view of its operational aspects stressed that the CAS is not to be looked upon as a mere regulatory
measure which is confined to large borrowers. The basic purpose of CAS is to ensure orderly credit management
and improve quality of bank lending so that all borrowings, whether large or small, are in conformity with the
policies and priorities laid down by the Central Banking Authority. If the CAS scrutiny has to be limited to a
certain segment of borrowers, it is because of administrative limitations or convenience, and it should not imply
that there are to be different criteria for lending to the borrowers above the cut off point as compared to those
who do not come within the purview of the scheme.
5. Kannan Committee
With a view to free the banks from rigidities of the Tandon Committee recommendations in the area of Working
Capital Finance and considering the ongoing liberalizations in the financial sector, IBA constituted, following a
meeting of the Chief Executives of Selected public sector banks with the Deputy Governor of Reserve Bank of
India on 31.8.96, a committee on Working Capital Finance including Assessment of Maximum Permissible
Bank Finance (MPBF), headed by Mr. K. Kannan, the then Chairman and Managing Director of the Bank of
Baroda.
The Committee examined all the aspects of working capital finance and gave far reaching recommendations on
the modalities of assessment of working capital finance in its report, submitted to IBA on February 25, 1997. It
observed that since commercial banks in India were undergoing a metamorphosis of deregulations and
liberalizations, it was imperative that micro-level credit administration should be handled by each bank individually
with their own risks-perceptions, risks-analysis and risks-forecastings. The final report of the Committee was
submitted to RBI for its consideration in March, 1997. In its final report, the Kannan Committee also pointed that
alongwith modification of existing systems of working capital assessment and credit monitoring, certain
undermentioned areas also need to be addressed:
(1) Regular interface with the borrower to have a better understanding of (i) his business/activity; and, (ii)
problems/constraints faced by him and the future action plan envisaged;
(2) Periodical obtaining of affidavits from the borrowers, declaring highlights of their assets, liabilities and
operating performance (in lieu of subjecting even the high rated/high valued borrowers to several routine
inspections/ verifications) in order to bestow faith-oriented, rather than ab initio doubt-oriented, approach
in monitoring the credit dispensation.
(3) Periodical exchange of information between/among financing banks/financial institutions to pick-up the
alarm signals at the earliest.
(4) Establishing, within, a time bound programme, a Credit Information Bureau to provide updated
information of existing/new borrowers before taking a credit decision. (Modality of Information Bureau in
advanced countries may be taken as a guide for floating an appropriate Credit Information Bureau).
256 PP-FT&FM
Accordingly, the Kannan Committee recommended that the arithmetical rigidities, imposed by Tandon Committee
(and reinforced by Chore Committee) in the form of MPBF-computation, having so far been in vogue, should be
given a go-by. The committee also recommended for freedoms to each bank in regard to evolving their own
system of working capital finance for a faster credit delivery in order to serve more effectively various segments
of borrowers in the Indian economy.
Concurring with recommendations of the Kannan Committee, Reserve Bank of India (vide circular No. IECD No.
23/08.12.01/96 dated 15.04.1997) advised to all the banks, inter-alia, as under:
It has now been decided that the Reserve Bank of India shall withdraw forthwith the prescription in regard to
assessment o working capital needs based on the concept of maximum permissible bank finance (MPBF)
enunciated by Tandon Working Group. Accordingly, an appropriate system may be evolved by banks for assessing
the working capital needs of borrowers within the prudential guidelines and exposure norms already prescribed.
The turnover method, as already prevalent for small borrowers, may continue to be used as a tool of assessment
for this segment; since major corporates have adopted cash budgeting as a tool of funds management, banks
may follow cash budget system for assessing the working capital finance in respect of large borrowers; there
should also be no objection to the individual banks retaining the concept of the present maximum permissible
bank finance, with necessary modifications or any system.
Reserve Bank of India further directed that Working capital credit may henceforth be determined by banks
according to their perception of the borrower and the credit needs. Banks should lay down, through their boards
a transparent policy and guidelines for credit dispensation in respect of each broad category of economic activity.
OTHER ISSUES INVOLVED IN THE MANAGEMENT OF WORKING CAPITAL

Apart from the discussion of the nature of various components of working capital, we need to consider various
other aspects of this intricate system of financial management. These aspects undertake a finer and more
microscopic analysis of the components in order to strengthen control over the current assets on one hand and
to improve the productivity of working capital on the other. Some of the relevant issues are described as under:
(A) The Concept of Net Working Capital

Net working capital is the term used to denote the difference of current assets and current liabilities. Traditionally
it has been assumed that the current assets of a firm should be more than adequate to meet the current liabilities.
In other words, the current ratio, i.e. the ratio of current assets to current liabilities should be more than one. The
rationale behind this assumption is that the firm should at all times be in a position to maintain liquidity. By
definition, current assets are treated as those assets which are capable of quick conversion into cash and
secondly, the time period for conversion into cash is usually small but not more than one year in any case.
Carrying the argument further, one can postulate that the older the current asset gets, the lesser are its chances
of easy conversion into cash. So, in order to maintain the quality of its current assets, the firm seeks to reduce
their holding period. Simultaneously, the firm tries to prolong the time period available for payment of its current
liabilities by building up the level of inventory through trade finance and using bank borrowing against inventory
and debtors. The result of this exercise is that the net working capital of the firm turns negative and its current
ratio becomes less than one.
On the face of it the concept of negative net working capital appears to be fraught with unfavorable consequences
for the firm. In such a situation, if the firm is required to meet its current obligations all at once, it might not have
adequate liquidity available and as a result, it could default on its obligations. This could happen in a situation
where the cash has moved out of the operating cycle to long term uses like creation of fixed assets or towards
non-productive investments in other firms. But if the firm has, as part of its conscious working capital management
policy, kept the level of current assets to the minimum and deployed the surplus cash in non-working capital, yet
liquid investments, then it can afford to function with a net working capital that is negative.
Lesson 8
Working Captial 257
Hence so long as a firm does not default on payment of its current liabilities, the fact that it has a negative net
working capital need not be a cause for concern. This may not always be true as most of the organisatons may
like to see current assets more than current liabilities. Example of such organisations could be banks who
provide short-term credit or suppliers of raw material who sell on credit to firms.
(b) The Myth of Adequate Current Assets

Aligned to the first issue is the myth of adequate current asset. Traditionally, it has been believed that liquidity is
proportional to the level of current assets. A firm having a high current ratio is treated as favorably placed as
regards payment of its current liabilities. This is myth since the holding of current assets is always in proportion
to the turnover. If level of current assets is rising disproportionately to the turnover, then notwithstanding the high
current ratio, the situation has the following implications:
The age of current assets is increasing which tells upon their quality. As the current assets, particularly
inventory and receivables, get older the chances of their easy and complete conversion into cash recede.
Once this happens, there is every possibility of the operating cycle cracking.
The firm is paying a huge cost for the higher build up of current assets. This cost consists of
(a) The amount spent towards raw materials and intermediate inputs
(b) The cost incurred towards storing and maintaining the inventory.
(c) The interest cost for obtaining finance against these current assets
(d) The cost of obsolescence associated with holding inventory for longer periods and
(e) The cost of expected default on receivables as reflected in charge to Profit and loss account towards
bad debts.
(c) Does the balance sheet give a true picture of current assets?
We have restricted the discussion of current assets to the position obtained as on a particular date. This position
may not be representative of the state of affairs prevailing on a day to day basis throughout the year. In order to
even out the effects of daily variation in the level of current assets, it is advisable to take average of weekly,
monthly or quarterly holding depending upon the nature of the industry and turnover of the assets. The position
at the end of a day is a static position which is not representative of the entire year. By taking period averages
some amount of dynamism is brought into the picture.
The second point to be noted is that an industry might have seasonal peaks or troughs of working capital
requirement. For example agro based industry like fruit processing unit would need to stock more raw material
during the peak season when the crop has been harvested than during the lean season. In such cases different
norms have to be applied for peak season and non peak season for holding of current assets for judging the
reasonability of their holding.
We find, therefore that the high level of current assets is nothing but a fiction when we seek to realize the current
assets. It may happen that the inventory carried by the firm may consist of obsolete items, packing materials,
finished goods which have been rejected by buyers and items like dies and tools which are more fixed than current
in character. Prudence would advise that the firm should get rid of these current assets as early as possible.
On the other hand, the current liabilities are more ascertainable and less fictions. The payment of these liabilities,
if not possible from the operating cycle, has to be arranged from long term sources of funds which results in a
mismatch that is not conducive to financial health of the firm.
(d) The various forms of cash holding

Cash is considered to be the most liquid of current assets. It is held either as cash balances with the firms or in
258 PP-FT&FM
bank accounts. There are two ways of holding bank balances first as current accounts through which the day
to day transactions of the firm are carried out and secondly as fixed deposits in which balances are held for a
specified twice period. Current account balances are most liquid. Fixed account balances are convertible into
cash by adjustment downwards of the rate of interest even before maturity. Hence even fixed deposit balances
should be treated at par as regards liquidity. But there is a catch here. Quite a few fixed deposits are not held
perse, but as margin money deposits for availing the facilities like letters of credit and guarantee from banks. To
the extent of such margin money deposits, the liquidity of bank balances of the firm is impaired.
Cash balances are also held as un availed portion of the working capital facilities granted by the banks. All such
balances earn money for the firm in terms of the interest that is saved on unavailed portion. Yet the money
remains available to the firm almost on call. Such balances are most suitable to a firm for enhancement of
liquidity provided the firm has the policy of availing bank finance for its working capital requirements.
These firms maintain just enough balance in their current accounts and transfer the surplus immediately to the
borrower accounts for saving interest thereon. In most such cases, even the routine transactions are carried out
through the borrowal accounts, thus precluding the need for maintaining current accounts even.
ACCOUNTING POLICIES OF FIRMS FOR WORKING CAPITAL MANAGEMENT

The pattern of working capital management of a firm is determined to a large extent by its accounting policies
regarding sales, receivables inventories and payables. These policies establish the level of working capital of
the firm. Let us examine the accounting policies of three different firms say A, B, and C:
Accounting policies of Firm A

1. Sales
(i) Sales are counted on dispatch of products and includes cost of self-consumption of goods produced.
(ii) Income from works contract, consultancy and other services rendered is, accounted for on percentage
of completion basis.
(iii) Revenue on real estate development is recognized on completion of contract.
(iv) Lease rental income is accounted as per terms of lease.
2. Accounting for claims and subsidies
(i) Claims receivable are accounted at the time of lodgment depending on the certainty of receipt and
claims payable are accounted at the time of acceptance.
(ii) Claims raised by the Government authorities regarding taxes and duties, which are disputed by the
company, are accounted based on the merits of each claim.
(iii) Subsidy receivable against an expense is deducted from such expense and subsidy/grant receivable
against a fixed asset is deducted from the cost of the relevant fixed assets.
(iv) Investment subsidy not specifically related to a fixed asset is credited to capital reserve and retained till
the requisite conditions are fulfilled.
3. Inventories
(i) Raw materials, stock-in-trade and work-in-progress are valued at cost or net realizable value whichever
is lower.
(ii) Cost is determined on a weighted average basis.
(iii) Expenditure incurred on mobilization and creation of facilities in respect of incomplete contracts is
carried forward and written off in proportion to work done.
Lesson 8
Working Captial 259
4. Receivables
(i) Sundry debtors are classified into two categories, secured and unsecured.
(ii) Secured debts are backed by agreements, documents and physical security. All these debts are
considered good unless default occurs. Further classification of these debts is done as over six months
old and less than six months old.
(iii) Unsecured debts are divided into these over six months old and less than six month old. The former
category contains a sub-classification of doubtful debts which is charged to provision made for bad and
doubtful debts.
Accounting policies of firm B

1. Revenue recognition
(i) Sales are recognized when goods are supplied and are recorded net of trade discounts, rebates, sales
tax and excise duties but include, whenever applicable export incentives such as duty drawbacks and
premiums or sales of import licences.
(ii) Income from property development activity is recognized under the completed contract method and in
terms of arrangements with developers, whenever applicable.
2. Inventories
(i) Inventories are valued at the lower of cost, computed on a weighted average basis, and estimated net
realizable value, after providing for cost of obsolescence and other anticipated losses, wherever
considered necessary.
(ii) Finished goods and works-in-process include costs of conversion and other costs incurred in bringing
the inventories to their present location and condition.
3. Sundry Debtors and loans and advances
Sundry debtors and loans and advances are stated after making adequate provisions for doubtful advances.
Accounting policies of firm C

1. Revenue recognition
Revenue from professional services consists primarily of revenue earned from services performed on a
time and material basis. The related revenue is recognized as and when the services are performed.
2. The company also performs time bound fixed price engagements, under which revenue is recognized using
the percentage of completes method of accounting, unless work completed cannot be reasonably estimated.
3. Amounts received or billed in advance of services performed are recorded as unearned revenue. Unbilled
revenue, included in debtors, represents amounts recognized based on services performed in advance of
billing in accordance with contract terms.
Comments on Accounting Policies

We may note that all the firms have adopted realistic and conservative polities for valuation of the current
assets. These policies help in correct assessment of net working capital as the current liabilities are also
appropriately stated and the picture one obtains is more amenable to rigorous analysis.
FACTORING SERVICES
As the accounts receivable amount to the blocking of the firms funds, the need for an outlet to impart these
liquidity is obvious. Other than the lag between the date of sale and the date of receipt of dues, collection of
260 PP-FT&FM
receivables involves a cost of inconvenience associated with tapping every individual debtor. Thus, if the firm
could contract out the collection of accounts receivable it would be saved from many things such as administration
of sales ledger, collection of debt and the management of associated risk of bad-debts etc.
Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a financial
institution called the factor which specialises in the management of trade credit. Under a typical factoring
arrangement, a factor collects the accounts on the due dates, effects payments to the firm on these dates
(irrespective of whether the customers have paid or not) and also assumes the credit risks associated with the
collection of the accounts. As such factoring is nothing but a substitute for in-house management of receivables.
A factor not only enables a firm to get rid of the work involved in handling the credit and collection of receivables,
but also in placing its sales in effect on cash basis.
Origin of Factoring Services

Factoring has a long and fascinating history and the word factor has its etymological origin in the Latin word
Facere which means to make or do, i.e. to get things done. During 15th and 16th centuries, factors were
appointed by manufacturers in England, France and Spain in order to arrange for sales and distribution of then
goods in the colonies in the New World. The first credit factors in modern times were textile agents in the
eighteenth century. Thus, the earlier factors used to provide services under marketing, distribution, administration
and finance. From 1920s however the factors began to specialise in performing the credit and collection function
for their clients.
The working group by RBI (Vaghul Committee) has recommended that banks as well as private non-bank
financial institutions should develop factoring services. It has been widely accepted as a form of financing the
working capital requirements in the USA, UK and Europe but has yet to take its roots in India. It will require the
development of matching services such as information dissemination network and highly efficient communication
facilities. It will thus, help in shortening the operating cycle and thereby reducing the money tied in working
capital.
Definition and functions Factoring Services

Factoring may be defined as a relationship between the financial institution or banker (factor) and a business
concern (the supplier) selling goods or providing services to trade customers (the customer) whereby the
factor purchases book debts with or without recourse (with a recourse means that in the event of bad debts
factor can approach the supplier) to the supplier and in relationship thereto controls the credit extended to the
customers and administers the sales ledger of the supplier.
Though the purchase of book debts is fundamental to the functioning of factoring, there are a number of functions
associated with this unique financial services. A proper appreciation of these functions would enable one to
distinguish it from the other sources of finance against receivables. They are:
assumption of credit and collection function;
credit protection;
encashing of receivables;
collateral functions such as:
(a) loans on inventory,
(b) loans on fixed assets, other security and on open credit,
(c) advisory services to clients.
Lesson 8
Working Captial 261
Factoring vs. Accounts Receivable Loans

Accounts receivable loan is simply a loan secured by a firms accounts receivable by way of hypothecation or
assignment of such receivables with the power to collect the debts under a power of attorney. In case of factoring
however, there is an outright sale of receivables. Thus in case of the former, the bank may debit clients account
for handling charges if the debt turns out to be bad as against non-recourse factoring.
Factoring vs. Bill Discounting

Under a bill discounting arrangement, the drawer undertakes the responsibility of collecting the bills and remitting
the proceeds to the financing agency, whereas under factoring agreement, the factor collects clients bills.
Moreover, bill discounting is always with recourse whereas factoring can be either with recourse or without
recourse. The finance house discounting bills does not offer any non-financial services unlike a factor which
finances and manages the receivables of a client.
Mechanics of Factoring
Factoring offers a very flexible mode of cash generation against receivables. Once a line of credit is established,
availability of cash is directly geared to sales so that as sales increase so does the availability of finance. The
dynamics of factoring comprises of the sequence of events outlined in figure.
(1) Seller (client) negotiates with the factor for establishing factoring relationship.
(2) Seller requests credit check on buyer (client).
(3) Factor checks credit credentials and approves buyer. For each approved buyer a credit limit and period
of credit are fixed.
(4) Seller sells goods to buyer.
(5) Seller sends invoice to factor. The invoice is accounted in the buyers account in the factors sales ledger.
SELLER
4. GOODS
BUYER
5. CREDIT CHECK
1. NEGOTIABLE
2. REQUESTS CREDIT
6. INVOICE NOTICE
FACTOR
OF ASSIGNMENT
3. INVOICE
7. 80% PAYMENT
8. PAYMENT ON DUE
9. BALANCE PAYMENT
DATE
Figure: Mechanics of Factoring

Source: Ranjani Chari, 1991, Factoring in India, M.Phil, Dissertation, Delhi University.
262 PP-FT&FM
(6) Factor sends copy of the invoice to buyer.
(7) Factor advices the amount to which seller is entitled after retaining a margin, say 20%, the residual
amount paid later.
(8) On expiry of the agreed credit period, buyer makes payment of invoice to the factor.
(9) Factor pays the residual amount to seller.
Types of Factoring: Factoring services may be rendered to cover domestic as well as international sales. The
various services offered by factors for domestic sales are of six types whose essential characteristics are outlined
in Table 1.
Table 1 : Types of Factoring Services
Type of Factoring
Type of Functions
Availability of
Finance
bad debts
Protection*
against
Credit
Advice
Sales
Ledger
Administration
Collection
Disclosure
Customers
Full Source(Non-Recourse)
Yes
Yes
Yes
Yes
Yes
Yes
Recourse Factoring
Yes
Yes
Yes
Yes
Yes
Agency Factoring
Yes
Possible
No
No
Yes
Bulk Factoring
Yes
Possible
No
No
Yes
Invoice** Discounting
Yes
Possible
No
No
No
No
Undisclosed Factoring
Yes
Possible
No
No
No
No
* Any form which includes this element may be referred to as non-recourse factoring
** Also referred to as confidential or non-notification factoring.
Source: Ranjani Chari-opcit. P. 28.
Illustration:
The turnover of Zenith Ltd. is ` 100 lakh of which 72% is on credit. Debtors are allowed one month to clear
off the dues. A factoring company is willing to advance 80% of the bills raised on credit for a fee of 1% a
month plus a commssion of 5% on the total amount of debts. Zenith Ltd. as a result of this arrangement is
likely to save ` 48,000 annually in management costs and avoid bad debts at 1% on the credit sales.
A bank has come forward to make an advance equal to 80% of the debts at an annual interest rate of 15%.
However, its processing fee will be at 1% on the debts. Would you accept factoring or the offer from the
bank?
Lesson 8
Working Captial 263
Solution:
Cost of Factoring
Annual Credit Sales
100 x 72%
= ` 72 Lakh
Monthly Credit Sales
72 Lakh / 12
= ` 6 Lakh
Fee [6,00,000 x 0.80]
4,80,000
4,80,000 x 0.01
= ` 4,800
Commission [600000 x 0.05]
= ` 30,000
= ` 34,800
Less : Savings in Cost:

Management Cost [48000/12]
` 4,000
Savings in Bad Debts [` 600000 x 0.01]
` 6,000
Net Cost of Factoring [Per Month]
` 10,000
` 24,800
Cost of Bank Advance

Interest [` 600000 x 0.80 x 0.15 x 1/12]
` 6,000
Processing Fee [` 600000 x 0.01]
` 6,000
Bad Debts [` 600000 x 0.01]
` 6000
Management Cost
` 4,000
Net Cost (Per Month)
` 22,000
Since cost of Bank Finance is les than the cost of factoring, therefore, it is advisable to accept bank offer.
OTHER TECHNIQUES FOR CONTROL OF WORKING CAPITAL

Cash forecast technique can be used for control of funds flowing in and out of business to check surpluses and
shortages. Daily, weekly, monthly, cash flow statements are used to regulate flow of funds and arrange for fund
shortage and invest surplus cash.
1. Fund Flow Statement

Fund flow statements are used to find changes in assets over a period of time showing uses of funds and
sources of funds. Funds flow represent movement of all assets particularly of current assets because movement
in fixed asserts is expected to be small except at times of expansion or diversification.
2. Forfaiting Services
Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the purchase of trade
bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in the form of
discounting the documents covering entire risk of non-payment in collection. All risks and collection problems
are fully the responsibility of the purchaser (forfeiter) who pays cash to seller after discounting the bills/notes.
The salient features of forfaiting as a form of export relating financing are as under:
(i) The exporter sells and delivers goods to the importer on deferred payment basis.
(ii) The importer draws a series of promissory notes in favour of the exporter for payment including interest
charge. Alternatively the exporter draws a series of bill which are accepted by the importer.
264 PP-FT&FM
(iii) The bills/notes are sent to the exporter. The promissory notes/bills are guaranteed by a bank which may
not necessarily be the importers bank. The guarantee by the bank is referred to as an Aval, defined as
an endorsement by a bank guaranteeing payment by the importer.
(iv) The exporter enters into a forfaiting agreement with a forfeiter which is usually a reputed bank. The
exporter sells the avalled notes/bills to the bank at a discount without recours and recives the payment.
(v) The forfeiter may hold these notes/bills till maturity for payment by the importers bank.
Forfaiting vs. Export Factoring
Forfaiting is similar to cross border factoring to the extent both have common features of non recourse and
advance payment. But they differ in several important respects:
(a) A forfeiter discounts the entire value of the note/bill but the factor finances between 75-85% and retains
a factor reserve which is paid after maturity.
(b) The avalling bank which provides an unconditional and irrevocable guarantee is a critical element in the
forfaiting arrangement wheras in a facoring deal, particularly non-recourse type, the export factor bases
his credit decision on the credit standards of the exporter.
(c) Forfaiting is a pure financing arrangement while factoring also includes ledger administration, collection
and so on.
(d) Factoring is essentially a short term financing deal. Forfaiting finances notes/bills arising out of deferred
credit transaction spread over three to five years.
(e) A factor does not guard against exchange rate fluctuations; a forfeiter charges a premium for such risk.
3. Ratio Analysis
Ratio Analysis is normally used for working capital control. The following ratios are commonly used:
1. Current Ratio
Current Assets
Current Liabilities
2. Acid Test Ratio
Current Assets
Inventories
Current Liabilities
3. Inventory Turnover
Cost of goods sold

Average Inventory
4. Current Assets Turnover

5. Receivable Turnover
Annual Sales
Current Assets
Sales
Debtors
6. Total Debt to share capital and free reserves.

Besides above, for managing current assets, it is advisable to calculate the following ratios also:
1. Quantum of shareholders funds invested in current assets.
2. Quantum of shareholders funds and long-term debts invested in current assets.
3. Relationship between the shareholders and long term funds on one hand and the short term funds on
the other pertaining to current assets.
Lesson 8
Working Captial 265
CASE STUDIES
Exercise No. 1 : Calculate cash conversion period from the financial variables given hereunder:
Year 2010-2011
Year 2011-12
Year 2012-13
Inventory
940
936
Bills Receivables
942
962
Bills Payable
608
606
Sales
7,936
Cost of Goods sold
7,036
Solution :
Inventory conversion period:
{(940 + 936)/2*365 = 48.7 days

(7,036)
B/R conversion period:
{942 + 962)/2*365} = 43.8 days

(7,936)
Payables conversion period:
{(608+606)/2}
= 31.5 days
7036
Cash conversion period:
48.7 + 43.8 31.5 = 61 days
Exercise No. 2 Find the average conversion period with the help of the following data:
Gross operating cycle
88 days
Net operating cycle
65 days
Raw material storage period
45 days
Work-in-progress conversion period
4 days
Finished goods storage period
25 days
Solution :
Average conversion period : 88 - (45 + 4 + 25) = 14 days
Exercise No. 3 Calculate the finished goods conversion period if:
(` lakh)
Finished goods opening stock
525
Finished goods closing stock
850
Cost of production
8,000
Administrative expenses
2,250
Excise duty
3,000
Solution :
Average stock of finished goods : ` (525 + 850)/2 = ` 687.5 lakh
266 PP-FT&FM
Cost of goods sold : ` 525 Lakh + 8,000 Lakh + 2,250 Lakh + 3,000 Lakh 850 Lakh = ` 12,925 lakh
Daily average = 12,925/365 ` 35.41 lakh
Finished goods conversion period = 687.5/35.41 = 19.42 days
Exercise No. 4 : Firm uses 1,100 units of a raw material per annum, the price of which is ` 1,500 per unit. The
order cost per order is ` 150 and the carrying cost of the inventory is ` 200 per unit. Find the EOQ and the
number of orders that are to be made during the year.
Solution :
Economic Order Quantity
= 41
No. of orders during the year = 1,100/41 = 26.8 or 27
Exercise No. 5 : A factory uses 40,000 tonnes of raw material priced at ` 50 per tonne. The holding cost is ` 10
per tonne of inventory. The order cost is ` 200 per order. Find the EOQ. Will this EOQ be maintained if the
supplier introduces 5% discount if the order lot is 2000 tonnes or more?
Solution :
Economic Order Quantity
= 1265
No. of orders = 40,000/1265 = 31.62
Order cost = ` 200 31.62 = 6325
Carrying cost = ` 10/2 1265 = 6,325
Total cost = ` 6,325 + 6,325 = ` 12,650
EOQ with discount:
No. of orders = 40,000/2000 = 20
Order cost = ` 200 20 = ` 4,000
Carrying cost = ` 10/2 2,000 = ` 10,000
Price discount = 40000 0.05 = ` 2,000
Total cost = 4,000 + 10,000 2,000 = ` 12,000
Since total cost without discount > total cost with discount, discount may be availed. In this case, there
will be deviation from the EOQ.
Lesson 8
Working Captial 267
Exercise No. 6 : Find out the average size of receivables if the goods are sold for ` 10,00,000 on a net 60 credit
term with an assumption that 20% of the customers do not pay within the prescribed time. Will there be any
change in the average size if the terms of credit change to 2/10 net 60 with an assumption that 60% of the
customers avail the discount?
Solution
Case I:
Average collection period = 60 + 0.20 60 = 72 days
Average size of receivables = ` (10,00,000/360) 72 = ` 2,00,000
Case II:
Average collection period = (0.6 10) + 0.4 (60 + 0.2 60)
= 6 + 28.8 = 35 days
Average size of receivables = ` (10,00,000 / 360) 35 = ` 97,222.22
Exercise No. 7 : A firm sells 25,000 units at an average price of ` 200 per unit. The variable cost is 80 per cent
of the sale price. The credit term is 1/10 net 30. One-tenth of the customers avail the discount and the average
collection period is 28 days. Administrative cost is ` 20,000. Collection cost/sales and bad debt/sales ratios are
2% each. To increase the level of sales, credit term is changed as 2/10 net 30 as a result of which the sales are
expected to be 50,000 units. The administrative cost, collection cost ratio and bad debt ratio are expected to be
unchanged. The cost of funds is 10%. Tax rate is 30%. Find the net benefit of the changed credit terms.
Solution
Average size of receivables:
Case I : ` (50,00,000 /360) 28 = ` 3,88,889
Case II : ` (1,00,00,000 /360) 28 = ` 7,77,778
Financing cost:
Case I: ` 3,88,889 0.10 = ` 38,889
Case II: ` 7,77,778 0.10 = 77,778
Net Benefit:
Case I
Case II
Revenue (sales)
50,00,000
1,00,00,000
Less variable cost
40,00,000
80,00,000
Net revenue
10,00,000
20,00,000
Less financing cost
38,889
77,778
Less administrative cost
20,000
20,000
Less collection cost
1,00,000
2,00,000
Less bad debt losses
1,00,000
2,00,000
Profit before tax
7,41,111
15,02,222
Less tax @ 30%
2,22,333
4,50,667
Net profit after tax
5,18,778
10,51,555
268 PP-FT&FM
Net benefit of liberal term = ` 10,51,555 5,18,778 = ` 5,32,777
Exercise No. 8 : From the following information extracted from the books of a manufacturing company, compute
the operating cycle in days and the amount of working capital required:
Particulars
Amount in `
Average Total of Debtors Outstanding
48,000
Raw Material Consumption
4,40,000
Total Production Cost
10,00,000
Total Cost of Sales
10,50,000
Sales for the year
16,00,000
Value of Average Stock maintained:
Raw Material
32,000
Work-in-progress
35,000
Finished Goods
26,000
Period Covered in days
365
Average period of credit allowed by suppliers in days
16
Solution
Computation of Operating Cycle
(i) Raw material held in stock:
= 27 days
Less: Average credit period granted by Suppliers = 16 days
Period for raw material holding = 11 days
(ii)
= 13 days
(iii)
= 9 days
(iv)
= 11 days
Lesson 8
Working Captial 269
Total operating cycle period: (i) + (ii) + (iii) + (iv) = 44 days

Number of Operating cycles in a year = 365/44 = 8.30
= ` 1,26,500
Exercise No. 9 : From the following information calculate;
(1) Re-order level
(2) Maximum level
(3) Minimum level
(4) Average level
Normal usage
: 100 units per week
Maximum usage
: 150 units per week
Minimum usage
: 50 units per week
Re-order quantity (EOQ) 500
: units
Log in time
: 5 to 7 weeks
Solution
(1) Re-order Level
= Maximum consumption Maximum Re-order period
= 1507=1050 units
(2) Maximum Level
= Re-order level + Re-order quantity (Minimum consumption Minimum delivery period)
= 1050 + 500 (50 5) = 1300 units
(3) Minimum Level
= Re-order level (Normal consumption Normal delivery period)
= 1050 (100 6) = 450 units
(4)
= 875 units
270 PP-FT&FM
LESSON ROUND-UP
Gross Working Capital is the total of all current assets. Networking capital is the difference between
current assets and current liabilities.
Permanent Working Capital is that amount of funds required to produce goods and services necessary
to satisfy demand at its lowest point.
Various factors such as nature of firms activities, industrial health of the country, availability of material,
ease or tightness of money markets affect the working capital.
Factors which influence cash balance include credit position of the company, status of receivables
and inventory accounts, nature of business enterprise and managements attitude towards risk.
The amount of time needed for inventories to travel through the various process directly affect the
amount of investment. The investment in inventories is guided by minimization of costs and
managements ability to predict the forces that may cause disruption in the follow of inventories like
strikes or shifts in demand for the product.
Factors influencing investment in receivables are mainly the cost and time values of funds.
The operating cycle is the length of time between the companys outlay on raw materials, wages and
other expenditures and the inflow of cash from the sale of the goods.
In deciding companys working capital policy, an important consideration is trade-off between profitability
and risk.
Working capital leverage may refer to the way in which a companys profitability is affected in part by
its working capital management.
Funds flow represent movement of all assets particularly of current assets because of movement in
fixed assets is expected to be small except at times of expansion or diversification.
Cash management means management of cash in currency form, bank balance and reality marketable
securities.
As John Maynard Keynes put, these are three possible motivates for holding cash, such as transaction
motive, precautionary motives and speculative motive.
Inventory management has at its core the objective of holding the optimum level of inventory at the
lowest cost.
There are various technical tools used in inventory management such as ABC analysis, Economic
Order Quantity (EOQ) and inventory turnover analysis.
ABC analysis is based on paid to those item which account for a larger value of consumption rather
than the quantity of consumption.
EOQ determines the order size that will minimize the total inventory cost EOQ =
2 AB
C
Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a
financial institution called the factor which specializes in the management of trade credit.
Lesson 8
Working Captial 271
SELF-TEST QUESTIONS
1. What do you understand by working capital? What are its components?
2. Working Capital Management is nothing more than deciding about level, structure and financing of
current assets. Comment.
3. How would you assess the working capital requirements for seasonal industry in which you have been
appointed as Finance Manager? Illustrate your answer with the example.
4. What are the norms for working capital management to be observed in sick industries? How would
you control the liquidity of resources to avoid sickness in industrial unit facing shortage of cash
resources?
5. Write short note on banking norms and macro aspects of working capital management keeping in
view the recommendations of the Tandon Committee and Chore Committee.
6. What is the significance of working capital for a firm?
7. Briefly describe main constituents of working capital?
8. Why does the operating cycle determine the extent of working capital?
9. Describe the principles of effective cash management.
10. What are the main components of inventory?
11. Write short notes on the following:
(i) Working Capital Leverage.
(ii) Financing of working capital.
(iii) Techniques for control of working capital.
272 PP-FT&FM
Lesson 9
Security Analysis and Portfolio Management 273
Lesson 9
Security Analysis and Portfolio
Management
LESSON OUTLINE
LEARNING OBJECTIVES
SECURITY ANALYSIS
Measuring
of
Systematic
Unsystematic Risk
Security Analysis and Portfolio Management are

two very important aspect of financial
management and these are essential function
of a finance manager. Keeping this important
aspect in view, the subject Security Analysis and
Portfolio Management has been included in the
syllabus. The object of the study is to enable
the students to understand:
and
Fundamental Analysis (Economic,

Industry and Company)
Technical Approach and Efficient Capital
Market Theory
PORTFOLIO MANAGEMENT

understand
Meaning, Objectives; Portfolio Theory
Concept of Investment and Security

Analysis
Traditional Approach; Fixed and Variable

Income Securities
Risks and its types
Markowitz Portfolio Theory
Approaches to Valuation of a Security
Modern Approach - CAPM Model
Fundamental Analysis
Economic Value Added
Technical Analysis
Sharpe Single & Multi Index Model
Efficient Market Theory
Arbitrage Pricing Theory (APT)
Portfolio Management
Risk Adjusted Measure of Performance
Portfolio Analysis
LESSON ROUND UP
Risk in Investment situation
SELF TEST QUESTIONS
Markowitz Model
Sharp Index Model
Capital Asset Pricing Model
Arbitrage Pricing Theory
273
274 PP-FT&FM
THE CONCEPT OF SECURITY ANALYSIS

Security Analysis means the entire process of estimating return and risk for individual securities. It involves
analysis of various attributes of a security with a view to determine its value for investment decisions. Investments
generally involve real assets or financial assets. Real assets are tangible, material things such as buildings, ,
furniture, automobiles etc. Financial assets are pieces of paper representing an indirect claim to real assets in
form of debt or equity commitments. Therefore, a security is understood to be a debt or equity instrument issued
by a firm in lieu of the funds raised by it to meet its long term and short term requirements. Among the many
properties that distinguish real from financial assets are liquidity and marketability. These features make the
financial assets more attractive for investors as they are able to liquidate their investments easily in ready and
active markets.
For the purpose of our discussion we shall stick to the definition only and consider various avenues available in
the Indian context. We shall, therefore, describe the term securities generally and discuss the prevalent options
available in the Indian Securities market.
WHAT ARE SECURITIES

Securities may be defined as instruments issued by seekers of funds in the investment market to the providers
of funds in lieu of funds.
These instruments prima facie provide evidence of ownership to the holder of the instrument. The owner is
entitled to receive all the benefits due on the instrument and to retrieve his investment at the time of redemption.
Securities can broadly be divided into two categories Debt Securities and Equity Securities. However, Section
2(h) of Securities Contract (Regulation) Act, 1956, defines securities as under:
Securities include
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like
nature in or of any incorporated company or body corporate.
(ia) derivative.
(ib) units or any other instrument issued by any collective investment scheme to the Investors in such
schemes.
(ic) security receipt as defined in clause (zg) of Section 2 of the Securitisation and Reconstruction of
Financial Assets and Enforcement of Security Interest Act, 2002.
(id) units or any other such instrument issued to the investors under any mutual fund scheme.
(ie) any certificate or instrument (by whatever name called) issued to an investor by any issuer being a
special purpose distinct entity which possesses any debt or receivable including mortgage debt,
assigned to such entity and acknowledging beneficial interest of such investor in such debt or
receivable, including mortgage debt, as the case may be.
(ii) government securities.
(iia) such other instruments as may be declared by the Central Government to be securities and,
(iii) rights or interests in securities.
The investor makes a comparison of the returns available from each avenue of investment, the element of risk
involved in it and then makes the investment decision that he perceives to be the best having regard to the time
frame of the investment and his own risk profile.
Investment differs from speculation. Speculation also involves deployment of funds but it is not backed by a
Lesson 9
conscious analysis of pros and cons. Mostly it is a spur of the moment activity that is promoted and supported by
half-baked information and rumours. Speculative deployment of funds is generally prevalent in the secondary
equity market. What attracts people to speculation is a rate of return that is abnormally higher than the prevailing
market rates. The balancing of risk and return nevertheless operates in speculative activity also and as such the
risk element in speculation is very high.
Investment differs from gambling and betting also. Both gambling and betting are games of chance in which
return is dependent upon a particular event happening. Here also, there is no place for research-based activity.
The returns in gambling are high and known to the parties in advance.
To say that investors like return and dislike risk is, however, simplistic. To facilitate our job of analyzing securities
and portfolios within a risk return context, we must begin with a clear understanding of what risk and return are,
what creates them and how they should be measured.
RISKS AND ITS TYPES

Risk in security analysis is generally associated with the possibility that the realized returns will be less than the
returns that were expected. Risk can be further classified as systematic risk and unsystematic risk. Those forces
that are uncontrollable, external and broad in their effect are called sources of systematic risk. On the other hand,
controllable, internal factors which are peculiar to a particular industry or firm/(s) are known as unsystematic risk.
In this way economic, political and sociological changes are sources of systematic risk. For example, if an
economy moves into recession or if there is a political upheaval, it will cause the prices of nearly all the securities,
whether bond or equity to decline.
Conversely, unsystematic risk is the portion of the total risk that is unique to a firm or industry. It may be because
of change in management, labour strikes which will impact the returns of only specific firms which are facing the
problem.
Firms with high systematic risk tend to be those whose sales, profits and stock prices follow the general trend in
the level of economic or stock market activity. These may include companies that deal in basic industrial goods
like automobile manufactures.
Higher proportion of unsystematic risk are found in firms producing non durable consumer goods. Examples
include suppliers of telephone, power and food stuffs.
Chart: Risk and its Types
Risk
(Forces that
contribute to
variation in return)
Systematic Risk
That portion of total variability in
return caused by factors affecting
the pricing of all securities
Interest
Rate Risk
Market
Risk
Unsystematic Risk
That portion of total risk that is
unique to a firm or industry.
Business
Risk
Financial
Risk
276 PP-FT&FM
Systematic and unsystematic risk can be subdivided. Systematic risk for bonds is normally identified with interest
rate risk; for stocks with market risk. Unsystematic risk includes business and financial risk.
Return of the Security

Another important property of a security that the investors are concerned with is the return that can be expected
from holding a security. Earning a return on an investment requires a passage of time. After some time has
passed, one may make an objective measurement of the rate of an investment return that has been achieved.
The word return can be misleading, since no single measure of return can answer all possible questions
regarding results. The reasons lie in the fact that taxes, inflation, commissions, and the timing of cashflows all
play major roles in correct calculation of returns.
Total Return
Total return, or holding period return (r), is perhaps the best unique, rational and comparable measures of
results, no matter what type of asset is under discussion. For example, if a bought a stock on April 1, for ` 10,
received Re.1 in dividends at year end, and the stock price was `11 on March 31st, then total return or holding
period return is :
1+2 =
Income payments received during the period (`) + Value at end period
Value or the begining of the period (`)
1+r = (1+11)/10 = 1.20

r = (1+r) 1
r= 0.2 or 20%
If `. 1 is invested in the Tata Steel stock at the end of 1950 had grown to ` 347.96 by the end of 2012 and if all
dividends had been reinvested and there were no taxes or transaction costs paid, the overall return for the 62year period would be:
1+r = 348/1 = 348
r = 3470%
This can be converted into an annual total return by solving:
r=
(1+r1)+(1+r2)+..(1+rn) 1
where n= number of years

r = 62 1+348 - 1= 9.9%
This 9.9 percent is the compound rate of return on the investment that will turn Re.1 into ` 348 in 62 years.
Often, it is necessary to adjust the return for taxes which makes a difference to the total returns. Let us take a
simple example to illustrate these points.
Portfolio Information
Beginning value
` 1,00,000
Cash flows
Dividends received
`7,500
Capital appreciation
`12,500
Ending value
Total Return
`1,20,000
[(1,20,000/1,00,000)]-1 = 20%
Lesson 9
Suppose the investor has a tax rate of 30%. The `7,500 in dividends yields only `5,250 after taxes
(`7500 *.70), and the capital gains is only `8,750 after taxes (`12,500*.70). So, after-tax return equals
[(1,00,000+5,250+ 8,750)/1,00,000]-1= 14%
High nominal returns may also reflect high inflation rate. Suppose that during the performance measurement
period a 10 percent return was required just to maintain purchasing power. After-tax real return equals
[(1,00,000+5,250+ 8,750)/1,00,000(1.10)]-1= 3.6364%
So, the rate of return to this portfolio is either 20% or 14% or 3.6364%. for a tax exempt investor the 20% return
is appropriate. For a taxable investor, the return is only 14%. Inflation affects both equally.
APPROACHES TO VALUATION OF SECURITY

Security analysis begins with assessing the intrinsic value of security. There are three main schools of thought
on the matter of security price evaluation. Advocates of different schools can be classified as (1) Fundamentalists;
(2) Technicians; and (3) efficient market advocates. Let us compare these different perspectives in summary
form before describing them in detail.
(1) The Fundamental Approach: The Fundamental approach suggests that every stock has an intrinsic value.
Estimate of intrinsic worth of a stock is made by considering the earnings potential of firm which depends upon
investment environment and factors relating to specific industry, competitiveness, quality of management,
operational efficiency, profitability, capital structure and dividend policy. The earning potential is converted into
the present value of the future stream of income from that stock discounted at an appropriate risk related rate of
interest. Security analysis is done to compare the current market value of particular security with the intrinsic or
theoretical value. Decisions about buying and selling an individual security depends upon the comparison. If the
intrinsic value is more than the market value, the fundamentalists recommend buying of the security and vice
versa.
(2) Technical Approach: The technical analyst endeavours to predict future price levels of stocks by examining
one or many series of past data from the market itself. The basic assumption of this approach is that history
tends to repeat itself and the price of a stock depends on supply and demand in the market place and has little
relationship with its intrinsic value. All financial data and market information of a given security is reflected in the
market price of a security. Therefore, an attempt is made through charts to identify price movement patterns
which predict future movement of the security. The main tools used by technical analysis are: (1) The Dow
Jones theory which asserts that stock prices demonstrate a pattern over four to five years and these patterns
are mirrored by indices of stock prices. The theory employs two Dow Jones averages the industrial average
and the transportation average. If industrial average is rising, then transport average should also rise. Simultaneous
price movement is the main prediction which may show bullish as well as bearish results. Chart Patterns are
used along with Dow Jones Theory to predict the market movements.
(3) Efficient Capital Market Theory : The theory is popularly known as Efficient Capital Market Hypothesis:
(ECMH). The advocates of this theory contend that securities markets are perfect, or at least not too imperfect.
It is based on the assumption that in efficient capital markets prices of traded securities always fully reflect all
publicly available information concerning those securities. For market efficiency, there are three essential
conditions; (i) all available information is cost free to all market participants; (ii) no transaction costs; (iii) all
investors similarly view the implications of available information on current prices and distribution of future
prices of each security.
It has been empirically proved that stock prices behave randomly under the above conditions. These conditions
have been rendered unrealistic in the light of the actual experience because there is not only transaction cost
involved but traders have their own information base. Moreover, information is not costless and all investors do
not take similar data and interpretation with them.
278 PP-FT&FM
Efficient Market Hypothesis has put to challenge the fundamental and technical analysts to the extent that
random walk model is valid description of reality and the work of charists is of no real significance in stock price
analysis. In practice, it has been observed that markets are not fully efficient in the semi-strong or strong sense.
Inefficiencies and imperfections of certain kinds have been observed in the studies conducted so far to test the
efficiency of the market. Thus, the scope of earning higher returns exists by using original, unconventional and
innovative techniques of analysis. Also, the availability of inside information and its rational interpretation can
lead to strategies for deriving superior returns.
In short, if these theories are taken in their strongest forms, fundamentalists say that a security is worth the
present value (discounted) of a stream of future income to be received from the security; technicians assert that
the price tend data should be studied regardless of the underlying data; efficient market theorists contend that a
share of stock is generally worth whatever it is selling for.
There are four confusing terms which are appearing at this juncture-face value, book value; market value and
intrinsic value. Let us first clarify them.
Face value of the security is the denominating value. It is also called the nominal value. When we say that
authorized share capital of a company is ` 200 lac divided into 20 lac shares of ` 10 each, we mean that the face
value or the nominal value of the share is ` 10/- each.
The book value may be much more than the face value. Let us assume that the shares of ` 10/- each are issued
at ` 30/- each. The issuer is charging a premium of ` 20/- for the intrinsic value equalization. The issuer normally
charges premium for the following attributes:
Long years of establishment and profitable track record.
Leadership position in the market.
Potential for continued growth in the future.
Existence of free reserves with the issuer which makes the book value higher than the face value.
Case Study
Let us clarify the concept of book value a little further. Assuming that a company has been incorporated with an
authorized capital of 2 crore shares of ` 10/- each and the company operates profitably for three years, the
broad financial position of the company shall be as under:
(` In lacs)
Item
Year 1
Year 2
Year 3
Income
600
1,200
2,400
Expenditure
800
1,000
1600
Profit/Loss
(200)
200
800
Equity Capital
2,000
2,000
2,000
Free Reserves
200
800
10
10
10
10
14
Face Value/share
Book Value/share
(Share capital + free reserves)
Lesson 9
Book value of the share of the company became less than face value at the end of the first year due to the loss
incurred by it. The book value was equal to the face value at the end of the second year due to recoupment of the
loss. At the end of the third year the book value become ` 14/- due to building up of reserves. If, after the end of the
third year the issuer wishes to come up with an offering of additional shares, the offer price will not be less than ` 14.
In actual market conditions does the book value track the market value? We may observe the trend of few
company
Sl.
No.
Name of the Company
Face Value
Per Share
Book Value
Market Value
(As on 30
September)
(1)
(2)
(3)
(4)
(5)
HB Ltd.
13.8
168.70
FI Ltd.
10
136.3
250.50
IT Ltd.
314.3
3411.30
ITB Ltd.
10
175.8
349.80
BIS
10
299.3
229.70
RP Ltd.
10
20.4
22.60
RL Ltd.
10
138.2
562.60
IDD Ltd.
10
101.9
144.85
MTGL Ltd.
10
151.2
109.50
10
SC Ltd.
61.4
210.70
11
RLD Ltd.
190.5
821.15
12
HCT Ltd.
60.5
205.90
13
HPC Ltd.
10
173.8
172.45
14
CIP Ltd.
10
152.8
946.35
15
NES Ltd.
10
27.5
565.85
16
HH Ltd.
34.3
248.75
17
TISC Ltd.
10
93.6
116.50
18
LCET Ltd.
10
77.1
129.15
19
T&L Ltd.
10
133.0
167.00
20
BA Ltd.
10
283.2
380.05
21
BHL Ltd.
10
182.6
160.15
22
HIND Ltd.
10
621.5
522.10
23
ZTE Ltd.
99.2
57.50
24
BSS Ltd.
10
194.3
216.20
25
GRA Ltd.
10
295.3
309.00
26
GSIM Ltd.
10
75.3
367.15
280 PP-FT&FM
27
GLX Ltd.
10
155.14
163.00
28
ASC Ltd.
10
171.17
138.15
29
CAS Ltd.
10
32.1
189.80
30
CIG Ltd.
10
18.2
131.20
We note that the market value is not equal to the book value for shares of any of the leading companies of the
country. In fact, there is wide divergence between these two. The divergence is mostly on the upper side except
in some cases. We can conclude, therefore, that book value is not a perfect indicator of the intrinsic value of a
security. At best it can be an indicator of the floor value or base value below which the market value in normal
circumstances should not slide. Book value is a historic indicator. It depicts what the company has earned and
saved in the past. It does not reflect the future earning potential of the company.
Having considered that the book value is not an appropriate measure for ascertaining the real or intrinsic value
of a security, let us take up a more rigourous process of evaluating securities called fundamental analysis.
FUNDAMENTAL APPROACH TO VALUATION

The investor seeks to arrive at the real value or the intrinsic value of a security through the process of security
analysis. This value is arrived at by using a number of tools of financial analysis and it approximates the level at
which the demand and supply of stock of the security would be in equilibrium leading to stability of prices. Price
of the security below and above this level would tend to be unstable.
Money has a time value. the powerful tools of compounding and discounting can help us build a theoretical
framework of valuation of bonds and stocks. Bond values are reasonably easy to determine. As long as a bond
is not expected to go into default, the value of the bond is made up of present values of annual interest payments
plus the principal amount to be recovered at maturity or sooner. Valuation of equity is different because earnings
and dividend streams are uncertain as to timing of receipt and the amount of dividend. The value of an equity
stock at any moment in time can be thought of as the discounted value of a series of uncertain future dividends
that may grow or decline at varying rates over time.
It is easiest to start with equity valuation where the expected holding period is one year. The benefit any investor
receives from holding an equity stock consists of dividends plus any change in price during the holding period.
Suppose we buy one share of SBI at the beginning of the year for ` 500. We hold the stock for one year. `20 in
dividends is collected at year-end, and the share is sold for `530. the rate of return achieved is the composite of
dividend yield and change in price (capital gains yield). Thus we get
Dividend yield = D/P= 20/500 = .04
Capital gains yield = 530-500/500= .06
The total rate of return achieved is .04+.06=.10 or 10 percent. How might we express this same notion in terms
of present values? Thus:
P0 =
D1
1+r
P1
1+r
where:
D1 = dividend to be received at the end of year 1
r = investors required rate of return or discount rate
P1 = selling price at the end of year 1
P0 = selling price today
Lesson 9
Therefore,
500 = ` 20 + ` 530
1+r
1+r
Will r = .10 balance the equation? At a required rate of return of 10 percent, the dividend is worth `18.18
(`20*.909) and selling price has a present value of ` 481.8182 (`530 *.909)(see present value table). The
combined present value is ` 500.
Should a rate of return of 15 percent have been required, the purchase price would have been too high at
` 500. (the dividend of `20 and selling price of `530 remains constant). To achieve a 15% return, the value of the
stock at the beginning of the year would have had to be
P0 = (`20/1.15) + (`530/1.15)
= `17.39 + 460.87
= ` 478.26
An alternative approach would be to ask the question: at what price must we be able to sell the stock at the end
of one year (if purchase price is ` 500 and the dividend is ` 20) in order to attain a rate of return of 15 percent?
` 500 = (`20/1.15) + (P1/1.15)
` 500 = `17.39 + .87 P1
` 554.72 = P1 (selling price)
Now let us look at a multiple year holding period. In most cases dividends will grow from year to year. We can
similarly add the present value of all dividends to be received over the holding period and the present value of
the selling price of the stock to the end of the holding period to arrive at the present value of the stock.
To simplify let us assume that dividends will grow at the constant rate into the indefinite future. Under this
assumption the value of a share is
P0 =
D(1+g) + D (1+g)2 + D(1+g)3 +.. D(1+g)n

(1+r)1
(1+r)2
(1+r)3
(1+r)n
where N approaches infinity, this equation collapses simply to

P0 =
D1
r1 -g
This model states that the price of a share should be equal to next years expected dividend divided by the
difference between the appropriate discount rate for the share and its expected long term growth rate. Alternatively,
this model can be stated in terms of the rate of return on an equity share as
r = (D1/P0) + g
Illustration: An investor is holding 1000 shares of Right Choice Ltd. The current rate of dividend paid by the
company is ` 5/- per share. The long term growth rate is expected to be 10% and the expected rate of return is
19.62%. We need to find out the current market price of the share:
Solution
P0
D 1 8
rg
282 PP-FT&FM
5 1 0.10
.1962 .10
5 1.1
5.5
57.17
0.0962 0.0962
The real value or intrinsic value is valid for a given set of conditions. These conditionalities include the national
and international economic situation, industry specific and company specific circumstances. The first three
conditionalities are viewed from a macro perspective in order to even out the effect of minor happenings. The
last conditionality is observed at the micro level because at this level, even relatively smaller happenings can
disturb the demand supply equilibrium.
Fundamental analysis is a three level systematic process that analyse the overall external and internal environment
of the company before placing a value on its shares. The three levels at which the analysis is carried out are the
following:
(a) Analysis of the economy
(b) Industry Level Analysis
(c) Company Analysis
We shall describe the analytical process at all these levels in greater details hereunder:
Analysis of the economy

Performance of a company is intimately related to the overall economic environment of the country because
demand for products and services of the company would under normal circumstances be directly related to
growth of the countrys economy. If the country has an improving GDP growth rate, controlled inflation and
increasing investment activity then chances are that the valuation of securities shall be liberal. The capital
market is said to be in a bullish phase with share values shooting up across the board. As the economy is
growing, the analyst expects almost every industry to do well.
On the other hand, if the GDP growth rate slackens, inflation is out of control and investment activity is stagmant
or declining, the investor or the analyst will expect the performance of industries to slow down. Under such
circumstances, valuation of securities tends to be conservative. The capital market enters a bearish phase and
share values decline across to board.
Industry Level Analysis

Industry level analysis focuses on a particular industry rather than on the broader economy. In this analysis, the
analyst has to look for the composition of the industry, its criticality vis--vis the national economy, its position along
the industrial life cycle, entry and exit barriers. All these factors have a bearing upon the performance of the company.
Industry is a combination or group of units whose end products and services are similar. Having a common
market, the participants in the industry group face similar problems and opportunities. To the extent that an
industry loses or gains from certain happenings, the performance of the participants is sure to be similarly
impacted. These happenings may be technological changes, shifts in consumer preferences, availability of
substitutes etc. These changes also drive the life cycle of the industry.
The industry life cycle or the industry growth cycle can be divided into three major stages-pioneering stage,
expansion stage and stagnation stage. The pioneering stage is related to sunrise status of the industry. It is the
stage when technological development takes places. The products have been newly introduced in the market
and they gain ready acceptance. The pioneering units in the industry make extraordinary profits and thus attract
competition. As competition increases profitability in the industry comes under strain and less efficient firms are
Lesson 9
forced out of the market. At the end of the pioneering stage, selected leading companies remain in the industry.
In the expansion stage of the growth cycle the demand for the products increases but at a lower rate. There is
less volatility in prices and production. Capital is easily available in plenty for these units. Due to retention of
profits, internal accruals increase.
At the stagnation stage, the growth rate initially slows down, then stagnates and ultimately turns negative. There
is no product innovation. External capital is hard to come by. Even the internal capital takes flight. This stage of
the industry is most valuable during times of slow down in national economy.
Company Analysis
Armed with the economic and industry forecasts, the analyst looks at the company specific information. Company
information is generated internally and externally. The principle source of internal information about a company
is its financial statements. Quarterly and annual reports including the income statement, the balance sheet and
cash flows must be screened to assure that the statements are correct, complete, consistent, and comparable.
Many popular and widely circulated sources of information about the companies emanate from outside, or
external sources. These sources provide supplements to company-generated information by overcoming some
of its bias, such as public pronouncements by its officers. External information sources also provide certain
kinds of information not found in the materials made available by companies themselves. There are traditional
and modern techniques of company analysis.
Among the traditional techniques are forecasting expected dividends and earnings using price-earning ratios
which help us to determine whether a stock is fairly valued at a point in time. Such approaches allow us to
evaluate an equity share for a short term horizon. Moreover, an approach combining the dividend discount
model (with variable growth rates) and the concept of systematic risk can also be helpful in evaluating a stock for
a longer term holding period. Among the modern methods are regression analysis, and the related tools of trend
and correlation analysis, decision tree analysis and simulation. Modern methods have strengths of the traditional
methods while attempting to overcoming their shortcomings.
TECHNICAL ANALYSIS
In the fundamental analysis, share prices are predicted on the basis of a three stage analysis. After the analysis
has been completed, the deciding factors that emerge are the financial performance indicators like earnings
and dividends of the company. The fundamentalist makes a judgement of the equity share value with a risk
return framework based upon the earning power and the economic environment. However, in actual practice, it
often happens that a share having sound fundamentals refuses to rise in value and vice versa. We would now
examine an alternative approach to predicting share price behavior. This approach is called the Technical Analysis.
It is used in conjunction with fundamental analysis and not as its substitute.
Technical analysis assumes that market prices of securities are determined by the demand-supply equilibrium.
The shifts in this equilibrium give rise to certain patterns of price and volume of trading which have a tendency to
repeat themselves over a period of time. An analyst who is familiar with these patterns can predict the future
behaviour of stock prices by noticing the formation of these patterns.
It is a science of predicting the share price movements from the past data about share price movements. These
predictions are indicative and do not provide irrefutable declarations about future trends. In this type of analysis,
no weightage is given to intangible items like investors attitude, market sentiment, optimism, pessimism etc.
Technical analysis is based on the following assumptions:
The inter-play of demand and supply determines the market value of shares.
Supply and demand are governed by various factors both rational and irrational.
Stock values tend to move in trends that persist for a reasonable time.
284 PP-FT&FM
These trends change as a result of change in demand-supply equilibrium.
Shifts in demand and supply can be detected in charts of market action.
Chart patterns tend to repeat themselves and this repetition can be used to forecast future price
movements.
Markets behave in a random style.
Markets discount every future event that has a bearing upon share values.
DOW JONES THEORY

It is one of the earliest theories of technical analysis. The theory was formulated by Charles H. Dow of Dow
Jones & Co. who was the first editor of Wall street Journal of USA. According to this theory, share prices
demonstrate a pattern over four to five years.
These patterns can be divided into three distinct cyclical trends- primary, secondary and minor trends.
The primary trend lasts from one to three years. Over this period, the markets exhibit definite upward or downward
movement which is punctuated by shorter spans of trend reversal in the opposite directions. The trend reversal
is called the secondary trend. Primary trend is indicative of the overall pattern of movement.
If the primary trend is upward, it is called a bullish phase of the market. If the primary trend is downwards, it is
called a bearish phase. Illustrations of bullish phase and bearish phase are given below:
Graph of Bullish Phase
In a bullish phase, after each peak, there is a fall but the subsequent rise is higher than the previous one. The
prices reach higher level with each rise. After the peak has been reached, the primary trend now turns to a
bearish phase.
Lesson 9
Graph of a Bearish Phase
In a bearish phase, the overall trend is that of decline in share values. After each fall, there is slight rise but the
subsequent fall is even sharper. The secondary trend reversals last for one to three months.
Minor trends are changes occurring every day within a narrow range. These trends are not decisive of any major
movement.
TOOLS OF TECHNICAL ANALYSIS

The two variables concerning groups of securities or individual securities that technicians watch are the behavior
of prices and volume of trading contributing to and influenced by changing prices. Technical analysts use two
major types of tools for their analysis. These are the charts and the price indicators.
1. TECHNICAL CHARTS
These are the plottings of prices and trading volumes on charts. The purpose of reading and analysing these charts
is to determine the demand-supply equation at various levels and thus to predict the direction and extent of future
movement of the prices. The charts are not infallible but because of their repeated accuracy, they have come to be
accepted. In all the charts, a correlation exists between market price action and the volume of trading when the price
increase is accompanied by a surge in trading volumes, it is a sure sign of strength. On the other hand, when the
decline in share prices is accompanied by increased volumes, it is indicative of beginning of bearish trend.
There are three ways to construct a chart. These are the Line Chart, Bar Chart and Point & Figure Chart.
Line Chart
In a Line Chart, the closing prices of successive time periods are connected by straight lines and the intra-period
highs and lows of stock prices are ignored. This type of chart is useful for making broad analysis over a longer
period of time.
286 PP-FT&FM
(a) Bar Chart These charts portray intra-period high, low and closing values on a single verticle line designated
for each time period. The vertical dimensions of the line represent price. The horizontal axis of the chart indicates
the complete time period of analysis. Bar charts focus on time, volume and price.
(c) Point and Figure Chart In this type of charts, emphasis is laid on charting price changes only and time and
volume elements are ignored. The first step in drawing a figure and point chart is to put a X in the appropriate
price column of a graph. Successive price increases are added vertically upwards in the same column as long
as the uptrend continues. Once the price drops, the figures are moved to another column and Os are entered in
downward series till the downward trend is reversed.
Patterns created by charts

Once the charts have been constructed, analysts seek to locate certain indicators/patterns in the charts. The
common patterns are being described below:
1. Support and resistance levels
A support level indicates the bottom which the share values are unable to pierce. After rising time and again, the
share price dips to a particular level and then starts rising again. At this level, the share gets buying support. A
resistance level is that level after which the share price refuses to move up in repeated efforts. At this level,
selling emerges. Support and resistance levels are valid for a particular time period. Once these levels are
breached, beginning of a new bull or bear phase is signaled.
2. Heads and Shoulders configuration
In this type of chart configuration, a formation similar to heads and shoulders is created wherein the neckline
acts as the resistance or support line. As the head and shoulder top is formed, a resistance level appears at the
top of the head. The volumes start declining near the head top and reversal sets in. The volumes become heavy
again and shrink near the neckline where another reversal of trend begins.
Limitations of charts
Interpretation of charts is prone to subjective analysis. This factor is a major cause of often contradictory analysis
being derived from the same charts. Also the changes in charts are quite frequent in the short term perspective
leading to a host of buy and sell recommendations which are not in the best interest of the investor. Another
disadvantage is that decisions are made on the basis of chart alone and other factors are ignored.
2. TECHNICAL INDICATORS
Apart from the charts, technical analysts use a number of indicators generated from prices of stocks to finalise
their recommendations. These indicators are often used in conjunction with charts. Some of the important
indicators are the Advance Decline Ratio, the Market Breadth Index and Moving Averages.
(a) Advance-Decline Ratio

It is the ratio of the number of stocks that increase to the number of stocks that have declined. If the ratio is more
than one, the trend is assumed to be bullish. If the ratio starts declining, a change of trend is signaled.
(b) Market Breadth Index

This index is a variation of the Advance-Decline Ratio. This index is computed by taking the difference between
the number of stocks rising and the number of stocks falling. If during a month, 400 out of 1000 stocks in the
market have risen and 300 have declined while 300 have remained unchanged, then market breadth would be
calculated as = 2(400300)/300. The figure of each time period is added to the previous period. If market
breadth is increasing along with rise in stock indices, it confirms the bullish trend and vice cersa.
Lesson 9
(c) Moving Averages

A moving average is the average of share values of a set of consecutive number of days. If we have to calculate
50 days moving average, we calculate the average for days 150. Then on day 51, we add the value of day 51
and deduct the value of day 1 and so on . Similarly, moving averages for 100 days, 200 days and 300 days can
be calculated. Moving averages provide a benchmark for future valuation. If share value is below the moving
average, it has scope for appreciation. If the value is above the moving average, the upside is limited in the near
term.
ALTERNATIVE APPROACHES TO VALUATION

1. Random walk theory
In the Fundamental Analysis, factors such as economic influences, industry factors and particular company
information are considered to form a judgement on share value. On the other hand, price and volume information
is analysed in Technical Analysis to predict the future course of share values. There is another approach which
negates both Fundamental and Technical analysis. This approach has been based upon the research aimed at
testing whether successive price changes are independent in different forms of market efficiency.
According to the theory, share prices will rise and fall on the whims and fancies of manipulative individuals. As
such, the movement in share values is absolutely random and there is no need to study the trends and movements
prior to making investment decisions. No sure prediction can be made for further movement or trend of share
prices based on the given prices as at a particular moment. The Random Walk Theory is inconsistent with
technical analysis. Whereas, it states that successive price changes are independent, the technicians claim that
they are dependent. But believing in random walk does not mean that one should not believe in analyzing
stocks. The random walk hypothesis is entirely consistent with an upward and downward movement in price, as
the hypothesis supports fundamental analysis and certainly does not attack it.
One of the advantages of this theory is that one is not bothered about good or bad judgement as shares are picked
up without preference or evaluation. It is easier for believers in this theory to invest with confidence. The second
advantage is that there is no risk of being ill informed while making a choice as no information is sought or concealed.
Random walk theory implies that short term price changes i.e day to day or week to week changes are random
but it does not say anything about trends in the long run or how price levels are determined.
2. Efficient Market Theory

Efficient Market Hypothesis accords supremacy to market forces. A market is treated as efficient when all
known information is immediately discounted by all investors and reflected in share prices. In such a situation,
the only price changes that occur are those resulting from new information. Since new information is generated
on a random basis, the subsequent price changes also happen on a random basis. Major requirements for an
efficient securities market are:
Prices must be efficient so that new inventions and better products will cause a firms securities prices
to rise and motivate investors to buy the stocks.
Information must be discussed freely and quickly across the nations so that all investors can react to the
new information.
Transaction costs such as brokerage on sale and purchase of securities are ignored.
Taxes are assumed to have no noticeable effect on investment policy.
Every investor has similar access to investible funds at the same terms and conditions.
Investors are rational and make investments in the securities providing maximum yield.
Research studies devoted to test the random walk theory on Efficient Capital Market Hypothesis (ECMH) are
put into three categories i.e.
288 PP-FT&FM
(a) the strong form,
(b) the semi-strong form, and
(c) the weak form theory.
Strong
Form
of efficiency
Semi-strong form of efficiency
Weak form of efficiency
All information
(inside and
publicly
available)
in public
domain
Only historical
information in
public domain
All Publicly
available
information in
public domain
(a) The Strong Form of Efficiency: This test is concerned with whether two sets of individuals one having
inside information about the company and the other uninformed could generate random effect in price
movement. The strong form holds that the prices reflect all information that is known. It contemplates that
even the corporate officials cannot benefit from the inside information of the company. The market is not only
efficient but also perfect. The findings are that very few and negligible people are in such a privileged position
to have inside information and may make above-average gains but they do not affect the normal functioning
of the market.
(b) Semi-strong form of Efficiency: This hypothesis holds that security prices adjust rapidly to all publicly
available information such as functional statements and reports and investment advisory reports, etc. All publicly
available information, whether good or bad is fully reflected in security prices. The buyers and sellers will raise
the price as soon as a favourable price of information is made available to the public; opposite will happen in
case of unfavourable piece of information. The reaction is almost instantaneous, thus, printing to the greater
efficiency of securities market.
(c) The Weak Form theory: This theory is an extension of the random walk theory. According to it, the current
stock values fully reflect all the historical information. If this form is assumed to be correct, then both Fundamental
and Technical Analysis lose their relevance. Study of the historical sequence of prices, can neither assist the
investment analysts or investors to abnormally enhance their investment return nor improve their ability to select
stocks. It means that knowledge of past patterns of stock prices does not aid investors to make a better choice.
The theory states that stock prices exhibit a random behaviour.
In this way, if the markets are truly efficient, then the fundamentalist would be successful only when (1) he has
Lesson 9
inside information, or (2) he has superior ability to analyse publicly available information and gain insight into the
future of the company. The empirical evidence of the random walk hypothesis rests primarily on statistical tests,
such as runs test, correlation analysis and filter test. The results have been almost unanimously in support of the
random walk hypothesis, the weak form of efficient market hypothesis.
Individual securities have risk-return characteristics of their own. In any case, given an estimate of return, the
investor is always concerned about the probable downside price expectation or the risk. Portfolio, or combination
of securities, helps in spreading this risk over many securities. The investors hope that if they hold different
assets, even if one goes bad, the others will provide some protection from an extreme loss.
Portfolio management thus refers to managing efficiently the investment in the securities by diversifying the
investments across industry lines or market types. The reasons are related to the inherent differences in the
debt and equity markets, coupled with a notion that investment in companies in dissimilar industries would most
likely do much better than the companies within the same industry.
However, there is disagreement over the right kind of diversification and the right reason. In the following
paragraphs a formal, advanced notion of diversification conceived by Harry Markowitz will be introduced. Markowitz
assumes that investor attitudes towards portfolio depend exclusively upon (1) expected return and risk, and (2)
quantification of risk. And risk is,by proxy, the statistical notion of variance, or standard deviation of return.
PORTFOLIO ANALYSIS
While discussing Security Analysis, we had restricted our discussion to the behavior of value of individual equity
securities. Portfolio Analysis seeks to analyze the pattern of returns emanating from a portfolio of securities, i.e.
a number of securities that absorb a proportion of total amount of investment. Although holding two securities is
probably less risky than a portfolio composed exclusively of less risky asset. How? This is done by finding two
securities each of which tends to perform well whenever the other does poorly. This makes a reasonable return
for the portfolio more certain as a whole, even if one of its components happens to be quite risky. For example,
if you invest in two stocks, say, one in company engaged in sugar production and other, in a company engaged
in cement production, you would be always able to get a reasonable return as cement is a highly cyclical
industry and sugar is non cyclical. When cement industry will rise, the sugar industry will just perform below
average but when cement industry will fall sugar industry will outperform.
We shall clarify the concept of Portfolio with the help of following illustration:
Stock X
Stock Y
Return (%)
7 or 11
13 or 5
Probability
.5 each return
.5 each return
Expected return(%)
9*
Variance (%)
16
Standard deviation(%)
*Expected return = (.5)(7) + (.5)(11) = 9

Expected return = (.5)(13) + (.5)(5) = 9
It is clear that although X and Y have the same expected return, 9 percent, Y is riskier than X (standard deviation
of 4 versus 2). Suppose that when Xs return is high, Ys return is low, and vice versa. In other words, when the
return on X is 11 percent, the return on Y is 5 percent; similarly, when the return on X is 7 percent, the return on
Y is 13 percent. Question: Is a portfolio of some X and some Y in any way superior to an exclusive holding of X
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alone (has it less risk)?
Let us construct a portfolio consisting of two-thirds stock X and one-third stock Y. The average return of this
average return of each security in the portfolio; that is;
N
(20.1)
Rp =
X i Ri
i=1
where:
Rp = expected return to portfolio
Xi = proportion of total portfolio invested in security i
Ri = expected return to security i
N = total number of securities in portfolio
Therefore,
Rp = (2/3)(9) + (1/3)(9) = 9
But what will be the range of fluctuation of the portfolio? In periods when X is better as an investment, we have
Rp = (2/3)(11) + (1/3)(5) = 9; and similarly, when Y turns out to be more remunerative, Rp = (2/3)(7) + (1/3)(13) = 9.
Thus, by putting part of the money into the riskier stock, Y, we are able to reduce risk considerably from what it
would have been if we had confined our purchases to the less risky stock, X. If we held only stock X, our
expected return would be 9 percent, which could in reality be as low as 7 percent in bad periods or as much as
11 percent in good periods. The standard deviation is equal to 2 percent. Holding a mixture of tow-thirds X and
one-third Y, or expected and experienced return will always be 9 percent, with a standard deviation of zero. We
can hardly quarrel with achieving the same expected return for less risk. In this case we have been able to
eliminate risk altogether.
The above illustration indicates that it is better to spread out or diversify the investment in order to minimize the
risk associated with investment in single securities. This fact is the essence of Portfolio Analysis.
Portfolio is a collection of securities belonging to a diverse set of industries. Management of a portfolio is considered
to be a specialised activity because of the time and effort involved in tracking of each component of the portfolio.
Portfolio management is a relatively new concept in security analysis. It gained prominence after World War II when
it was realised that the instability of the securities market had put at stake fortunes of individuals, companies and
governments. It was then discovered that investing in a basket of stocks maximised profits while minimising risks.
Risk in investment situation

We have seen in the above illustration that investment in securities X and Y has been fraught with risk because
the return on investment has varied from one year to the other and obviously from any expected rate of return
also that might have been fixed.
Risk means that the return on investment would be less than the expected rate. Risk is a combination of possibilities
because of which actual returns can be different or greatly different from expected returns. Thus risk can be high
or low. In case we want to quantify how high or how low the risk in investment is going to be, we have to intimate
the probability of various outcomes and their deviation from expected outcome.
The risk involved in individual securities can be measured by standard deviation or variance. When two securities
are combined, we need to consider their interactive risk, or covariance. If the rates of return of two securities
move together, we say their interactive risk or covariance is positive. If rates of return are independent, covariance
is zero. Inverse movement results in covariance that is negative. Mathematically, covariance is defined as
Lesson 9
N
COVxy
/N
[Rx Rx] [Ry Ry]
Where the probabilities are equal and

COVxy = covariance between x and y
Rx = return on security x
Ry = return on security y
Rx = expected return to security x
Ry = expected return to security y
N = number of observations
Continuing with the above illustration,
Return
Expected
Return
Difference
Stock X
-2
Stock Y
13
Stock X
11
Stock Y
-4
Product
-6
-6
COV = 1/2[(7 - 9)(13 9) +[(11 - 9)(5 9)]
= 1/2[(-8) + (-8)] = -16/2 = -8
The coefficient of correlation is another measure designed to indicate the similarity or dissimilarity in the behavior
of two variables. We define
rxy =
covxy
x y
where:
rxy = coefficient of correlation of x and y
COVxy = covariance between x and y
x
= standard deviation of x
= standard deviation of y
The coefficient of correlation is, essentially, the covariance taken not as an absolute value but relative to the
standard deviations of the individual securities (variables). It indicates, in effect, how much x and y vary together
as a proportion of their combined individual variations, measured by x y In our example, the coefficient of
correlation is
rxy = 8/[(2)(4)] = -8/8 = -1.0
If the coefficient of correlation between two securities is -1.0, then a perfect negative correlation exists (rxy
cannot be less than -1.0). If the correlation coefficient is zero, then returns are said to be independent of one
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another. If the returns on two securities are perfectly correlated, the correlation coefficient will be +1.0, and
perfect positive correlation is said to exist (rxy cannot exceed +1.0).
Thus, correlation between two securities depends upon (1) the covariance between the two securities, and (2)
the standard deviation of each security.
We have shown the effect of diversification on reducing risk. The key was not that two stocks provided twice as
much diversification as one, but that by investing in securities with negative or low covariance among themselves,
we could reduce the risk. Markowitzs efficient diversification involves combining securities with less than positive
correlation in order to reduce risk in the portfolio without sacrificing any of the portfolios return. In general, the
lower the correlation of securities in the portfolio, the less risky the portfolio will be. This is true regardless of how
risky the stocks of the portfolio are when analyzed in isolation. It is not enough to invest in many securities; it is
necessary to have the right securities.
Let us conclude our two-security example in order to make some valid generalization. Then we can see what
three-security and larger portfolios might be like. In considering a two-security portfolio, portfolio risk can be
defined more formally now as:
p
Eq 0.1
Where:
p
= portfolio standard deviation
Xx = percentage of total portfolio value in stock X

Xy = percentage of total portfolio value in stock Y
x
= standard deviation of stock X
= standard deviation of stock Y
rxy = correlation coefficient of X and Y

Note: rxy
= covxy
Thus we now have the standard deviation of a portfolio of two securities. We are able to see that portfolio risk
( p) is sensitive to
(i) the proportions of funds devoted to each stock,
(ii) the standard deviation of each stock, and
(iii) the covariance between the two stocks.
If the stocks are independent of each other, the correlation coefficient is zero (rxy = 0). Second, if rxy is greater
than zero, the standard deviation of the portfolio is greater than if rxy = 0. Third, if rxy is less than zero, the
covariance term is negative, and portfolio standard deviation is less than it would be if rxy were greater than or
equal to zero. Risk can be totally eliminated only if the third term is equal to the sum of the first two terms. This
occurs only if (1) rxy = -1.0, and (2) the percentage of the portfolio in stock X is set equal to X x = y/( x + y).
To clarify these general statements, let us return to our earlier example of stocks X and Y. In our example,
remember that
Stock X
Stock Y
Expected return (%)
Standard deviation (%)
Lesson 9
We calculated the covariance between the two stocks and found it to be -8. The coefficient of correlation was 1.0. The two securities were perfectly negatively correlated.
Changing the proportion of amount invested
What happens to portfolio risk as we change the total portfolio value invested in X and Y? Using Equation 9.1,
we get:
Stock X
(%)
Stock Y
(%)
Portfolio
Standard
Deviation
100
2.0
80
20
0.8
66
34
0.0
20
80
2.8
100
4.0
Notice that portfolio risk can be brought down to zero by the skillful balancing of the proportions of the portfolio
to each security. The preconditions were rxy = -1.0 and the proportion of amount invested in X is Xx = y/( x + y),
or 4/(2 + 4) = .666.
Changing the Coefficient of Correlation

What effect would be there using x = 2/3 and y = 1/3 if the correlation coefficient between stocks X and Y had been
other than -1.0? Using Equation 9.2 and various values for rxy, we have
rxy
Portfolio Standard Deviation
-0.5
1.34*
0.0
1.9
+0.5
2.3
+1.0
2.658
= (.666)2(2)2 + (.334)2+(2)(.666)(.334)(-5)(2)(4) =
1.777 + 1.777 (.444)(4) = 1.77 = 1.34
If no diversification effect had occurred, then the total risk of the two securities would have been the weighted
sum of their individual standard deviations:
Total undiversified risk = (.666)(2) + (.334)(4) = 2.658
Since the undiversified risk is equal to the portfolio risk of perfectly positively correlated securities (rxy = +1.0),
we can see that favorable portfolio effects occur only when securities are not perfectly positively correlated.
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Figure: 10.1 : Graphic illustration of the correlation between two securities
+1
A
-1
Line XY represent various combinations of X and Y. Point X has 100% holding of X and point Y has 100%
holding of Y. The coefficient of correlation along XY is +1. It means that 100% holding of X is least risky and
100% holding of Y is most risky.
Segment XAY has zero correlation and line XR has 1 coefficient of correlation.
The crucial point of how to achieve the proper proportions of X and Y in reducing the risk to zero will be taken up
in the Markowitz model. However, the general notion is clear. The risk of the portfolio is reduced by playing off
one set of variations against another.
MARKOWITZ MODEL
Dr. Harry M. Markowitz is credited with developing the first modern portfolio analysis model. It provides a theoretical
framework for analysis of risk-return choices. The concept of efficient portfolios has been enunciated in this
model A portfolio is efficient when it yields highest return for a particular level of risk or minimizes risk for a
specified level of expected return.
The Markowitz model makes the following assumptions regarding investor behaviour:
Investors consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period.
Investors maximize one period expected utility and possess utility curve, which demonstrates diminishing
marginal utility of wealth.
Individuals estimate risk on the basis of variability of expected returns.
Investors base decisions solely on expected return and variance of returns only.
At a given risk level, higher returns are preferred to lower returns. Similarly for a given level of expected
returns, investors prefer less risk to more risk.
Lesson 9
Simple Markowitz Portfolio Optimization

It is possible to develop a fairly simply decision rule for selecting an optimal portfolio for an investor that can take
both risk and return into account. This is called a risk-adjusted return. For simplicity, it can be termed the utility
of the portfolio for the investor in question. Utility is the expected return of the portfolio minus a risk penalty. This
risk penalty depends on portfolio risk and the investors risk tolerance.
The Risk Penalty

The more risk one must bear, the more undesirable is an additional unit of risk. Theoretically, and as a
computational convenience, it can be assumed that twice the risk is four times as undesirable. The risk penalty
is as follows:
Risk penalty = Risk squared/Risk tolerance
Risk squared is the variance of return of the portfolio. Risk tolerance is a number from zero through 100. The
size of the risk tolerance number reflects the investors willingness to bear more risk for more return. Low (high)
tolerance indicates low (high) willingness. Risk penalty is less as tolerance is increased.
For example, if a portfolios expected return is 13 percent, variance of return (risk squared) is 225 percent, and
the investors risk tolerance is 50. the risk penalty is 4.5 percent:
Risk penalty = 225%/50 = 4.5%
Since utility is expected return minus the risk penalty, we have
Utility = 13 4.5 = 8.5%
The optimal (best) portfolio for an investor would be the one from the opportunity set (efficient frontier) that
maximizes utility.
Efficient Frontier
Expected
Return
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Standard Deviation
In the above graphic presentation, arc XY is the efficient frontier. All points on this arc provide a superior
combination of risk and return to other combinations with the shaded area, which represent attemptable
portfolios. Each portfolio has its own combination of risk and return. Investors final choice out of the range
depends on his taste.
Portfolio Optimization
The investor has four indifference curves.

In I1 to I4 , I1 provides greatest satisfaction but since the efficient range touches only I3 is the maximum that can
be achieved.
Limitation of Markowitz Model

The Markowitz approach requires several inputs for portfolio analysis. These are expected return of the securities,
variances of their return and co variances. Calculation of efficient portfolios is easy when the number of securities
in the portfolio is two or three. As the number of securities in the portfolio increases, which indeed is the case in
real life situations, the amount of calculations required to be done becomes enormous. Further, in the real world,
portfolio analysts do not keep track of correlations between stocks of diverse industries. As such, correlating a
security to a common index is much more convenient than correlating to a large number of individuals securities.
Secondly, the assumption that correlation in the values of two securities depends on the characteristics of these
two securities alone is not valid. In fact movement in value of securities is affected by a variety of other factors.
A stock index is more representative benchmark that incorporates the general economic conditions more
authentically.
Lesson 9
CAPITAL ASSET PRICING MODEL

The CAPM developed by William F Sharpe, John Linter and Jan Mossin establishes a linear relationship between
the required rate of return of a security and its beta. Beta, as we know is the non-diversifiable risk in a portfolio.
A portfolios standard deviation is a good indicator of its risk. Thus if adding a stock to a portfolio increases its
standard deviation, the stock adds to the risk of the portfolio. This risk is the un-diversified risk that can not be
eliminated. Beta measures the relative risk associated with any individual portfolio as measured in relation to the
risk of the market portfolio.
Beta =
Non-diversifiable risk of asset or portfolio

Risk of market portfolio
Thus Beta is a measure of the non-diversifiable or systematic risk of an asset relative to that of the market
portfolio. A beta of 1 indicates an asset of average risk. If beta is more than 1, then the stock is riskier than the
market. On the other hand, if beta is less than one, market is riskier.
Recall that portfolio theory implied that each investor faced an efficient frontier. In general, the efficient frontier
will differ among investors because of differences in expectations. When we introduce riskless borrowing and
lending there are some significant changes involved. Lending is best thought of as an investment in a riskless
security. This security might be a savings account, Treasury bills, or even high-grade commercial paper. Borrowing
can be thought of as the use of margin. Borrowing and lending options transform the efficient frontier into a
straight line. See Figure below for the standard efficient frontier ABCD. Assume that an investor can lend at the
rate of RF = .05, which represents the rate on Treasury bills.
Frontier with introduction of Lending
Hence the point RF represents a risk-free investment (RF = .05; p = 0). The investor could place all or part of his
funds in this riskless asset. If he placed part of his funds in the risk-free asset and part in one of the portfolios of
risky securities along the efficient frontier, what would happen? He could generate portfolios along the straightline segment RF B.
298 PP-FT&FM
Let us examine the properties of a given portfolio along the straight-line segment RF B. Consider point B on the
original efficient frontier ABCD where, say, Rp = .10 and p = .06. If we placed one-half of available funds in the
riskless asset and one-half in the risky portfolio, B, the resulting combined risk-return measures for the mixed
portfolio, O, can be found from Equation A and B:
(eqnA) Rp = XRM + (1 X)RF
where:
Rp = expected return on portfolio
X = percentage of funds invested in risky portfolio
(1 X) = percentage of funds invested in riskless asset
RM = expected return on risky portfolio
RF = expected return on riskless asset
and:
(eqnB)
=X
where:
p
= expected standard deviation of the portfolio
X = percentage of funds invested in risky portfolio

M
= expected standard deviation on risky portfolio
For our example, the risk-return measures for portfolio M are:

Rp = (
=(
1
1
) (.10) + ( ) (.05) = .075
2
2
1
1
) (.06) + ( ) (.00) = .03
2
2
Introduction of the possibility of borrowing funds will change the shape of our efficient frontier in 22.1 to the right
of point B. In borrowing, we consider the possibilities associated with total funds invested being enlarged through
trading on the equity.
Consider three cases. If we assume that X is the percentage of investment wealth or equity placed in the risky
portfolio, then where X = 1, investment wealth is totally committed to the risky portfolio. Where X < 1, only a
fraction of X is placed in the risky portfolio, and the remainder is lent at the rate RF. The third case, X > 1,
signifies that the investor is borrowing rather than lending. It may be easier to visualize this by rewriting Equation
A as follows:
(eqnC) Rp = XRM (X 1) RF
where all terms are as in Equation A and the term RF is the borrowing rate. For simplicity, the borrowing rate
and lending rate are assumed to be equal or 5 percent. The first component of Equation C is the gross return
made possible because the borrowed funds, as well as the original wealth or equity, are invested in the risky
portfolio. The second term refers to the cost of borrowing on a percentage basis. For example, X = 1.25 would
indicate that the investor borrows an amount equal to 25 percent of his investment wealth. This is equivalent
to a margin requirement of 80 percent (X = 1/margin requirement). His net return on his investment wealth
would become:
Lesson 9
Rp = (1.25) (.10) (0.25) (.05) = .1125

The associated risk would become:
p=X
= (1.25) (.06) = .075
Hence the levered portfolio provides increased return with increased risk.
The introduction of borrowing and lending has given us an efficient frontier that is a straight line throughout. In
Figure below we show the new efficient frontier. Point M now represents the optimal combination of risky securities.
The existence of this combination simplifies our problem of portfolio selection. The investor need only decide
how much to borrow or lend. No other investments or combination of investments available is as efficient as
point M. the decision to purchase M is the Investment decision. The decision to buy some riskless asset (lend)
or to borrow (leverage the portfolio) is the financing decision.
Efficient Frontier with Borrowing and Lending
These conditions give rise to what has been referred to as the separation theorem. The theorem implies that all
investors, conservative or aggressive, should hold the same mix of stocks from the efficient set. They should
use borrowing or lending to attain their preferred risk class. This conclusion flies in the face of more traditional
notions of selection of portfolios for conservative clients and others for investors who are more daring. This
analysis suggests that both types of investors should hold identically risky portfolios. Desired risk levels are then
achieved through combining portfolio M with lending and borrowing.
If all investors face similar expectations and the same lending and borrowing rate, they will face a diagram such
as that in Figure above and, furthermore, all of the diagrams will be identical. The portfolio of assets held by any
investor will be identical to the portfolio of risky assets held by any other investor. If all investors hold the same
risky portfolio, then, in equilibrium, it must be the market portfolio (M). The market portfolio is a portfolio comprised
of all risky assets. Each asset will be held in the proportion which the market value of the asset represents to the
total market value of all risky assets. This is the key: All investors will hold combinations of only two portfolios, the
market portfolio and a riskless security.
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The straight line depicted in Figure above is referred to as the capital market line. All investors will end up with
portfolios somewhere along the capital market line and all efficient portfolios would lie along the capital market
line. However, not all securities or portfolios lie along the capital market line. From the derivation of the efficient
frontier we know that all portfolios, except those that are efficient, lie below the capital market line.
Observing the capital market line tells us something about the market price of risk. The equation of the capital
market line (connecting the riskless asset with a risky portfolio) is
Re = R F +
RM-RF
eM
where the subscript e denotes an efficient portfolio.

The term (RM RF)/ M can be thought of as the extra return that can be gained by increasing the level of risk
(standard deviation) on an efficient portfolio by one unit.
The entire second term on the right side of the equation is thus the market price of risk times the amount of risk
in the portfolio. The expression RF is the price of time. That is, it is the price paid for delaying consumption for one
period. The expected return on an efficient portfolio is
(Price of time) + (Price of risk) (Amount of risk)
Although this equation sets the return on an efficient portfolio, we need to go beyond to deal with returns on
nonefficient portfolios or on individual securities.
Security Market Line

For well-diversified portfolios, nonsystematic risk tends to go to zero, and the only relevant risk is systematic
risk measured by beta. Since we assume that investors are concerned only with expected return and risk, the
only dimensions of a security that need be of concern are expected return and beta.
We have seen that all investments and all portfolios of investments lie along a straight line in the return-to-beta
space. To determine this line we need only connect the intercept (beta of zero, or riskless security) and the
market portfolio (beta of one and return of RM). These two points identify the straight line shown in Figure below.
The equation of a straight line is
Ri =
+ bi
The first point on the line is the riskless asset with a beta of zero, so
RF =
RF =
+ b(0)
Lesson 9
FIGURE The Security Market Line
The second point on the line is the market portfolio with a beta of 1. Thus,
RM =
+ b(1)
RM
=b
(RM RF) = b
Combining the two results gives us
Ri = RF + i (RM RF)
This is a key relationship. It is called the security market line. It describes the expected return for all assets and
portfolios of assets, efficient or not. The difference between the expected return on any two assets can be
related simply to their difference in beta. The higher beta is for any security, the higher must be its expected
return. The relationship between beta and expected return is linear.
Recall that in the beginning of this chapter we said that the risk of any stock could be divided into systematic and
unsystematic risk. Beta is an index of systematic risk. This equation suggests that systematic risk is the only
important ingredient in determining expected returns. Unsystematic risk is of no consequence. It is not total
variance of returns that affects returns, only that part of the variance in returns that cannot be eliminated by
diversification.
The CAPM is based on a list of critical assumptions:
Investors are risk averse and use the expected rate of return and standard deviation of return as
appropriate measures of risk and return for their portfolio.
Investors make their investments decisions based on a single period horizon which is the immediate
next time period.
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Transaction costs are either absent or so low that these can be ignored.
Assets can be bought and sold in any desired unit.
The investor is limited by his wealth and the price of the asset only.
Taxes do not affect the choice of buying assets.
All individuals assume that they can buy the assets at the going market price and they all agree on the
nature of the return and risk associated with each investment.
In the CAPM, the expected rate of return is equal to the required rate of return because the market is in equilibrium.
The risk-less rate can be earned by investing in instruments like treasury bills. In addition to the risk free rate,
investors also expect a premium over and above the risk free rate to compensate them for investing in risky
assets since they are risk averse. Thus the required rate of return for the investors becomes equal to the sum of
Risk-free rate and the risk premium.
The risk premium can be calculated as the product of Beta and market risk premium, i.e. difference between
expected rate of return and risk-free rate of return.
ECONOMIC VALUE ADDED

Adam Smith, one of the fathers of classical economic thought, observed that firms and resource suppliers,
seeking to further their own self-interest and operating within the framework of a highly competitive market
system, will promote the interest of the public, as though guided by an invisible hand. (Smith, 1776)
The market mechanism of supply and demand communicates the wants of consumers to businesses and
through businesses to resource suppliers. Competition forces business and resource suppliers to make
appropriate responses. The impact of an increase in consumer demand for some product will raise that goods
price. The resulting economic profits signal other producers that society wants more of the product. Competition
simultaneously brings an expansion of output and a lower price.
Profits cause resources to move from lower valued to higher valued uses. Prices and sales are dictated by the
consumer. In the quest for higher profits, businesses will take resources out of areas with lower than normal
returns and put them into areas in which there is an expectation of high profits.
Profits allocate resources

The primary objective of any business is to create wealth for its owners. If nothing else the organization must
provide a growth dividend to those who have invested expecting a value reward for their investment. As companies
generate value and grow, society also benefits. The quest for value directs scarce resources to their most
promising uses and most productive users. The more effectively resources are employed and managed, the
more active economic growth and the rate of improvement in our standard of living as a society. Although there
are exceptions to the rule relating to the value of economic wealth, most of the time there is a distinct harmony
between creating increased share value of an organization and enhancing the quality of life of people in society.
In most companies today the search for value is being challenged by a seriously out of date financial management
system. Often, the wrong financial focus, cash strategies, operating goals, and valuation processes are
emphasized. Managers are often rewarded for the wrong achievements and in many cases they are not rewarded
for the efforts that lead to real value. Balance sheets are often just the result of accounting rules rather than the
focus of value enhancement. These problems beg for approaches to financial focus that are completely different
from current approaches. New approaches must start nothing less than an evolution in thinking in the process of
economic evaluation. One of the focuses that have proved to be incorrect in the valuation of economic worth is
earnings per share (EPS). EPS has long been the hallmark of executives that appear in meetings of the
shareholders, as the measure of their accomplishments. This, along with return on equity has long been thought
Lesson 9
of as the way to attract Wall Street investment. There is nothing that points to EPS as anything more than a ratio
that accounting has developed for management reporting. Many executives believe that the stock market wants
earnings and that the future of the organizations stock depends on the current EPS, despite the fact that not one
shred of convincing evidence to substantiate this claim has ever been produced. To satisfy Wall Streets desire
for reported profits, executives feel compelled to create earnings through creative accounting. Accounting tactics
that could be employed to save taxes and increase value are avoided in favor of tactics that increase profit.
Capital acquisitions are often not undertaken because they do not meet a hypothetical profit return. R&D and
market expanding investments get only lip service. Often increased earnings growth is sustained by overzealous
monetary support of businesses that are long past their value peak. We must ask then, what truly determines
increased value in stock prices. Over and over again the evidence points to the cash flow of the organization,
adjusted for time and risk that investors can expect to get back over the life of the business.
Economic Value Added (EVA) is a measurement tool that provides a clear picture of whether a business is
creating or destroying shareholder wealth. EVA measures the firms ability to earn more than the true cost of
capital. EVA combines the concept of residual income with the idea that all capital has a cost, which means that
it is a measure of the profit that remains after earning a required rate of return on capital. If a firms earnings
exceed the true cost of capital it is creating wealth for its shareholders.
Definition of Economic Value Added

A discussion on Economic Value Added has to begin with the origin of the concept. EVA is based on the work of
Professors Franco Modigliani and Merton H. Miller. In October, 1961, these two finance professors published
Dividend Policy, Growth and the Valuation of Shares, in the Journal of Business. The ideas of free cash flow
and the evaluation of business on a cash basis were developed in this article. These ideas were extended into
the concept of EVA by Bennett Stewart and Joel Stern of Stern, Stewart & Company. Economic Value Added is
defined as net operating profit after taxes and after the cost of capital. (Tully, 1993) Capital includes cash,
inventory, and receivables (working capital), plus equipment, computers and real estate. The cost of capital is
the rate of return required by the shareholders and lenders to finance the operations of the business. When
revenue exceeds the cost of doing business and the cost of capital, the firm creates wealth for the shareholders.
EVA = Net Operating Profit Taxes Cost of Capital
Example
Say you made a ` 20,000 capital investment in your company. Your operating profit, after taxes, is ` 10,000. The
opportunity cost of that investment is 10%.
In This case EVA would be Net Operating Profit after taxes Cost of Capital
i.e. ` 10,000- 10% of ` 20,000 = ` 8,000.
The goal of EVA is to take into account the cost of capital invested in the company. If you have ` 50,000 and you
invest that money in your company, you should receive a return but you might not, at least in the above listed
example.
SHARPE SINGLE AND MULTI INDEX MODELS

Sharpe Index Model
One Simplification of CAPM formula was done by Sharpe (1963), who developed the Single-Index Model. The
single-index model imposes restrictions on how security returns can covary. In particular, it is assumed that all
covariance arises through an "index." As we will see, this leads to a dramatic reduction in complexity. Sharpe's
model has since been extended to multi-index models, and leads to a more general theory called the Arbitrage
Pricing Theory, developed by Ross (1976). Besides simplifying the covariance matrix, this approach is easily
304 PP-FT&FM
extended to take account of non-financial factors. In the multi-index model, for example, one of the indexes
could easily be the rate of inflation.
Single-Index Model
The major assumption of Sharpe's single-index model is that all the covariation of security returns can be
explained by a single factor. This factor is called the index, hence the name "single-index model."
According to the Sharpe single index model the return for each security can be given by the following equation:
R= I+ I+e
Where R
Expected return on a security
Alpha Coefficient
Beta Coefficient
Expected Return an index
Error term with a mean of zero and a constant standard deviation.
Alpha Coefficient refers to the value of Y in the equation Y = ? + ? x when X = 0. Beta Coefficient is the slope of
the regression line and is a measure of the changes in value of the security relative to changes in values of the
index.
A beta of +1.0 means that a 10% change in index value would result in a 10% change in the same direction in the
security value. A beta of 0.5 means that a 10% change in index value would result in 5% change in the security
value. A beta of 1.0 means that the returns on the security are inversely related.
The equation given above can also be rearranged as shown below:
R=
I +
+e
Here the component I is the market related or systematic component of the return. The other component
represents the unsystematic component. As is assumed to be near zero the unsystematic return is given by
alpha only.
Multi-Index Models
The multi-index model assumes a return-generating process that is a linear function of many factors. In this
approach, each factor is a source of systematic risk. Since investors cannot diversify systematic risk, they are
assumed to be compensated for bearing this risk.
ri=0+AfA+BfB....+KfK+i
As a result, a security's sensitivity to each factor affects the assumed return-generating process for the security.
This sensitivity is captured by a "factor beta," and the return-generating process is assumed to take the form
The last term is the source of idiosyncratic or diversifiable risk. Except for the fact that multiple factors make this
a richer model than the single index model, the use of a multi-factor model is similar to the single-index model.
A broad generalization of these models is the Arbitrage Pricing Theory.
SIMPLE SHARPE PORTFOLIO OPTIMIZATION

The construction of an optimal portfolio is simplified if there is a single number that measures the desirability of
including a stock in the optimal portfolio. If we accept the single index model (Sharpe), such a number exists. In
this case, the desirability of any stock is directly related to its excess return-to-beta ratio.
Lesson 9
Ri RF/i
where:
Ri = expected return on stock i
RF = return on a riskless asset
i = expected change in the rate of return on stock I associated with a 1 percent change in the market
return
If stocks are ranked by excess return to beta (from highest to lowest), the ranking represents the desirability of
any stocks inclusion in a portfolio. The number of stocks selected depends on a unique cutoff rate such that all
stocks with higher ratios of (Ri RF)/ i wil be included and all stocks with lower ratios excluded.
To determine which stocks are included in the optimum portfolio, the following steps are necessary:
1. Calculate the excess return-to-beta ratio for each stock under review and the rank from highest to
lowest.
2. The optimum portfolio consists of investing in all stocks for which (Ri RF)/ i is greater than a particular
cutoff point C.
Sharpe notes that proper diversification and the holding of a sufficient number of securities can reduce the
unsystematic component of portfolio risk to zero by averaging out the unsystematic risk of individual stocks.
What is left is systematic risk which, because it is determined by the market (index), cannot be eliminated
through portfolio balancing. Thus the Sharpe model attaches considerable significance to systematic risk and its
most important measure, the beta coefficient ().
According to the model, the risk contribution to a portfolio of an individual stock can be measured by the stocks
beta coefficient. The market index will have a beta coefficient of +1.0. A stock with a beta of, for example, +2.0
indicates that it contributes far more risk to a portfolio than a stock with, say,a beta of + .05. Stocks with negative
betas are to be coveted, since they help reduce risk beyond the unsystematic level.
Since efficient portfolios eliminate unsystematic risk, the riskiness of such portfolios is determined exclusively by
market movements. Risk in an efficient portfolio is measured by the portfolio beta. The beta for the portfolio is
simply the weighted average of the betas of the component securities. For example, an optimal portfolio which
has a beta of 1.35, suggests that it has a sensitivity above the + 1.0 attributed to the market. If this portfolio is
properly diversified (proper number of stocks and elimination of unsystematic risk), it should move up or down
about one-third more than the market. Such a high beta suggests an aggressive portfolio. Should the market
move up over the holding period, this portfolio will be expected to advance substantially. However, a market
decline should find this portfolio falling considerably in value.
In this way, establishing efficient portfolios (minimum risk for a given expected return) comprising broad classes
of assets (e.g., stocks, bonds, real estate) lends itself to the mean-variance methodology suggested by Markowitz.
Determining efficient portfolios within an asset class (e.g., stocks) can be achieved with the single index (beta)
model proposed by Sharpe.
ARBITRAGE PRICING THEORY

The capital asset pricing model (CAPM) asserts that only a single number a securitys beta against the market
is required to measure risk. At the core of arbitrage pricing theory (APT) is the recognition that several systematic
factors affect security return.
The returns on an individual stock will depend upon a variety of anticipated and unanticipated events. Anticipated
events will be incorporated by investors into their expectations of returns on individual stocks and thus will be
incorporated into market prices. Generally, however, most of the return ultimately realized will result from
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unanticipated events. Of course, change itself is anticipated, and investors know that the most unlikely occurrence
of all would be the exact realization of the most probable future scenario. But even though we realize that some
unforeseen events will occur, we do not know their direction or their magnitude. What we can know is the
sensitivity of returns to these events.
Systematic factors are the major sources of risk in portfolio returns. Actual portfolio returns depend upon the
same set of common factors, but this does not mean that all portfolios perform identically. Different portfolios
have different sensitivities to these factors.
Because the systematic factors are primary sources of risk, it follows that they are the principal determinants of
the expected, as well as the actual, returns on portfolios. It is possible to see that the actual return, R, on any
security or portfolio may be broken down into three constituent parts, as follows:
(Z)
R = E + bf + e
where:
E = expected return on the security
b = securitys sensitivity to change in the systematic factor
f = the actual return on the systematic factor
e = returns on the unsystematic, idiosyncratic factors
Equation Z merely states that the actual return equals the expected return, plus factor sensitivity times factor
movement, plus residual risk.
Empirical work suggests that a three-or-four-factor model adequately captures the influence of systematic factors
on stock-market returns. Equation Z may thus be expanded to:
R = E + (b1) (f1) + (b2) (f2) + (b3) (f3)
+ (b4) (f4) + e
Each of the four middle terms in this equation is the product of the returns on a particular economic factor and
the given stocks sensitivity to that factor. Suppose f3 is associated with labor productivity. As labor productivity
unexpectedly increases, f3 is positive, and firms with high b3 would find their returns very high. The subtler
rationale and higher mathematics of APT are left for development elsewhere.
What are these factors? They are the underlying economic forces that are the primary influences on the stock
market. Research suggests that the most important factors are unanticipated inflation, changes in the expected
level of industrial production, unanticipated shifts in risk premiums, and unanticipated movements in the shape
of the term structure of interest rates.
The biggest problems in APT are factor identification and separating unanticipated from anticipated factor
movements in the measurement of sensitivities. Any one stock is so influenced by idiosyncratic forces that it is
very difficult to determine the precise relationship between its return and a given factor. Far more critical is the
measurement of the bs. The bs measure the sensitivity of returns to unanticipated movements in the factors. By
just looking at how a given stock relates to, say, movements in the money supply, we would be including the
influence of both anticipated and unanticipated changes, when only the latter are relevant.
Empirical testing of APT is still in its infancy, and concrete results proving the APT or disproving the CAPM do not
exist. For these reasons it is useful to regard CAPM and APT as different variants of the true equilibrium pricing
model. Both are, therefore, useful in supplying intuition into the way security prices and equilibrium returns are
established.
Lesson 9
RISK ADJUSTED MEASURE OF PERFORMANCE

Does the choice of risk-adjusted performance measure matter? This is the question the current discussion in
academic literature revolves around. Risk-adjusted performance measures are an important tool for investment
decisions. Whenever an investor evaluates the performance of an investment he will not only be interested in
the achieved absolute return but also in the risk-adjusted return i.e. in the risk which had to be taken to realize
the profit.
The first ratio to measure risk-adjusted return was the Sharpe Ratio introduced by William F. Sharpe in 1966. It
has been one of the most referenced risk/return measures used in finance, and much of this popularity can be
attributed to its simplicity. The ratio's credibility was boosted further when Professor Sharpe won a Nobel Memorial
Prize in Economic Sciences in 1990 for his work on the capital asset pricing model (CAPM).
The Ratio Defined

Most people with a financial background can quickly comprehend how the Sharpe ratio is calculated and what
it represents. The ratio describes how much excess return you are receiving for the extra volatility that you
endure for holding a riskier asset. Remember, you always need to be properly compensated for the additional
risk you take for not holding a risk-free asset.
S(X)=(rX Rf)/StdDev(X)
where
X is the investment
rX is the average rate of return of x
Rf is the best available rate of return of a risk-free security (i.e. T-bills)
StdDev(X) is the standard deviation of rX
Return (rx)
The returns measured can be of any frequency (i.e. daily, weekly, monthly or annually), as long as they are
normally distributed, as the returns can always be annualized. Herein lies the underlying weakness of the ratio
- not all asset returns are normally distributed.
Abnormalities like kurtosis, fatter tails and higher peaks, or skewness on the distribution can be a problematic
for the ratio, as standard deviation doesn't have the same effectiveness when these problems exist. Sometimes
it can be downright dangerous to use this formula when returns are not normally distributed.
Risk-Free Rate of Return (rf)

The risk-free rate of return is used to see if you are being properly compensated for the additional risk you are
taking on with the risky asset. Traditionally, the risk-free rate of return is the shortest dated government T-bill (i.e.
U.S. T-Bill). While this type of security will have the least volatility, some would argue that the risk-free security
used should match the duration of the investment it is being compared against.
For example, equities are the longest duration asset available, so shouldn't they be compared with the longest
duration risk-free asset available - government issued inflation-protected securities (IPS)?
Standard Deviation [StdDev(x)]

Now that we have calculated the excess return from subtracting the return of the risky asset from the risk-free
rate of return, we need to divide this by the standard deviation of the risky asset being measured. As mentioned
above, the higher the number, the better the investment looks from a risk/return perspective.
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How the returns are distributed is the Achilles heel of the Sharpe ratio. Bell curves do not take big moves in the
market into account. As Benoit Mandelbrot and Nassim Nicholas Taleb note in their article, "How The Finance
Gurus Get Risk All Wrong", which appeared in Fortune in 2005, bell curves were adopted for mathematical
convenience, not realism.
However, unless the standard deviation is very large, leverage may not affect the ratio. Both the numerator
(return) and denominator (standard deviation) could be doubled with no problems. Only if the standard deviation
gets too high do we start to see problems. For example, a stock that is leveraged 10 to 1 could easily see a price
drop of 10%, which would translate to a 100% drop in the original capital and an early margin call.
Using the Sharpe Ratio

The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance of a
portfolio. The ratio helps to make the performance of one portfolio comparable to that of another portfolio by
making an adjustment for risk.
For example, if manager A generates a return of 15% while manager B generates a return of 12%, it would
appear that manager A is a better performer. However, if manager A, who produced the 15% return, took much
larger risks than manager B, it may actually be the case that manager B has a better risk-adjusted return.
To continue with the example, say that the risk free-rate is 5%, and manager A's portfolio has a standard
deviation of 8%, while manager B's portfolio has a standard deviation of 5%. The Sharpe ratio for manager A
would be 1.25 while manager B's ratio would be 1.4, which is better than manager A. Based on these calculations,
manager B was able to generate a higher return on a risk-adjusted basis.
To give you some insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is
considered excellent.
The Sharpe ratio is quite simple, which lends to its popularity. It's broken down into just three components: asset
return, risk-free return and standard deviation of return. After calculating the excess return, it's divided by the
standard deviation of the risky asset to get its Sharpe ratio. The idea of the ratio is to see how much additional
return you are receiving for the additional volatility of holding the risky asset over a risk-free asset - the higher
the better.
CASE STUDIES
Question No 1: The following table summarizes risk premiums for stocks relative to treasury bills and bonds, for
different time periods:
Risk Premium for Equity

Stocks - T. Bills
Stocks - T. Bonds
Arithmetic Average
Geometric Average
Arithmetic Average
Geometric Average
1926-2010
8.41%
6.41%
7.24%
5.50%
1962-2010
4.10%
2.95%
3.92%
3.25%
1981-2010
6.05%
5.38%
0.13%
0.19%
A. What does this premium measure?

B. Why is the geometric mean lower than the arithmetic mean for both bonds and bills?
C. If you had to use a risk premium, would you use the most recent data (1981-2010), or would you use the
longer periods? Explain your reasoning.
Lesson 9
Solution 1
A. It measures, on average, the premium earned by stocks over government securities. It is used as a
measure of the expected risk premium in the future.
B. The geometric mean allows for compounding, while the arithmetic mean does not. The compounding
effect, in conjunction with the variability of returns, will lower the geometric mean relative to the arithmetic
mean.
C. The longer time period is most appropriate, because it covers more of the possible outcomes - crashes,
booms, bull markets, bear markets. In contrast, a ten-year period can offer a slice of history that is not
representative of all possible outcomes.
Question 2
You are an investor who is interested in the emerging markets of Asia. You are trying to value some stocks in
Afghanistan, which does not have a long history of financial markets. During the last two years, the stock market
has gone up 60% a year, while the government borrowing rate has been 15%, yielding an historical premium of
45%. Would you use this as your risk premium, looking into the future? If not, what would you base your
estimate of the premium on?
Solution 2
Recent history is probably not an appropriate basis for estimating the premium, since this history can be skewed
upward or downward by a couple of good or bad years. The premium should be based on the fundamentals
driving the Afghanistan market, relative to other emerging and developed markets, and estimate a premium
accordingly.
Question 3
The beta for Marathon Limited is 1.10. The current six-month treasury bill rate is 3.25%, while the thirty-year
bond rate is 6.25%. Estimate the cost of equity for Marathon Limited, based upon
(a) Using the treasury bill rate as your risk-free rate.
(b) Using the treasury bond rate as your risk-free rate.
(Use the premiums in the table in question 1, if necessary.)
Which one of these estimates would you use in valuation? Why?
Solution 3
CAPM: using T.Bill rate = 3.25% + 1.10 (8.41%) = 12.50%
CAPM: using T.Bond rate = 6.25% + 1.10 (5.50%) = 12.30%
The long-term bond rate should be used as the risk-free rate, because valuation is based upon a long time
horizon.
* 8.41% is the arithmetic mean average premium earned by stocks over treasury bills between 1926 and 2010.
** 5.50% is the geometric mean average premium earned by stocks over treasury bonds between 1926 and
2010.
Question 4
You have been asked to estimate the beta of a high-technology firm which has three divisions with the following
characteristics
310 PP-FT&FM
Division
Beta
Market Value
Personal Computers
1.60
` 100 million
Software
2.00
` 150 million
Computer Mainframes
1.20
` 250 million
A. What is the beta of the equity of the firm?

B. What would happen to the beta of equity if the firm divested itself of its software business?
C. If you were asked to value the software business for the divestiture, which beta would you use in your
valuation?
Solution 5
A. Beta = 1.60 * 100/500 + 2.00 * 150/500 + 1.20 * 250/500 = 1.52
B. If they pay the cash out as a dividend: Beta = 1.60 * 100/350 + 1.20 * 250/350 = 1.31
If they keep the cash in the firm: Beta = 1.60*100/500 + 0*150/500 + 1.20*250/500 = 0.92
C. Use 2.00, the beta for the software division.
Question No 5
Dhanpat, an investor, is seeking the price to pay for a security, whose standard deviation is 5%. The correlation
coefficient for the security with the market is 0.75 and the market standard deviation is 4%. The return from riskfree securities is 6% and from the market portfolio is 11%. Dhanpat knows that only by calculating the required
rate of return, he can determine the price to pay for the security. What is the required rate of return on the
security?
Solution:
Calculation of beta coefficient
Standard deviation
5%
Correlation coefficient
0.75
Market Standard Deviation
4%
Calculation of required rate of return on security

Rf= 6%
Rm= 11%
E(R1) = Rf +[Rm Rf]
= 6.0 + 0.9375 [11.00 6.00]
= 6.0 + 0.9375 x 5
= 6.0 + 4.6875
= 10.6875%
Question No. 6: The market portfolio has a historically based expected return of 0.10 and a standard deviation
of 0.04 during a period when risk-free assets yielded 0.03. The 0.07 risk premium is thought to be constant
through time. Riskless investments may now be purchased to yield 0.09. A security has a standard deviation of
0.08 and a co-efficient of correlation with the market portfolio is 0.85. The market portfolio is now expected to
have a standard deviation of 0.04. You are required to find
Lesson 9
(i) market's return-risk trade-off;

(ii) security beta; and
(iii) equilibrium required expected return of the security
Solution:
(i) Markets Return Risk Tradeoff
=
Rm R F
Where,
Rm = Market rate of return, i.e. 0.10
RF = Risk free return, i.e. 0.03
= Standard deviation 0.04
=
0.10 0.03
0.04
= 1.75
(ii) Security Beta :

1 =
x rM
xrm
Where,
1 = Beta factor of investment
= Standard deviation of investment in security, i.e. 0.08
rm - Co-efficient of Correlation with market portfolio, i.e. 0.085

m
= Market portfolio standard deviation, i.e. 0.04
(iii) Equilibrium required for expected rate of return on the security :

E(R1) = RF + 1 (RM RF)
Where:
E(R1)
m
= Expected rate of return on investment

= Riskless investment yield = 0.09
Rm
= Expected return on market portfolio
= Market sensitive index (Beta factor) of investment, i.e. 1.7

= 0.09 + 1.7 (0.10 0.03)
= 0.09 + 0.119
= 0.209
= 20.9%
LESSON ROUND-UP
Investment may be defined as a conscious act on the part of a person that involves deployment of
money in securities issued by firms with a view to obtain a target rate of return over a specified period
312 PP-FT&FM
of time.
Investment is conscious act of deployment of money in securities issued by firms. Speculation also
involves deployment of funds but is not backed by a conscious analysis of pros and cons.
The main objective of security analysis is to appraise are intrinsic value of security.
The Fundamental approach suggests that every stock has an intrinsic value which should be equal to
the present value of the future stream of income from that stock discounted at an appropriate risk
related rate of interest.
Technical approach suggests that the price of a stock depends on supply and demand in the market
place and has little relationship with its intrinsic value.
Efficient Capital Market Hypothesis (ECMH) is based on the assumption that in efficient capital markets
prices of traded securities always fully reflect all publicly available information concerning those
securities.
Performance of a company is intimately related to the overall economic environment of the country
because demand for products and services of the company would under normal circumstances be
directly related to growth of the countrys economy.
Industry level analysis focuses on a particular industry rather than on the broader economy.
Down Jones theory shows that share prices demonstrate a pattern over four to five years and these
patterns can be divided into primary, secondary and minor trends.
Charts and Indicators are two major tools of Technical Analysis.
Portfolio management refers to managing efficiently the investment in the securities by professionals
for both small investors and corporate investors who may not have the time and skills to arrive at
sound investment decisions.
Portfolio Analysis seeks to analyze the pattern of return emanating from a portfolio of securities.
Risk means that the return on investment would be less than the expected rate. Risk is a combination
of possibilities because of which actual returns can be slightly different or greatly different from expected
returns.
As per Markowitz Model, a portfolio is efficient when it yields highest return for a particular level of risk
or minimizes risk for a specified level of expected return.
According to Sharpe Index Model, return on a security is correlated to an index of securities or an
index or an economic indicator like GDP or prices and the return for each security can be given by:
R=?I+?+e
Capital Asset Pricing Model provides that if adding a stock to a portfolio increases its standard deviation,
the stock adds to the risk of the portfolio. This risk is the un-diversified risk that can not be eliminated.
SELF-TEST QUESTIONS
1. What is security analysis? Why do we need to carry it out?
2. Describe the nature of Indian Financial System.
3. What are the various techniques of security analysis?
Lesson 9
4. Describe some techniques of Technical analysis.

5. Describe the Sharpe Index approach of Portfolio analysis.
6. Write a short note on expected return on a portfolio.
7. CAPM is a tool to workout cost of equity. Discuss.
8. Differentiate between:
(i) Markowitz model and Sharpe index model.
(ii) Efficient Portfolio and Optimal Portfolio
9. Mohan has a portfolio of 6 securities, each with a market value of 10,000. The current beta of the
portfolio is 1.30 and beta of the riskiest security is 1.80. Mohan wishes to reduce his portfolio beta to
1.15 by selling the riskiest security and replacing it with another security with a lower beta . What must
be the beta of the replacement security?
10. Excel Ltd. is considering investing in a risky project which would be added to an existing portfolio of
investment projects, also subject to risk. It envisages six possible states of the economy for which it
has estimated probabilities and outcome as follows :
State of
Economy
Probability
Return on Existing Portfolio Return on Proposed Projects
0.1
12%
8%
0.2
14%
10%
0.2
15%
12%
0.3
16%
10%
0.1
18%
14%
0.1
20%
6%
You are required to determine whether the project should be accepted. The riskfree rate of return is
6%.
314 PP-FT&FM
Lesson 10
Derivatives and Commodity Exchanges An Overview 315
Lesson 10
Derivatives and Commodity Exchanges
An Overview
LESSON OUTLINE
LEARNING OBJECTIVES
Meaning, features of Derivatives
The emergence and growth of the market for

derivative instruments can be traced back to the
willingness of economic agents to guard
themselves against uncertainties arising out of
fluctuations in asset prices. Derivatives are
meant to facilitate the hedging of price risks of
inventory holdings or a financial/commercial
transaction over a certain period. Following the
growing instability in the financial markets, the
financial derivatives gained prominence after
1970 but Indias tryst with derivatives began in
2000 when both the NSE and the BSE
commenced trading in equity derivativesThe
study will enable the students to understand:
Participants in Derivatives market

Types of Derivative Market
Difference between spot and forward
market
Difference between future and Options
Development of derivative market in India
Equity derivatives and its classification
Forex Derivatives, its classification and
advantages
Interest rate derivative
Definition and concept of Derivatives
Credit derivatives
Characteristics of Derivatives
Trading, Clearing and Settlement of

Derivatives on Stock Exchanges
Participants in the derivatives market
Commodity Market
Spot Contract vis--vis forward Contract
Participants of Commodity Market
Forward Markets
Commodity Exchange in India
Options Put Option Call Option
Types of Derivatives
Futures
LESSON ROUND UP
Swaps
SELF TEST QUESTIONS
Clearing and Trading and Settlement

Mechanism
Risk Management System
Commodities Market-Evaluation and
Advantages Commodity Future Trading
in India
315
316 PP-FT&FM
INTRODUCTION
A derivative (or derivative security) is a financial instrument whose value depends on the values of other, more
basic underlying variables. In recent years, derivatives have become increasingly important in the world of
finance. Futures and options are now traded actively on many exchanges. Forward contracts, swaps, and many
different types of options are regularly traded outside exchanges by financial institutions, fund managers, and
corporations in what is termed the over-the-counter market. Derivatives also often form part of a bond or stock
issue.
The variables underlying derivatives are the prices of traded assets. A stock option, for example, is a derivative
whose value is dependent on the price of a stock. However, as we shall see, derivatives can be dependent on
almost any variable, from the price of hogs to the amount of snow falling at a certain ski resort.
In recent decades, financial markets have been marked by excessive volatility. As foreign exchange rates,
interest rates and commodity prices continue to experience sharp and unexpected movements, it has become
increasingly important that corporations exposed to these risks, be equipped to manage them effectively. Price
fluctuations make it hard for businesses to estimate their future production costs and revenues. Derivative
securities provide them a valuable set of tools for managing these risk. Risk management, being used to control
such price volatility has consequently risen to the top of financial agendas. It is here that derivative instruments
are of utmost utility.
CONCEPT OF DERIVATIVES
In any commercial transaction, there are minimum two parties. Between these parties there is an exchange of
price and goods or service. One of the parties
pays the price while the other party provides goods or services. The exchange of price and goods or services
could be either simultaneous or follow one another with a time gap.
Let us consider these illustrations:
Illustration 1
You [along with two friends] want to go for the Aero India January 2013 air show, for which tickets are sold out.
Through one of your close friends, you obtain a recommendation letter, which will enable you to buy three
tickets. The price of a ticket is Rs 1,000. Which is the commodity that you are suppose to buy? Money/
recommendation letter (instrument) or both?
The recommendation letter is a derivative instrument. It gives you a right to buy the ticket. The underlying asset
is the ticket. The letter does not constitute ownership of the ticket. It is indeed a promise to convey ownership.
The value of the letter changes with changes in the price of the ticket. It derives its value from the value of the
ticket.
Illustration 2
A agrees to buy a shirt from B for ` 800/-. A pays ` 800/- to B while B promises to deliver the shirt after one
week.
Illustration 3
A agrees to buy a shirt from B while A promises to pay in four monthly installments of ` 200/- each.
All the above three illustrations are examples of Spot transactions. Virtually all the commercial transactions are
Lesson 10
Spot transactions. In a spot transaction, pricing of goods or services is done according to the current value.
The goods or services being purchased are tangible.
Now let us consider a situation where both the parties in a transaction agree to the quantity of goods and price
but the exchange is to take place at a future date.
Illustration 4
A is a farmer who intends to sell his crop of 50 tones of wheat, which shall be ready after six months. He wants
to make sure about the price that he should get for his crop. B is a bakery owner who needs 50 tonnes of wheat
at the time of the next crop for his bakery business. He wants to make certain that he gets the quantity after six
months. Both of them negotiate a deal under which A agrees to supply 50 tonnes of wheat to B at a price of `
10,000 per tonne.
The above illustration is a case of forward contract in which the quantity of wheat and its price have been settled
but the exchange is to take place after six months. In this contract, the item to be exchanged i.e. wheat, is a
commodity. There can be instances when the subject of exchange is foreign currency, shares, real estate etc. In
every forward transaction, a nominal amount (expensed as a percentage of the contract amount) is paid upfront
by the buyer to the seller as a token of his willingness to buy and also with a view to impose a moral binding upon
the seller in addition to the legal binding of the contract.
WHAT ARE DERIVATIVES?

Derivatives are financial instruments which derive their value from their underlying assets or securities. For
examples, if a buyer enters into a contract with a seller to buy a specified number of shares of a company at a
specified price after a specified period, the buyer has entered into a futures contract. It is important to note that
the buyer has bought the contract and not the stock of shares under reference. This contract is called a derivative
while the stock of shares to which it applies is called the underlying asset. Apart from futures, other commonly
used derivatives are options, warrants, convertibles and many more. The special characteristics of derivatives,
as shall discuss later, have made them a very popular mode of risk management in the stock markets. As
instruments of risk management, these, generally, do not influence the fluctuations in the underlying asset
prices. However, by locking-asset prices, derivative products minimize the impact of fluctuations in asset prices
on the profitability and cash flow situation of risk-averse investors.
Thus, a derivative is a financial instrument, or contract, between two parties that derive its value from some
other underlying asset or underlying reference price, interest rate, or index. A derivative by itself does not
constitute ownership; instead it is promise to convey ownership.
The Underlying Securities for Derivatives are:
Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes)
Precious Metals (Gold, Silver)
Short-Term Debt Securities (Treasury Bills)
Interest Rates
Common Shares/Stock
Stock Index Value (NSE Nifty)
Derivative ontracts are primarily of two kinds contracts that are traded on the exchanges and contracts that are
traded outside the exchanges. Products/contracts that are traded on the exchanges are called Exchang-traded
318 PP-FT&FM
derivatives. Products/contracts traded outside the exchanges are called Over-the-counter derivatives. The generic
term used for the market outside the exchanges is over-the-counter market. Worldwide, large volume is traded
in both exchange-traded and OTC derivative products. India also trades in both exchange-traded and OTC
derivative products on different asset classes.
Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines derivative to include
1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or
contract for differences or any other form of security;
2. A contract which derives its value from the prices, or index of prices, of underlying securities.
Derivatives are securities under the SC( R)A and hence the trading of derivatives is governed by the regulatory
framework under the SC(R)A.
CHARACTERISTICS OF DERIVATIVES
The important characteristics of derivatives are as follows:
Derivatives traded on exchanges are liquid and involves the lowest possible transaction costs.
Derivatives can be closely matched with specific portfolio requirements.
The margin requirements for exchange-traded derivatives are relatively low, reflecting the relatively low
level of credit-risk associated with the derivatives.
Derivatives are traded globally having strong popularity in financial markets.
Derivatives maintain a close relationship between their values and the values of underlying assets.
The change in values of underlying assets will have effect on values of derivatives based on them.
PARTICIPANTS IN THE DERIVATIVES MARKET

1. Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset.
2. Speculators use futures and options contracts to get extra leverage in betting on future movements in the
price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a
speculative venture.
3. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If,
for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting
positions in the two markets to lock in a profit.
TYPES OF DERIVATIVE MARKETS

Exchange Traded Derivative Markets
Market where standardised contracts are traded over an exchange such as NCDEX
Quantities and qualities can not be customised
Counterparty for each transaction is the exchange
Lesson 10
Over-The-Counter (OTC)
Usually done between two financial institutions/corporate bodies
Not listed
Trades are typically larger than exchange traded derivative transactions
Structure can be customised as per the requirements of the two parties.
TYPES OF MARKETS
Types of Markets
Spot Market
Over the counter market
Equity
Derivative
Derivatives Market
Commodity
Derivative
Exchange Traded Derivative Market
Forex or financial
Derivative
Interest Rate
Derivative
Credit
Derivative
Derivative contracts can be of different types:

Futures
Options
Swaps
Caps
Floor
Collars etc.
The most popular derivative instruments are futures and Options.
Today, international markets trade innumerable derivative products on all kinds of underlying assets, both tangible
and intangible. Without getting into the complexities of derivatives at this level, it is important to understand the
following three generic derivative products/contracts in detail:
1. Forward contract
2. Futures contract
3. Option contract
It is necessary here, to state that an in-depth understanding of these concepts will create a strong foundation for
a meaningful interpretation of complex derivative structures and innovations. Forward, futures, option and swap
contracts must be understood as concepts, without limiting their thinking to a specific asset. Once the concepts
are understood clearly, they may be applied to any asset class. In other words, characteristics of these contracts
do not alter with change in the underlying asset.
320 PP-FT&FM
FORWARD CONTRACT
A Forward contract is a one-to-one, bipartite/tripartite contract, which is to be performed mutually by the contracting
parties, in future, at the terms decided upon, on the contract date. In other words, a forward contract is an
agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the
contract assumes a long position, i.e. agrees to buy the underlying asset while the other assumes a short
position, i.e. agrees to sell the asset. As this contract is traded out of the exchange and settled mutually by the
contracting parties, it is called an over-the-counter product. As mentioned before, over-the-counter(OTC) is a
generic term used for a product/market, which is off the exchange.
Forward contracts are extensively used in India in the foreign exchange market. Forward contracts are negotiated
by the contracting parties on a one-to-one basis and hence offer tremendous flexibility in terms of determining
contract terms such as price, quantity, quality (in case of commodities), delivery time and place. The parties may
freely decide upon all these terms, based on their circumstances and negotiation powers. They may also carry
out subsequent alterations in the contract terms, by mutual consent.
Differences between spot contract and forward contract

In a spot contract, at least one component, i.e. either the price or the goods/ services is tendered at
the time of the contract. In a forward contract, both the components are exchanged at a specified future
date.
In a spot contract, both the parties transact on the basis of their present capability. The buyer purchases
according to his ability to pay for the goods or services and the seller sells according to his present
ability to deliver the goods or services. In a forward contract, a leveraging of capabilities is involved.
Since no down payment is involved, the buyer might contract to buy a larger number of goods or
services, expecting to derive some benefits from the perceived price differential between the spot price
and the likely price at the time of maturity of the forward contract. Also the seller, feeling that a larger
number of goods shall be available at the contracted price at the time of maturity, agrees to sell a far
larger number of goods.
In a spot contract, execution of the contract is more or less certain because both the components, i.e.
money and goods are available. Even through the transaction does not pass through a regulated delivery
and payment mechanism yet the chances of default are very less. The problems of payment and delivery
get magnified in the case of a forward contract.
Advantages of forward markets

In spite of the problems of the forward contracts described above, there are two important contributions of these
contracts.
(a) Forward contracts are useful hedging tools
Hedging is a process of risk management under which the risks emanating from a transaction are covered or
mitigated. So, when the farmer enters into the forward contract with bakery owner for selling 50 tonnes of wheat
six months hence, he is hedging against the decline in price. The bakery owner, on the other hand, is hedging
against the lack or shortage of supply. Both of them are trying to create a certain future for themselves as far as
this transaction is concerned. Viewed in this background, forward contracts are excellent means of hedging
against price risk and quantity risk.
(b) Forward contracts help in price discovery
The time gap between signing or formulation of a forward contract and its execution gives rise to uncertainty.
From this uncertainty is born speculation regarding future price of the goods and services. Assuming that both
Lesson 10
the seller and the buyer have near perfect information about future price of the goods and services, the forward
contract may be considered as an appropriate means of their price discovery.
Problems in case of a forward contract/Limitations of forward contract

There are three major problems in a forward contract Liquidity, inadequate knowledge, and counter party risk.
(a) The problem of liquidity
One basic problem with the forward markets is that the terms of the contract are too general and too flexible.
Thus A and B might agree for delivery of a particular variety of 50 tonnes of wheat at a particular place after six
months. Now this contract has been tailor-made for the requirements of A and B. Both of them have tied up
irrevocably to the contract and there is no way they can assign the contract to third parties unless of course they
can find individuals with exactly matching requirements. Possibility of that happening is remote and as a result
A and B are left holding on to a contract which both of them must fulfill.
(b) Inadequate knowledge
Further, in the forward transactions, there is no regular interface between the buyers and the sellers. At best
there could be telephonic interaction but there is neither organized market nor any intermediaries on which both
the parties could rely. Since a forward contract is a bilateral relationship between two parties, it requires utilization
of only that much information as might be available to them. This results in inefficient transactions based upon
inadequate discovery of price and insufficient knowledge about the quality of goods and services.
(c) Problem of Counter Party Risk
Yet another risk that is faced in forward transactions is that of Counter Party Risk. By this term we mean that
there is an ever present risk of the other party not being able to honour its commitment.
Suppose that in the illustration being considered by us, at the time of the maturity of the forward contract, the
price of the wheat rules at ` 12,000/- instead of ` 10,000/- per tonne which is the contracted price. In this
situation, the seller might have a tendency to back out of the contract. Or alternately, the price may be ` 8,000/
- per tonne when the buyer may not like honour the contract since he has wheat of that particular kind available
at a lesser price.
Apart from the price element, counter party risk could also arise from variation in quality of the goods, place of
delivery etc. It could also happen that one of the parties to the forward contract goes bankrupt. In the absence
of a regulated market for these forward contracts, the counter party risk is an important element that can jeopardize
forward contracts.
How to eliminate limitations of forward contracts

If all the forward contracts were to be initiated, traded and settled through the medium of an exchange, the
limitations of forward contracts would be overcome. This is how it is done:
1. The large number of participants that trade through the exchange eliminates the problem of liquidity.
The demand and supply equilibrium of the goods keeps shifting constantly. The original contract is thus
capable of changing hands a number of times before final execution.
2. The limitation of inadequate knowledge is overcome by the pooling of knowledge of multitude of seasoned
players in the exchange. The imperfections of knowledge give way to a constantly updated knowledge
back up for the participants in an exchange-traded set up.
3. The limitation of counter party default is eliminated in a forward exchange having clearing house facilities.
The clearing house, by taking margin money from the participants, ensures that all the transactions are
paid for.
322 PP-FT&FM
Moving beyond forward contracts

Having discussed that forward contracts would be much more safe to enter into if routed through an exchange,
let us consider if anything else can be traded other than plain contracts to deliver a particular quantity of goods.
Forward contracts contain an undertaking to deliver goods at a future point of time. At the time of maturity of the
contract, the goods are to be delivered and payment is to be made. At best, in an exchange traded forward
contract, the contract can be negotiated by both the buyer and the seller.
Since the forward contract helps in price discovery and six months is a sufficiently long time to impact prices in
the spot market, it would be quite logical to conclude that the forward prices should also more in tandem with
spot prices. In case of frequent changes in the forward price, people would be tempted to play at the price
differential rather than deal in a single contract. This tendency on the part of investors gave rise to the advent of
instruments called futures, which reflect the perceptions about future prices of commodities and financial products.
Similarly, another variation of the contract gave an option or choice to the buyer to purchase or not to purchase
goods at the time of maturity. These variations or deviations from original objects of contracts are called derivatives.
FUTURES CONTRACT
A futures contract is an exchange traded forward contract to buy or sell a predetermined quantity of an asset
on predetermined future date at a predetermined price. Contracts are standardized and theres centralized
trading ensuring liquidity.
There are two positions in a future contract :
Long position: This is when a futures contract is purchased and the buyer agrees to receive delivery of the
underlying assets (Stock/indices/ commodities)
Short Position: This is when a futures contract is sold and the seller agrees to make delivery of the underlying
assets ((Stock/indices/ commodities)
Pricing of Futures
Futures should theoretically trade at a fair price.The fair price is the price adjusted for cost of carry for delivery at
a later date.The cost of carry is the interest cost on the amount actually paid for an asset on a spot purchase.
Cost of carry is adjusted for any dividends receivable in case of equities.
Cost of carry = Interest cost over period expected dividend yield
The fair price of a future contract is always at a premium to the spot price.
Example: A futures contract is available on a company that pays an annual dividend of `5 and whose stock is
currently priced at `200. Each futures contract calls for delivery of 1,000 shares of stock in one year, daily
marking to market, an initial margin of 10% and a maintenance margin of 5%. The corporate treasury bill rate is
8%.
(i) Given the above information, what should the price of one futures contract be?
(ii) If the company stock price decreases by 7%, what will be the change, if any, in futures price ?
(iii) As a result of the company stock price decrease, will an investor that has a long position in one futures
contract of this company realises a gain or loss? Why ? What will be the amount of this gain or loss ?
Solution:
(i) Annual dividend (D) = `5
Current Stock Price(S) = `200
Lesson 10
Initial Margin = 10%

Maintenance Margin = 5%
Corporate Treasury bill rate (C) = 8%
Price of One Future Contract
F = S + (S x C) D = 200 + (200 x 0.08) 5 = ` 211
(ii) If the company stock prices decrease by 7%, then price of futures contract
F = [200 x (1 0.07)] + [200 x (1- 0.07) x 0.08] 5
= 186 + 14.88 5 = ` 195.88
(iii) An investor with a long position in one future contract agrees to buy 1,000 shares of the company in one
year at `211. Therefore, this investor will benefit only if the future prices increase.
In this case, the future prices has decreased and the investor will therefore realize a loss of (` 195.88 ` 211)
x 1,000 = () ` 15,120
DIFFERENCE BETWEEN FORWARDS AND FUTURES

Based on the preceding, we may summarise the finer points of differentiation between forward and futures
contracts as follows:
Feature
Forward
Futures contracts
Operational mechanism
Traded directly between Contracting

parties (not Traded on the exchange)
Traded on the exchange
Contract specification
Differ from trade to trade
Counter party risk
Exists. But, sometimes jettisoned to a

guarantor
Contracts are standardise contracts.
Liquidation profile
Low, as contracts are tailor-made

contracts catering to the needs of the
parties involved Further, they are not
easily accessible to other market
participants
Exist. But, assumed by the clearing

agency, which becomes the counter
party to all trades or unconditionally
guarantees their settlement
High, as contracts are standardised
exchange-traded contracts
Price discovery
Not efficient, as markets are scattered
Efficient, as market are centralised

and all buyers and sellers come to a
common platform to discover the
price through a common order book
Quality of information and

its dissemination
Quality of information may be poor.

Speed of information dissemination is
weak
As futures are traded on a nationwide basis, every bit of decisionrelated

information
gets
disseminated very fast
Examples
Currency market in India
Commodities futures, index futures

and individual stock futures in India.
324 PP-FT&FM
OPTIONS CONTRACT
Option Contract gives its holder the right, but not the obligation, to take or make delivery on or before a specified
date at a stated price. But this option is given to only one party in the transaction while the other party has an
obligation to take or make delivery. Since the other party has an obligation and a risk associated with making
good the obligation, he receives a payment for that. This payment is called as option premium.
Option contracts are classified into two types on the basis of which party has the option:
Call Option: A call option is with the buyer and gives the holder a right to take delivery.
Put Option: The put is with the seller and the option gives the right to make delivery .
Option contracts are classified into two types on the basis of time at which option can be exercised:
European Option: European Style options are those contracts where the option can be exercised only on
the expiration date.
American Option: American style option are those contracts where the option can be exercised on or before
the expiration date.
What is a premium in Option market

In the options market, a contract is written giving the buyer of the contract the right (option) to purchase or sell a
particular security at a fixed price for a period of time. The seller agrees to deliver if the contract owner elects to
buy, or to purchase if the contract owner elects to sell. For agreeing to the terms of the contract, the seller
receives a fee, which in options is called the premium.
Suppose the common stock of ABC Ltd. is trading in the market at ` 140/- a share. A contract (option) might be
written allowing the buyer of this contract to purchase 100 shares of ABC Ltd. stock at ` 140/- at any time over
the next three months. The seller will have agreed to deliver the 100 shares at this price on demand. For
granting this option, the seller is paid a fee (premium) of say ` 8. This fee translates into ` 800 ` 8 a share for
each of the 100 shares covered by the contract.
If, within the next three months, A stock rises to ` 165/- a share, an option contract will be exercised by the buyer.
He will have purchased 100 shares of ABC Ltd. at ` 148 a share (` 140 contract price plus ` 8 per share
premium) which is well below the ` 165 market price.
If the stock had declined to ` 130/- a share during the three-month period, the owner of the contract would do
nothing. He will certainly not pay ` 140/- a share for stock worth only ` 130/-. The contract will expire. The seller
of the contract will keep the ` 800/- premium. The buyer will be out of ` 800/-.
This example illustrates an options contract that gave the owner the right to purchase stock. Options can also be
devised that give the owner the right to sell stock at a fixed price.
How to determine Option Premium
The three basic factors that determine an option premium are:
1. Intrinsic Value
2. Time Value and
3. Volatility
Intrinsic value is a options arithmetically determinable value based on the strike price of the option and the
market value of the underlying stock.
Lesson 10
Time value reflects the fact that the longer the option has to run until expiration, the greater the premium should
be. This is perfectly logical. The right to buy or sell a stock for two months should be worth more than the same
privilege for only one month. The third factor namely volatility is also easy to understand. Higher the volatility
higher the risk and higher the risk, higher the premium.
Two terms used frequently in the options are class and series.
Series of Options
A series of options is all options of the same class having both the same strike price and the same expiration
month. In the one class of TISCO calls, there is a number of different series as each call within that class has a
different strike price and/or a different expiration month from any other option within the class. Each individual
option is called a series. The total of all puts or calls on a particular stock makes up a class.
Options Derivatives
In simple terms, the options premium is determined by the three factors mentioned earlier, intrinsic value, time
value, and volatility.
But there are other, more sophisticated tools used to measure the potential variations of options premiums. They
are generally employed by professional options traders and may be of little interest to the individual investor.
Tools of Options Derivatives

These four tools are known as options derivatives. They are:
1. Delta
An options delta is used to measure the anticipated percentage of change in the premium in relation to a change
in the price of the underlying security. If a particular call option had a delta of 60% we would expect the option
premium to vary by 60% of the change in the underlying stock. If that stock rose 1 point, the option premium
should rise approximately 6/10 (60%) of 1 point.
2. Gamma
Gamma measures the expected change in the delta factor of an option when the value of the price of the
underlying security rises. If a particular option had a delta of 60% and a gamma of 5%, an increase of 1 point in
the value of the stock would increase the delta factor by 5% from 60% to 65%.
3. Theta
The theta derivative attempts to measure the erosion of an options premium caused by the passage of time. We
know that at expiration an option will have no time value and will be worth only the intrinsic value if, in fact, it has
any. Theta is designed to predict the daily rate of erosion of the premium.
Naturally other factors, such as changes in the value of the underlying stock will alter the premium. Theta is
concerned only with the time value. Unfortunately, we cannot predict with accuracy changes in a stocks market
value, but we can measure exactly the time remaining until expiration.
4. Vega
The fourth derivative, Vega is concerned with the volatility factor of the underlying stock. We have pointed out
that the volatility varies among different securities. Vega measures the amount by which the premium will rise
when the volatility factor of the stock increase.
Vega measures the sensitivity of the premium to these changes in volatility.
326 PP-FT&FM
Delta, gamma, theta and vega are very sophisticated tools for predicting changes in an options premium. They
merely take the three factors which determine a premium (price of the stock, passage of time, and volatility), and
measure each in an exacting manner. The derivatives vary for each series of options.
Difference between Futures and Options

Futures
Options
Both the parties are obliged to perform the contract.
Only the seller (writer) is obligated to perform the

contract.
No premium is paid by either party.
The buyer pays the seller (writer) a premium.
The holder of the contract is exposed to the entire

spectrum of downside risk and has potential for all
the upside return.
The buyers loss is restricted to downside risk to the

premium paid, but retains upward indefinite
potentials.
The parties of the contract must perform at the

settlement date. They are not obligated to perform
before the date.
The buyer can exercise his option any time prior to

the expiry date.
SWAPS
A swap can be defined as the exchange of one stream of future cash flows with another stream of cash flows
with different characteristics.
A swap is an agreement between two or more people/parties to exchange sets of cash flows over a period in
future. Swaps can be divided into two types viz.,
(a) Currency Swaps, (b) Interest Rate Swaps.
Currency Swaps: The currency swap is an agreement between two parties to exchange (swap) payments or
receipts in one currency for payment or receipts in other currency. Suppose if two entities are trading in currency,
the rationale for currency swap between them lies in the fact that one borrower has a comparative advantage in
borrowing in one currency, while the other borrower has an advantage in borrowing in another currency.
Interest Rate Swaps: An interest rate swap is an agreement whereby one party exchanges one set of interest
rate payment for another rate over a time period. The most common arrangement is an exchange of fixed
interest rate payment for another rate over a time period. The interest rates are calculated on notional values of
principals.
The comparative advantage argument

An explanation commonly put forward to explain the popularity of swaps concerns comparative advantages.
Consider the use of an interest-rate swap to transform a liability. Some companies, it is argued, have a
comparative advantage when borrowing in fixed-rate markets, whereas other ompanies have a comparative
advantage in floating-rate markets. to obtain a new loan, it makes sense for a company to go to the market
where it has a comparative advantage. As a result, the company may borrow fixed when it wants floating, or
borrow floating when it wants fixed. The swap is used to transform a fixed-rate loan into a floating-rate loan, or
vice versa.
Lesson 10
Table Borrowing Rates That Provide a Basis for the Comparative Advantage Argument
Fixed
Floating
Company A
10.0%
6-month LIBOR + 0.3%
Company B
11.2%
6-month LIBOR + 1.0%
An Example
Suppose that two companies, A and B, both wish to borrow $10 million for five years and have been offered
the rates shown in Table. We assume that company B wants to borrow at a fixed rate of interest, whereas
company A wants to borrow folating funds at a rate linked to six-month LIBOR. company B clearly has a worse
credit rating than company A because it pays a higher rate of interest than company A in both fixed and
floating markets.
A key feature of the rates offered to companies A and B is that the difference between the two fixed rates is
greater than the difference between the two floating rates. Company B Pays 1.2% per annum more than company
A in fixed-rate markets and only 0.7% per annum more than company A in floating-rate markets. Company B
appears to have a comparative advantage in floating-rate markets, whereas company A appears to have a
comparative advantage in fixed-rate markets.3 It is this apparentanomaly that can lead to a swap being negotiated.
Company A borrows fixed-rate funds at 10% per annum. Company B borrows floating-rate funds at LIBOR plus
1% per annum. They enter into a swap agreement to ensure that A ends up with floating-rate funds and B ends
up with fixed-rate funds.
To understand how the swap might work, we first assume that A and B get in touch with each other directly. The
sort of swap they might negotiate is shown in Figure 5.6. Company A agrees to pay company B interest at sixmonth LIBOR on $10 million. In return, company B agrees to pay company A interest at a fixed rate of 9.95% per
annum on $10 million.
Company A has three sets of interest-rate cash flows:
1. It pays 10% per annum to outside lenders.
2. It receives 9.95% per annum from B.
3. It pays LIBOR to B.
9.95%
Company A
Company B
10%
LIBOR
LIBOR + 1%
Swap agreement between A and B when rates in Table above apply.

10%
9.93%
Company A
LIBOR
9.97%
Financial
institution
LIBOR
B
Company
LIBOR + 1%
Swap agreement between A and B when rates in Table apply and a

financial inter-mediary is involved.
328 PP-FT&FM
The net effect of the three cash flows is that A pays LIBOR plus 0.05% per annum. This is 0.25% per annum less
than it would pay if it went directly to floating-rate markets. Company B also has three sets of interest rate cash
flows:
1. It pays LIBOR +1% per annum to outside lenders.
2. It receives LIBOR from A.
3. It pays 9.95% per annum to A.
The net effect of the three cash flows is that B pays 10.95% per annum. This is 0.25% per annum less than it
would pay if it went directly to fixed-rate markets.
The swap arrangement appears to improve the position of both A and B by 0.25% per annum. The total gain is,
therefore, 0.5% per annum. It can be shown that the total apparent gain in this type of interest rate swap
agreement is always a b, where a is the difference between the interest rates facing the two companies in
floating-rate markets. In this case, a = 1.2% and b = 0.70%.
If A and B did not deal directly with each other and used a financial institution, an arrangement, such as that
shown in Figure 5.7, might result. (This is similar to the example in Figure 5.4.) In this case, A ends up borrowing
at LIBOR + 0.07%, B ends up borrowing at 10.97%, and the financial institution earns a spead of four basis
points per year. The gain to company A is 0.23%; the gain to company B is 0.23%; and the gain to the financial
institution is 0.04%. The total gain to all three parties is 0.50% as before.
In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows
against another stream. These streams are called the legs of the swap.
The cash flows are calculated over a notional principal amount, which is usually not exchanged between
counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since
counterparties can earn the profit or loss from movements in price without having to post the notional amount in
cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the underlying.
Most swaps are traded Over The Counter (OTC), tailor-made for the counter parties. Some types of swaps are
also exchanged on future markets, for instance Chicago Mercantile Exchange Holdings Inc., the largest US
futures market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG.
Illustration: Two companies Rita Ltd. and Gita Ltd. are considering to enter into a swap agreement with each
other. Their corresponding borrowing rates are as follows:
Name of Company
Floating Rate
Fixed Rate
Rita Ltd.
LIBOR
11%
Gita Ltd.
LIBOR + 0.3%
12.5%
Rita Ltd. requires a floating rate loan of 8.million while Gita Ltd. requires a fixed rate loan of 8 million.
(i) Show which company had advantage in floating rate loans and which company has a comparative
advantage in fixed loans.
(ii) If Rita Ltd. and Gita Ltd. engage in a swap agreement and the benefits of the swap are equally split, at
what rate will Rita Ltd. be able to obtain floating finance and Gita Ltd. be able to obtain fixed rate
finance? Ignore bank charges.
Solution:
(i) Although Gita Ltd. faces higher rates in both markets, it has a comparative advantage in the floating rate
Lesson 10
market. It is paying only 30bp more in the floating rate market, but it must pay 150bp more in the fixed
rate market. Rita Ltd. has a comparative advantage in the fixed rate market because It is paying 150 bp
less there, compared to 30 bp less in the floating rate market.
(ii) Net Potential Gain = (LIBOR - (LIBOR + 0.3) + (12.5 - 11) = - 0.3 + 1.5 = 1.2 per cent i.e. 0.6 per cent
benefit to each company
Net floating rate cost to Rita Ltd. would be = LIBOR - .6% And net fixed rate cost to Gita Ltd. would be 12.5% .6% = 11.9%
So the swapping the interest rate obligations, both companies would be benefitted to the extent of .6%.
Swaption
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. While
options can be traded on a variety of swaps, the term swaption typically refers to options on interest rate
swaps.
Properties of Swaption
Unlike ordinary swaps, a swaption not only hedges the buyer against downside risk, also lets the buyer take
advantage of any upside benefits. Like any other option, if the swaption is not exercised by maturity, it expires
worthless.
If the strike rate of the swap is more favourable than the prevailing market swap rate, then the swaption will be
exercised as detailed in the swaption agreement.
It is designed to give the holder the benefit of the agreed upon strike rate if the market rates are higher,
with the flexibility to enter into the current market swap rate if they are lower.
The converse is true if the holder of the swaption receives the fixed rate under the swap agreement.
Investors can also use swaptions to trade the volatility of the underlying swap rate.
DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws
(Amendment) Ordinance, 1995. It withdrew the prohibition on options in securities. The market for derivatives
however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a
24-member committee under the Chairmanship of Dr. L.C. Gupta on November 18, 1996 to develop regulatory
framework for derivatives trading in India. In its report, the committee prescribed necessary pre-condition for
introduction of derivatives trading in India; it recommended that derivatives should be declared as securities so
that the regulatory framework applicable to trading of securities could also govern trading of securities. SEBI
also set up a group in June 1998 under the Chairmanship of Prof. J.R. Varma to recommend measures for risk
containment in derivatives market. The Report worked out the operational details of margining system,
methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring
requirements.
The Securities Contract Regulation Act SC(R)A was amended in December 1999 to include derivatives within
the ambit of securities. Thereafter a regulatory framework was developed for governing the trading in derivatives.
Derivatives were formally defined to include: (a) a security derived from a debt instrument, share, loan whether
secured or unsecured, risk instrument or contract for difference or any other form of security, and (b) a contract
which derives its value from the price, or index of price, or underlying securities. The Act also made it clear that
derivatives are legal and valid, but only if such contracts are traded on a recognized stock exchange. The
Government also rescinded in March 2000 the notification, which prohibited forward trading in securities.
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Derivatives trading commenced in India after SEBI granted the final approval to commence trading and settlement
in approved derivative contracts on the NSE and BSE. NSE started operations in the derivatives segment on
June 12, 2000. Initially, NSE introduced futures contracts on S&P CNX Nifty index. However, the basket of
instruments has widened considerably. Now trading in futures and options is based on not only on S&P CNX
Nifty index but also on other indices viz., CNX IT and Bank Index as well as options and futures on single stocks
and also futures on interest rates.
National Stock Exchange of India (NSE) has made noteworthy contribution in setting up an organized derivatives
market. At the outset it was realized that the fulfillment of certain pre-requisites was essential before the trading
in exchange traded derivatives could start. Some of the pre-requisites are:
1. Strong and healthy cash market
The first and foremost requirement is the existence of a strong and healthy cash market. An efficient, transparent
and fair cash market with strong settlement cycles helps in building an efficient derivatives market.
2. Clearing Corporation and Settlement Guarantee
Existence of a common clearing corporation providing settlement guarantee as well as cross margining is essential
for speedy settlement as well as for risk minimization. This is particularly important in the case of derivatives
where there are often no securities to be delivered and the settlement is arranged in the form of cash difference.
3. Reliable wide area telecommunication network
Since derivative trading must be introduced on nation wide basis so as to provide equal opportunities for hedging
to the investor population throughout the country, existing and reliable telecommunications network along with
existence of proven automated trading systems is extremely important.
4. Risk containment mechanism
There should exist a strong and disciplined margining system in the form of daily and mark to market margins,
which provide a cover for exposure along with price risk and notional loss in case of default in settling outstanding
positions, thereby minimizing market risk.
EQUITY DERIVATIVES
These are derivative instruments with underlying assets based on equity securities. An equity derivatives value
will fluctuate with c hange in its underlying assets equity, which is usually measured by share price change in
the price of the index.
Classification of Equity Derivatives

Equity Derivatives
Index futures
Stock Future
Index option
Stock Option
Index Futures: It is a future contract with the index as the under lying asset. There is no underlying security or
stock, which is to be believed to fulfil the obligations as index futures are cash settled. They can be used for
hedging against an existing equity position, or speculating on future movements of the index.
Stock Future: A stock future contract is a standardized contract to buy or sell a specific stock at a future date at
an agreed price. The contract derives its value from the underlying stock.
Index option: This an option contract where the option holder has the call or put option on the index.
Lesson 10
Stock option: Stock option is an option contract where the option holder has the right, but not the obligation, to
buy or sell the particular stock on or before a specified date at a stated price.
Advantages of trading in equity derivatives
It provides incentive to make profits with minimal amount of risk capital.
Lower cost of trading.
It increases trading volume in stock market liquidity.
It also provides liquidity, enables price discovery in underlying market.
STOCK INDEX FUTURES

Stock Index Futures are financial derivatives which have a Stock Index as the underlying.
An index is a scale of numbers that represents changes in a set of values between a base time period and
another time period. These changes are reflected through the movements of the index values along the scale.
A Stock Index, on the other hand is a particular kind of index that represents changes in the market values of a
number of securities contained in that index.
A Stock Index can be representative of a group of industries or of dominant companies among various industries.
It can have a broad base of hundreds of companies or a select base of say 30 companies.
But why do we need the Stock Index at all? A major reason for the development of the indices is that they provide
an efficient proxy for the market, to enable the portfolio managers to beat the market. Stock indices, being
representative in character act as an effective barometer of the national economy and the market sentiments.
Since the index is representative of the values of the component stocks there can be more than one ways in
which the values of the component stocks can be arranged in order to arrive at the index value.
Terminology commonly used terms in the Index Futures market:

Contract Size: is the value of the contract at a specific level of index. It is denominated by the product of
the index level and the multiplier.
Multiplier: It is a pre-determined value, used to arrive at the contract size. It is the price per index point.
Tick size: It is the minimum price difference between two quotes of similar nature.
Contract Month: It is the month in which the contract will expire.
Expiry Day: It is the last day on which the contract is available for trading.
Open Interest: It is the total outstanding long or short position in the market at any specific point in time.
As total long outstanding positions in the market would be equal to total short positions, for calculation
of open interest, only one side the contracts is counted.
Volume: It is the number of contracts traded during a specific period of time during a day, during a week
or during a month.
Long position: It is the outstanding/unsettled purchase position at any point of time.
Short position: It is the outstanding/unsettled sales position at any point of time.
Open position: It is the outstanding/unsettled long or short position at any point of time.
Calculation of Index Value

The value of underling index can be calculated by different methods. These are described as under:
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1. Market Capitalization Method
Under this arrangement, a weight is assigned to each component total of the Stock Index based upon its share
in market capitalization of all the components. Then, on daily basis, changes in the market capitalization of each
component impact the value of the index in proportion to their weights. Market capitalization, as we know is the
multiple of the market value and the number of outstanding shares.
2. Market Value Method
Under the method, the weight is assigned on the basis of the market value and the index represents the aggregated
market value of the component Stocks.
3. Equal Weightage
Under this arrangement of components, equal weightage is given to all the components. If there are 50 stocks
in an index, each shall have 2 percent weight.
Out of the above three methods of arrangement, the market capitalization method is the most rational since it
takes into account both market price and the number of shares. Thus a component having both larger floating
stock and greater market value gets a better weightage.
Stock Indices in India

Both the major stock exchanges in India, i.e. Bombay Stock Exchange (BSE) and National Stock Exchange
(NSE) have created a number of indices. Some of these are as follows:
BSE-30 (Sensex)
BSE-100
BSE-200
BSE-500
S & P CNX Nifty
S & P Mid cap
S & P CNX 500
The Sensex and Nifty are the most popular indices. Both of these are considered benchmark indices.
FINANCIAL DERIVATIVES
Financial derivatives came into the spotlight along with the rise of uncertainty of post 1970, when the U.S.A.
announced an end to the Britton Woods System of fixed exchange rates. This generated enormous discomfort
owing to currency fluctuations. To mitigate this risk, foreign currency derivatives were introduced on an Over the
Counter (OCT) basis by banks that ended up providing cover to their importer/ exporter clients at a cost. Within
a few years, commodity futures exchanges that had perfected the trading/clearing/settlement of derivatives over
many decades started futures trading for currencies.
Forex derivatives
A Foreign exchange (Forex) derivative is a financial derivative contract where the underlying is a particular
currency and/or its exchange rate. These can be used by currency or forex traders, as well as large multinational
corporations. The multinational corporations often uses these products when they expect to receive large amounts
of money in the future but want to hedge their exposure to currency exchange risk. Financial instruments that fall
into this category include: currency options contracts, currency swaps, and forward and futures contracts.
Lesson 10
Classification of Forex Derivatives

Currency futures: Future contracts are legally binding agreements in which one party agrees to either
buy or sell a certain financial instrument at a later date in time. These contracts are standardized depending
on what is being traded, the quantity, delivery time and delivery location for each specific commodity.
They consist of secondary markets and can also be dealt numerous times much like a bond and opposed
to a bank loan.
Currency forwards: A foreign exchange forward is an over-the-counter contract under which a purchaser
agrees to buy from the seller, and the seller agrees to sell to the purchaser, a specified amount of a
specified currency on a specified date in the future beyond the spot settlement date at a known price
denominated in another currency (known as the forward price) that is specified at the time the contract
is entered into. Forward contracts are different from futures contracts in that they are not standardized
and are negotiated privately.
Currency swaps: A Currency swap is a specified type of forex derivative. A currency swap is an
agreement between two parties to agree to exchange different currencies normally at the prevailing
spot exchange rate with an agreement to reverse the exchange of currencies, at the same spot exchange
rate, at a fixed date in the future, generally at the maturity of the swap.
Currency option: Currency options, commonly known as a Forex options are contracts which allows a
person the right to buy or sell an item of their choosing at a give price for a limited period of time however
it does not oblige them to do so. The only person obliged to perform anything is the seller of the option.
Advantages of Forex Derivatives

The two main purposes of the forex market are to establish exchange rates between currencies and to provide
a vehicle for making cross-border payments. Currency swaps allow companies to revise their debt conditions
to take advantage of currency or expected future market conditions. As a result of these advantages, they are
used as financial tools to lower the amount needed to service a debt. Foreign exchange is more of a liquid
market and is the biggest financial market in he world towering over the futures market in terms of daily
exchanges.
Forex derivatives allow companies to take advantage of the global markets more efficiently by bringing together
two parties that have an advantage in different markets. Although there is some risk associated with the possibility
that the other party will fail to meet its obligations, the benefits that a company receives from participating in a
forex derivative far outweigh the costs.
INTEREST RATE DERIVATIVES

An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a (usually
notional) amount of money at a given interest rate. The interest rate derivatives market is the largest derivatives
market in the world.
Classification of Interest Rate Derivatives

Majorly the interest rate derivatives can be classified as:
Interest Rate Swap: It is an agreement between two parties where one stream of future interest payments
is exchanged for another based on a specified principal amount. It is a cash-settled OTC derivative. The
most popular interest rate swaps are fixed-for-floating swaps under which cash flows of a fixed rate loan
are exchanged for those of a floating rate loan.
Interest rate cap/floor: An interest rate cap is a derivative in which the buyer receives payments at the
end of each period in which the interest rate exceeds the agreed strike price and an interest rate floor is
334 PP-FT&FM
a derivative in which the buyer of the floor receives money if on the maturity of any of the floor, the
reference rate fixed is below the agreed strike price of the floor.
Interest Rate Swaption: It is an option to enter an interest rate swap. In exchange for an option premium,
the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer
on a specified future date.
Payer Swaption: A swap option giving the holder the right to pay a fixed rate and receive a floating
rate in an interest rate swap.
Receiver Swaption: It gives the right but not the obligation to enter into an Interest rate future. It is
a financial derivative with an interest-bearing instrument as the underlying asset. For example,
Treasury-bill futures, Eurodollar futures etc.
Advantages of Interest Rate Derivatives

Interest Rate Derivative are mostly used by firms or corporations, therefore the advantages of using Interest
Rate Derivatives is also analyzed from their perspective. Some of the important advantages interest rate derivatives
are as follows:
It helps to limit or manage exposure to fluctuations in interest rates by providing protection against
falling interest rates and giving the freedom to benefit if interest rates move higher.
Interest Rate Swaps are often used because a domestic firm can usually receive better rates than a
foreign firm.
It also helps companies hedge against interest rate exposure by reducing the uncertainty of future cash
flows.
It allows companies to revise their debt conditions to take advantage of current or expected future
market conditions.
It allows companies to take advantage of the global markets more efficiently by bringing together two
parties that have an advantage in different markets.
Interest Rate Futures (IRFs) In India

On 29th August, 2009 RBI issued directions for trading of Interest Rate Futures on Currency Derivative Segment
of a Recognized Stock Exchange. The term Interest Rate Futures has been defined in the Regulations as:
Interest Rate Futures means a standardized interest rate derivative contract traded on a recognized stock
exchange to buy or sell a notional security or any other interest bearing instrument or an index of such instruments
or interest rates at a specified future date, at a price determined at the time of the contract.
Products that can be traded in the market are futures on long bond (10 year notional G-secs) and T-bills (91
days notional) and any other product which is approved by RBI.
CREDIT DERIVATIVES
Credit derivatives are financial contracts that provide insurance against credit-related losses. These contracts
give investors, debt issuers, and banks new techniques for managing credit risk that complement the loan sales
and asset securitization methods. The general credit risk is indicated by the happening of certain events, called
credit events, which include bankruptcy, failure to pay, restructuring etc. There is a party trying to transfer credit
risk, called protection seller.
A credit derivative being a derivative does not require either of the parties, the protection seller or protection
buyer to actually hold the reference asset. When a credit event takes place, there are two ways of settlement
cash and physical. Cash settlement means the reference asset will be valued, and the difference between its
Lesson 10
par and fair value will be paid by the protection seller. Physical settlement means the protection seller will
acquire the defaulted asset, for its par value.
According to the Report of the Working Group on Introduction of Credit Derivatives in India set up by the Reserve
Bank of India Credit derivatives are over the counter financial contracts. They are usually defined as off-balance
sheet financial instruments that permit one party (beneficiary) to transfer credit risk of a reference asset, which
it owns, to another party (guarantor) without actually selling the asset.
Types of Credit Derivatives

(1) Credit Default Swaps (CDS): It is a bilateral contract on one or more reference assets in which the
protection buyer pays a fees through the life of the contract in return for a contingent payment by the
protection seller following a credit event. The amount to be paid by the seller in case of a credit event
would be the difference between he original value of the asset and the amount recovered from it.
For example: Assume investors who owned long maturity bonds issued by a company ABC. The issuers
bonds have seen a widening of credit spreads with 3-year spreads currently quoted at 115 bps and 12year spreads at 203 bps. The investor could, if concerned with shorter term default risk, hedge with a
default swap.
Maturity
Three years
Reference credit
ABC Company
Reference loan
8.50% 3 year bond
Credit event
The business day following occurrence of specific credit event
Default payment
Notional amount [100% - market value of reference bond after

default]
Default swap premium
3.20% payable by the entity purchasing protection
The default payment is payable by the entity providing protection upon the occurrence of a credit event.
(2) Total Return Swaps (TRS): It is financial contract which transfers both the credit risk and market risk of
an underlying asset. In a TRS, the total return obtained from one asset is passed on the protection
seller, in return for a fixed pre-determined amount paid periodically. The total returns out of the asset are
reflected by the actual cash flows and the actual appreciation/ depreciation in its price over time.
For example: Suppose a bank lends ` 100 crores to a firm a fixed rate of 10%. The bank seeks to hedge
an unexpected increase in the borrowers credit risk. The Bank enters into a TRS whereby:
agrees to pay a counterparty the total return based on an annual rate (F) equal to the promised
interest and fees on the loan plus the change in the market value of the loan.
In return bank receives a variable market rate payment of interest annually (e,g, one year LIBOR)
that reflects the cost of its funds.
Counter
Party
F+(PT-PO)/PO
1 yr LIBOR
Bank
X
Loan to
Firm Z
(2) Credit Link Notes (CLN): CLNs are a securitized form of credit derivatives. The protection buyer
issues notes or bonds which implicitly carries a credit derivative. The buyer of the CLN sells protection
and pre-funds the protection sold by way of subscribing to he CLN. If there is a credit event payment
due from the protection seller, the amounts due on the notes/bonds on account of credit events will be
appropriated against the same and the balance will be paid to the CLN holder.
336 PP-FT&FM
For example: Let us consider an issuer of credit cards that wants to fund its (credit card) loan portfolio via an
issue of debt. In order to reduce the credit risk of the loans, it issues a two-year credit linked notes. The principal
amount of the bond is 100 percent as usual, and it pays a coupon of 7.50%, which is 200 bp above the two year
benchmark. If however, the incidence of bad debt amongst credit card holders exceeds 10% then the term
states that note holders will only receive back ` 85 per ` 100 nominal.
The credit card issuer has in effect purchased a credit option that lowers its liability in the event that it suffers
from a specified credit event, which in this case is an above-expected incidence of bad debts.
Investors may wish to purchase CLN because the coupon paid on it will be above what the credit card bank
would pay on a bond and higher than other comparable investments in the market.
Benefits from Credit Derivatives

Banks and other financial institutions stand to benefit from the credit derivations mainly for two reasons
efficient utilization of capital and flexibility in developing/managing a target risk portfolio. Banks generally
retain assets and hence, credit risk till maturity. This results in a blocking up of banks capital and impairs
growth through churning of assets. Due to exposure norms that restrict concentration of credit risk on
their books, banks are forced to forego attractive opportunities on existing relationships.
Financial intermediaries stand to gain from credit derivatives through indirect participation in creditlinked returns.
Non banking participants gain from credit derivatives primarily through hedging of credit risk exposure.
The ultimate benefit from the use of credit derivatives is on the whole financial system since there is an
increased usage of capital and more efficient pricing of exposures.
Some Modern Credit Derivatives

Over a period of time, the following other types of instruments have emerged on the landscape of financial derivatives:
(A) Stripped Mortgage Backed Securities
Also called SMBS, these instruments represent interest in a pool of mortgages, called Trenches the cash flow
of which has been separated into interest and principal components.
(B) Interest only securities
Called IOs, receive the interest portion of the mortgage payment and generally increase in value as interest
rates rise and decrease in value as interest rates fall. Where the underlying mortgages for an IO carry floating
rate of interest, the value of the IOs tends to increase in value during periods of rising interest rates because
individual borrowers are less likely to refinance and prepay their mortgages. The value of the SMBS would,
therefore, tend to increase over the life of the mortgage instrument.
(C) Principal only securities
Called POs, receive the principal portion of the mortgage payment and respond inversely to interest rate
movement. As interest rates go up the value of the PO would tend to fall, as the PO becomes less attractive
compared with other investment opportunities in the market place.
(D) Structured Notes
These are debt instruments where the principal and/or the interest rate is indexed to an unrelated indicator. An
example would be a bond whose interest rate is decided by the prevailing bank rate.
(E) Swaps
A swap is a simultaneous buying and selling of the same security or obligation. Interest rate swaps are fairly
common in which two parties exchange identical securities having different interest rate structures. The swap
Lesson 10
market has grown dramatically. Today Swaps involve exchange of other than interest rates, such as mortgages
and currencies. Swaps may also include Caps and Floors or Caps and Floors combined Collars. A derivative
consisting of an option to enter into an interest rate swap, or to cancel an existing swap in the future is called a
Swaption.
(F) Warrants
All options having maturity above one year are called warrants. These are generally traded over-the-counter.
(G) Leap
Leap the acronym for Long-term Equity Anticipation Securities are options having a maturity of up to three
years.
(H) Swaptions
Swaptions are options to buy/sell a swap that will become operative at the expiry of the option. Thus a swaption
is an option on a forward swap. Rather than having calls and puts, the swaptions market has receiver swaptions
and payer swaptions. A receiver swaption is an option to receive fixed and pay floating, whereas a payer swaption
is an option to pay fixed and receive floating.
TRADING, CLEARING AND SETTLEMENT OF DERIVATIVES ON STOCK EXCHANGES

The pattern of trading on both the BSE and the NSE is similar.
1. Trading Mechanism
The derivatives trading system at NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for derivatives on a nation-wide basis. It supports an anonymous order driven market, which
operates on strict price/ time priority. It provides tremendous flexibility to users in terms of kinds of orders that
can be placed on the system. Various time and price related conditions like Good-till-Day, Good-till-cancelled,
Good-Till-Date, Immediate or Cancel, Limit/market Price, Stop Loss, etc. can be built into an order.
There are four entities in the trading system.
The NEAT-F&O trading system distinctly identifies two groups of users. The trading user more popularly known
as trading member has access to functions such as, order entry, order matching, order and trade management.
The clearing user (clearing member) uses the trader workstation for the purpose of monitoring the trading
member(s) for whom he clears the trades. Additionally, he can enter and set limits on positions, which a trading
member can take.
2. Period
The contracts are traded in one-month two-month and three month expiry cycles. All contracts expire on the last
Thursday of the relevant month. On the Friday following the last Thursday, a new contract for that expiry period
would be introduced for trading. Thus at any point in time, three contracts would be available for trading with the
first contract expiring on the last Thursday of that month.
3. Lot Size
Trading is a minimum lot size of 200 units for NSE Nifty. Thus if the Nifty is trading at 1050, then the value of a
single futures contract would be ` 210000. The minimum tick size for a Nifty contract in 0.05 units and for
Sensex, it is 0.1 units.
4. Orders
Orders for trading are identified in the following manner:
338 PP-FT&FM
1. Buy Open
2. Sell Open
3. Buy Close
4. Sell Close
Buy Open orders are those wherein the client has first opened a buy position before sell. At the time of closure
of this open position, the order is called a sell Close.
Similarly when a client sells prior to buying, the sell order is identified as Sell Open and when the same sell
Open position is to be closed out the respective buy order is market as a Buy Close order.
The futures market is a zero-sum game, i.e. the total number of long in any contract always equals the total
number of short in any market. The total number of outstanding contracts (lot/short) at any point in time is called
the Open Interest.
The open-interest figure is a good indicator of the liquidity in every contract.
The index futures and index options contracts traded on NSE are based on S&P CNX Nifty Index and the CNX
IT Index, while stock futures and options are based on individual securities. Presently stock futures and options
are available on 119 securities. While the index options are European style, stock options are American style.
There are a minimum of 7 strike prices, three-in-the-money, one at-the-money and three out-of-money for
every call and put option. The strike price is the price at which the buyer has a right to purchase or sell the
underlying.
In respect of equity derivatives, at any point of time there are only three contracts available for trading, with 1
month, 2 months and 3 months to expiry. These contracts expire on last Thursday of their respective expiry
months. A new contract is introduced on the next trading day following the expiry of the near month contract. All
the derivatives contracts are presently cash settled.
5. Clearing and settlement
Clearing and settlement is undertaken by clearing members of the exchange and the clearing bank. Clearing
members can be either trading members, clearing members who can trade and settle only for their own trades;
or professional clearing members who can clear and settle their own trades as well as those of other trading
members.
6. Clearing Mechanism
The first step in clearing process is working out open positions and obligations of clearing (self clearing/tradingcum-clearing/professional clearing) members (CMs). The open positions of a CM is arrived at by aggregating
the open positions of all the trading members (TMs) and all custodial participants (CPs) clearing through him, in
the contracts which they have traded. The open position of a TM is arrived at by summing up his proprietary
open position and clients open positions. Proprietary positions are calculated on net basis for each contract and
that of clients are arrived at by summing together net positions of each individual client. A TMs open position is
the sum of proprietary open position, client open long position and client open short position.
7. Settlement Mechanism
All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index
futures/options of the index cannot be delivered. These contracts, therefore, have to be settled in cash. Stock
futures and stock options can be delivered as in the spot market. However, it has been currently mandated that
Stock Options and Futures would be cash settled. The settlement amount for a CM in netted across all their
TMs/clients, across various settlements. For the purpose of settlement, all CMs are required to open a separate
bank account with the stock exchanges clearing corporation designated clearing banks for F&O segment.
Lesson 10
Settlement of Futures Contracts

Future contracts have two types of settlements MTM settlement and the final settlement.
MTM Settlement for Futures: All futures contracts for each member are marked-to-market to the daily settlement
price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference
between:
(i) the trade price and the days settlement price in respect of contracts executed during the day but not
squared up,
(ii) the previous days settlement price and the current days settlement price in respect of brought forward
contracts,
(iii) the buy price and the sell price in respect of contracts executed during the day and squared-up.
The CMs who have suffered a loss are required to pay the mark-to-market (MTM) loss amount in cash which is
in turn passed on to the CMs who have made a MTM profit. This is known as daily mark-to-market settlement.
CMs are responsible to collect and settle the daily MTM profits/losses incurred by the TMs and their clients
clearing and settling through them. Similarly, TMs are responsible to collect/pay losses/profits from/to their
clients by the next day. The pay-in and pay-out of the mark-to-market settlement are effected on the day following
the trade day.
After completion of daily settlement computation, all the open positions are reset to the daily settlement price.
Such position become the open positions for the next day.
Final Settlement for Futures: On the expiry day of the futures contracts, after the close of trading
hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is
settled in cash. Final settlement loss/profit amount is debited/credited to the relevant CMs clearing
bank account on the day following expiry day of the contract.
Settlement Prices for Futures: Daily settlement price on a trading day is the closing price of the
respective futures contracts on such day. The closing price for a futures contract is currently calculated
as the last half an hour weighted average price of the contract executed in the last half an hour of trading
hours. In case future contract is not traded in the last half an hour, the theoretical future price is computed
and used as daily settlement price in the F&O segment of NSE. Final settlement price is the closing
price of the relevant underlying index/security in the Capital market segment of NSE, on the last trading
day of the contract. The closing price of the underlying Index/security is currently its last half an hour
weighted average value in the Capital Market Segment of NSE.
Settlement of Options Contracts

Daily Premium Settlement for Options: Buyer of an option is obligated to pay the premium towards
the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the
option sold by him. The premium payable amount and the premium receivable amount are netted to
compute the net premium payable or receivable amount for each client for each option contract.
Interim Exercise Settlement: Interim exercise settlement takes place only for option contracts on
securities. An investor can exercise his in-the-money options at any time during trading hours, through
his trading member. Interim exercise settlement is effected for such options at the close of the trading
hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the
option contract with the same series (i.e. having the same underlying, same expiry date and same strike
price), on a random basis, at the client level.
340 PP-FT&FM
The CM who has exercised the option receives the exercise settlement value per unit of the option from
the CM who has been assigned the option contract.
Final Exercise Settlement: Final Exercise settlement is effected for all open long in-the-money strike
price options existing at the close of trading hours, on the expiration day of an option contract. All such
long positions are exercised and automatically assigned to short positions in option contracts with the
same series, on a random basis.
The investor who has long in the money options on the expiry date will receive the exercise settlement
value per unit of the option from the investor who has been assigned the option contract.
Margins in settle of Future Options Contracts

The Clearing Corporation of the contracts to margins in two forms, Mark-to- market settlement and Initial margins.
Mark-to-Market settlement of index futures

All open positions in the index contracts are daily settled at the Mark-to-Market settlement price. Thus if a
contract entered on a particular day at Sensex value of 3300 has the value at 3310 the next day, the position of
the buyer will get credited by 10 points and position of seller will get debited by 10 points. The process will
continue till the closure of the position. On the expiry, the settlement price is the spot index value as on expiry of
any futures contract, the spot value and the futures value coverage. Mark-to-Market settlement is in cash.
Initial Margin
The computation of initial margin is done using the concept of Value-at-Risk (VAR). The initial margin amount
will be large enough to cover a one-day loss that can be encountered on 99% of the days. Value at Risk is a
single number which estimate maximum possible loss on an investment. VAR methodology seeks to measure
that a portfolio may stand to lose within a certain horizon time period due to potential changes in the underlying
assets market price. In other words VAR seeks to measure the maximum loss that a portfolio might sustain over
a period of time given a set probability level. Initial margin amount computed using VAR is collected up-front.
RISK MANAGEMENT SYSTEM- ROLE OF NSCCL

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The salient features
of risk containment measures on the F&O segment are:
The final soundness of the members is the key to risk management. Therefore, the requirements for
membership in terms of capital adequacy (net worth, security deposits) are quite stringent.
NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin
requirements for each futures/options contract on a daily basis. It also follows VAR-based margining
computed through SPAN. The CM in turn collects the initial margin from the TMs and their respective
clients.
The open positions of the members are marked to market based on contract settlement price for each
contract. The difference is settled in cash on a T +1 basis.
NSCCLs on-line position monitoring system monitors a CMs open position on a real-time basis. Limits
are set for each CM based on his base capital. The on-line position monitoring system generates alerts
whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs for MTM value
violation, while TMs are monitored for contract wise position limits violation.
CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs
clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through
him. NSCCL assists the CM to minor the intra-day-exposure limits set up by a CM and whenever a TM
Lesson 10
exceed the limits, it stops that particular TM from further trading.

A member is alerted of his position to enable him to adjust his exposure or bring in additional capital.
Position violations result in disablement of trading facility for all TMs of a CM in case of a violation by the
CM.
A separate Settlement Guarantee Fund for this segment has been created out of the base capital of
members.
The most critical component of risk containment mechanism for F & O segment is the margining system and online position monitoring. The actual position monitoring and margining is carried out on-line through Parallel Risk
Management System (PRISM) using SPAN (Standard Portfolio Analysis of Risk) system for the purpose of
computation of on-line margins, based on the parameters defined by SEBI.
NSE-SPAN
The objective of NSE-SPAN is to identify overall risk in a portfolio of all futures and options contracts for each
member. The system treats futures and options contracts uniformly, while at the same time recognizing the
unique exposures associated with options portfolios, like extremely deep out-out-the-money short positions and
inter-month risk.
Its over-riding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer
from one day to the next day based on 99% VAR methodology.
SPAN considers uniqueness of option portfolios. The following factors affect the value of an option:
(i) Underlying market price
(ii) Volatility (variability) of underlying instrument, and
(iii) Time to expiration.
(iv) Interest rate
(v) Strike price
As these factors change, the value of options maintained within a portfolio also changes. Thus, SPAN constructs
scenarios of probable changes in underlying prices and volatilities in order to identify the largest loss a portfolio
might suffer from one day to the next. It then sets the margin requirement to cover this one-day loss.
The complex calculations (e.g. the pricing of options) in SPAN are executed by NSCCL. The results of these
calculations are called risk arrays. Risk arrays, and other necessary data inputs for margin calculation are
provided to members daily in a file called the SPAN Risk Parameter file. Members can apply the data contained
in the Risk Parameter files, to their specific portfolios of futures and options contracts, to determine their SPAN
margin requirements.
Hence, members need not execute complex option pricing calculations, which is performed by NSCCL. SPAN
has the ability to estimate risk for combined futures and options portfolios, and also re-value the same under
various scenarios of changing market conditions.
Margins
Initial Margin: Margin in the F&O segment is computed by NSCCL upto client level for open positions
of CMs/TMs. These are required to be paid up-front on gross basis at individual client level for client
positions and on net basis for proprietary positions. NSCCL collects initial margin for all the open positions
of a CM as computed by NSE-SPAN. A CM is required to ensure collection of adequate initial margin
from his TMs up-front, in turn the TM collects it from his clients.
342 PP-FT&FM
Premium Margin: In addition to initial margin, premium margin is charged at client level. This margin is
required to be paid by a buyer of an option till the premium settlement is complete.
Assignment Margin for Options on Securities: Assignment margin is levied in addition to initial margin
and premium margin. It is required to be paid on assigned positions of CMs towards interim and final
exercise settlement obligations for option contracts on individual securities, till such obligations are
fulfilled. The margin is charged on the net exercise settlement value payable by a CM towards interim
and final exercise settlement.
Client Margins: NSCCL intimates all members of the margin liability of each of their client. Additionally
members are also required to report details of margins collected from clients to NSCCL, which holds in
trust client margin monies to the extent reported by the member as having been collected from their
respective clients.
PARALLEL RISK MANAGEMENT SYSTEM (PRISM)

PRISM, the Parallel Risk Management System, is the real-time position monitoring and risk management system
for the F&O market segment. The risk of each trading and clearing member is monitored on a real time basis by
generating various alerts whenever a CM exceeds any limit set up by NSCCL. These are detailed below:
Initial Margin Violation: The initial margin is computed on a real time basis i.e. for each trade the amount
of initial margin is reduced from the effective deposits of the CM held with the clearing corporation. For this
purpose, effective deposits are computed by reducing the total deposits of the CM by ` 50 lakh (referred to
as minimum liquid net worth). The CM receives warning messages on his terminal when 70%, 80% and
90% of the effective deposits are utilized. At 100% the clearing facility provided to a CM is automatically
withdrawn. Withdrawal of clearing facility of a CM in case of a violation leads to automatic withdrawal of
trading facility for all TMs and/or custodial participants clearing and settling through such CM.
Similarly, the initial margins on positions taken by a TM is also computed on a real time basis and
compared with the TM limits set by his CM. As the TM limit is used up to 70%, 80%, and 90%, the
member receives a warning message on his terminal. At 100%, the trading facility provided to the TM is
automatically withdrawn.
A member is provided with adequate warnings on the violation before his trading clearing facility is
withdrawn. A CM may appropriately reduce his exposure to contain the violation or alternately bring in
additional base capital.
Member-wise Position Limit Violation (Future and Option contracts on Equity index): The memberwise position limit on open position of a TM is supervised by PRISM. The open position in all index
futures in index option contracts of any TM, cannot exceed 15% of the total open interest of the market
or ` 250 crore, whichever is higher at any time, including trading hours. This limit shall be applicable on
open positions in all option contracts on a particular underlying index.
Member-wise Position Limit Violation (Future and Option contracts on Individual Securities):
The TM position limits in equity index futures contracts shall be higher of ` 250 crore or 15% of the total
open interest in the market in equity index futures contracts. This limit would be applicable on open
positions in all future contracts on a particular underlying index.
Exposure Limit Violation: PRISM monitors exposure of members on all futures and option contracts,
which cannot exceed 33.33 times the liquid net worth for index options and index futures contracts. For
option and futures contract on individual securities, the exposure limits of, which is higher, 5% or 1.5
standard deviation of the notional value of gross open position in futures on individual securities and
gross short open positions in options on individual securities in a particular underlying should be collected/
adjusted from the liquid networth of a member on a real time basis.
Lesson 10
Market-wide Position Limit Violation: PRISM monitors market wide position limits for futures and
option contracts on individual securities. The open position across all members, across all contracts
cannot exceed lower of the following limits; 30 times the average number of shares traded daily in the
previous calendar month or 20% of the number of shares held by non-promoters in the relevant underlying
security i.e. 20% of the free float in terms of the number of shares of a company. When the total open
interest in an option contract, across all members, reaches 60% of the market wide position limit for a
contract, the price scan range and volatility scan range (for SPAN margin) are doubled. NSCCL specifies
the market-wide position limits once every month, at the beginning of the month, which is applicable for
the subsequent month.
Client-wise Position Limit Violation: Whenever the open position of any client exceeds 1% of the
free float market capitalization (in terms of no. of shares0 or 5% of the open interest (in terms of
number of shares) whichever is higher, in all the futures and option contracts on the same underlying
security, then it is termed as client-wise position limit violation. The TM/CM through whom the client
trades/clears his deals should be liable for such violation and penalty may be levied on such TM/CM
which he may in turn recover from the client. In the event of such a violation, TM/CM should immediately
ensure that the client does not take fresh positions and reduce the position of those clients within the
permissible limit.
Misutilisation of TM/Constituents Collateral and/or Deposit: it is violation, if a CM utilizes the collateral
of one TM and/or constituent towards the exposure and/or obligations of a TM and/or constituent.
Violation of Exercised Position: When option contracts are exercised by a CM, where no open long
positions for such CM/tm and/or constituent exist at the end of the day, at the time the exercise processing
is carried out, it is termed as violation of exercised position.
COMMODITIES MARKET
India, a commodity based economy where two-third of the one billion population depends on agricultural
commodities, surprisingly has an under developed commodity market. Unlike the physical market, futures markets
trades in commodity are largely used as risk management (hedging) mechanism on either physical commodity
itself or open positions in commodity stock.
For instance, a jeweller can hedge his inventory against perceived short-term downturn in gold prices by going
short in the future markets.
In the present discussion, we aim at understanding the knowhow of the commodities market and how the
commodities traded on the exchange. The idea is to understand the importance of commodity derivatives and
learn about the market from Indian point of view. In fact it was one of the most vibrant markets till early 70s. Its
development and growth was shunted due to numerous restrictions earlier. Now, with most of these restrictions
being removed, there is tremendous potential for growth of this market in the country.
A commodity may be defined as an article, a product or material that is bought and sold. It can be classified as
every kind of movable property, except Actionable Claims, Money & Securities.
Commodities actually offer immense potential to become a separate asset class for market-savvy investors,
arbitrageurs and speculators. Retail investors, who claim to understand the equity markets, may find commodities
an unfathomable market. But commodities are easy to understand as far as fundamentals of demand and
supply are concerned. Retail investors should understand the risks and advantages of trading in commodities
futures before taking a leap. Historically, pricing in commodities futures has been less volatile compared with
equity and bonds, thus providing an efficient portfolio diversification option.
Commodity market is an important constituent of the financial markets of any country. It is the market where a
wide range of products, viz., precious metals, base metals, crude oil, energy and soft commodities like palm oil,
344 PP-FT&FM
coffee etc. are traded. It is important to develop a vibrant, active and liquid commodity market. This would help
investors hedge their commodity risk, take speculative positions in commodities and exploit arbitrage opportunities
in the market.
Need for commodity trading

It is important to understand why commodity derivatives are required and the role they can play in, risk
management. The prices of commodities, metals shares and currencies fluctuate over time. The possibility of
adverse price changes in future creates risk for businesses. Derivatives are used to reduce or eliminate price
risk arising from unforeseen price changes. The commodity derivative market is a direct way to invest in
commodities rather than investing in the companies that trade in those commodities. Commodity futures markets
allow commercial producers and commercial consumers to offset the risk of adverse price movements in the
commodities that they are selling or buying.
Advantages of Commodity Trading

A good low-risk portfolio diversifier.
A highly liquid asset class, acting as a counterweight to stocks, bonds and real estate.
Less volatile, compared with, equities and bonds.
Investors can leverage their investments and multiply potential earnings.
Better risk-adjusted returns.
A good hedge against any downturn in equities or bonds as there is little correlation with equity and
bond markets.
High co-relation with changes in inflation.
COMMODITY MARKETS IN INDIA

Bombay Cotton Trade Association Ltd., set up in 1875, was the first organized futures market. Bombay Cotton
Exchange Ltd. was established in 1893 following the widespread discontent amongst leading cotton mill owners
and merchants over functioning of Bombay Cotton Trade Association. The Futures trading in oilseeds started in
1900 with the establishment of the Gujarati Vyapari Mandali, which carried on futures trading in groundnut,
castor seed and cotton. Futures trading in wheat was existent at several places in Punjab and Uttar Pradesh.
But the most notable futures exchange for wheat was chamber of commerce at Hapur set up in 1913. Futures
trading in bullion began in Mumbai in 1920. Calcutta Hessian Exchange Ltd. was established in 1919 for futures
trading in raw jute and jute goods. But organized futures trading in raw jute began only in 1927 with the
establishment of East Indian Jute Association Ltd. These two associations amalgamated in 1945 to form the
East India Jute & Hessian Ltd. to conduct organized trading in both Raw Jute and Jute goods. Forward Contracts
(Regulation) Act was enacted in 1952 and the Forwards Markets Commission (FMC) was established in 1953
under the Ministry of Consumer Affairs and Public Distribution. In due course, several other exchanges were
created in the country to trade in diverse commodities.
Structure of Commodity Market

Ministry of Consumer Affairs
FMC
Commodity Exchanges
Lesson 10
National Exchanges
NCDEX
MCX
Regional Exchanges
NMCE
NBOT
Other Regional
Exchange
Commodities traded in commodity Method

World-over one will find that a market exits for almost all the commodities known to us. These commodities can
be broadly classified into the following:
Precious Metals: Gold, Silver, Platinum etc
Other Metals: Nickel, Aluminum, Copper etc
Agro-Based Commodities: Wheat, Corn, Cotton, Oils, Oilseeds.
Soft Commodities: Coffee, Cocoa, Sugar etc
Live-Stock: Live Cattle, Pork Bellies etc
Energy: Crude Oil, Natural Gas, Gasoline etc
Leading Commodity Exchanges in India

The government has now allowed national commodity exchanges, similar to the BSE & NSE, to come up and let
them deal in commodity derivatives in an electronic trading environment. These exchanges are expected to
offer a nation-wide anonymous, order driven, screen based trading system for trading. The Forward Markets
Commission (FMC) will regulate these exchanges.
Consequently four commodity exchanges have been approved to commence business in this regard. They are:
Multi Commodity Exchange (MCX) located at Mumbai.
National Commodity and Derivatives Exchange Ltd (NCDEX) located at Mumbai.
National Board of Trade (NBOT) located at Indore.
National Multi Commodity Exchange (NMCE) located at Ahmedabad.
Participants in Commodity Futures

Farmers/ Producers
Merchandisers/ Traders
Importers
Exporters
Consumers/ Industry
Commodity Financers
Agriculture Credit providing agencies
346 PP-FT&FM
Corporate having price risk exposure in commodities
Types of Commodity Derivatives

(i) Commodity futures contracts: A futures contract is an agreement for buying or selling for a
predetermined delivery price at a specific future time. Futures are standardized contracts that are traded
on organized future exchanges that ensure performance of the contracts ad thus remove the default
risk. The major function of futures markets is to transfer price risk from hedgers to speculators. For
example, if a farmer is expecting his crop of wheat to be ready in two months time, but is worried that the
price of wheat may decline in this period. In order to minimize the risk, he can enter into a futures
contract to sell his crops in two months time at a price determined now. This way he is able to hedge his
risk arising from a possible adverse change in the price of his commodity.
(ii) Commodity options contracts: Options are used for hedging and speculation. The commodity option
holder has the right, but not the obligation, to buy (or sell) a specific quantity of a commodity at a
specified price on or before a specified date. Option contracts involve two parties- the seller of the
option writes the option in favour of the buyer who pays a certain premium to the seller as a price for the
option. There are two types of commodity options: a call option gives the holder aright to buy a commodity
at an greed price, while a put option gives the holder a right to sell a commodity at an agreed price, while
a put option gives the holder a right to sell a commodity at an agreed price on or before a specified
date(called expiry date).
Advantages of commodity trading

1. Leverage: Commodity futures operate on margin, meaning that to take a position only a fraction of the total
value needs to be available in cash in the trading account.
2. Commission costs: It is a lot cheaper to buy/sell one futures contract than to buy/sell the underlying instrument.
For example, one full size S & P 500 contract is currently worth in excess of $ 250,000 and could be bought/sold
for as little as $20. The expense of buying/selling $250,000 could be $2,500+.
3. Liquidity: The involvement of speculator means that futures contracts are reasonable liquid. However, how
liquid depends on the actual contract being traded. Electronically traded contracts, such as the e-minis tend to
be the most liquid whereas the pit traded commodities like corn, orange juice are not readily available to the
retail trader and more expensive to trade in terms of commission and spread.
4. Ability to go short: Futures contracts can be sold as easily as they are bought enabling a speculator to profit
from falling markets as well as rising ones.
5. No time delay: Options suffer from time decay because the closer they come to expiry the less time is for the
option to come into the money. Commodity futures do not suffer from this as they are not anticipating a particular
strike price at expiry.
Disadvantages of commodity trading

Leverage: Low margin requirements can encourage poor money management, leading to excessive risk taking.
Not only are profits enhanced but so are losses.
Commodity Derivatives vs. Financial Derivatives

Derivatives as a tool for managing risk first originated in the Commodities markets. They were then found useful
as a hedging tool in financial markets as well. The basic concept of a derivative contract remains the same
whether the underlying happens to be a commodity or a financial asset. However there are some features,
which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these
contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not
Lesson 10
need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity
derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really
exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset
underlying a contract can vary largely. This becomes an important issue to be managed.
LESSON ROUND-UP
According to the Section 2(ac) of Securities Contract (Regulations) Act, 1956, derivatives includes:
a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument
or contract for difference or any other form of security;
a contract which derives it value from the prices, or index of the prices, of underlying securities.
An option represents the right but not the obligation to buy or sell a security or other asset during a
given time for a specified price called the Strike price. An option to buy is known as a Call and an
option to sell is called a Put.
In Forward Contract, the purchaser and its counter party are obligated to trade in security or other
asset at a specified date in future.
A Future represents the right to buy or sell a standard quantity and quality of an asset or security at a
specified date and price.
Interest only securities popularly known as IOs, receive the interest portion of the mortgage payment
and generally increase in value as interest rates rise and decrease in value as interest rates fall.
Structured Notes are debt instruments where the principal and/or the interest rate is indexed to an
unrelated indicator.
A swap is a simultaneous buying and selling of the same security or obligation. Interest rate swaps are
fairly common in which two parties exchange identical securities having different interest rate structures.
A Stock Index is a particular kind of index that represents changes in the market values of a number of
securities contained in that index.
Index futures are the future contracts for which the underlying is the cash market index. In India,
futures on both BSE Sensex and NSE Nifty are traded
Value at Risk is a single number which estimate maximum possible loss on an investment. VAR seeks
to measure the maximum loss that a portfolio might sustain over a period of time given a set probability
level.
The seller agrees to deliver if the contract owner elects to buy, or to purchase if the contract owner
elects to sell. For agreeing to the terms of the contract, the seller receives a fee, which in options is
called the premium.
A class of options consists of all options of the same type (put or call) covering the same underlying
security.
A series of options is all options of the same class having both the same strike price and the same
expiration month.
All futures and options contracts are cash settled, i.e. through exchange of cash. For the purpose of
settlement, all CMs are required to open a separate bank account with NSCCL designated clearing
banks for F&O segment.
348 PP-FT&FM
The actual position monitoring and margining is carried out on-line through Parallel Risk Management
System (PRISM) using SPAN (Standard Portfolio Analysis of Risk) system for the purpose of computation
of on-line margins, based on the parameters defined by SEBI.
Commodity defines as an article, a product or material that is brought and sold. It can be classified as
every kind of movable property, except actionable claim, money and security.
Forward Market Commission (FMC) will regulate commodities exchanges.
Derivatives as a tool for managing risk first originated in the commodities markets in India.
A strong and vibrant cash market is a pre-condition for a successful and transparent future market.
Adoption of risk management or risk mitigation tool is now sin qua non for success in business with
exposure to commodities.
SELF-TEST QUESTIONS
1. Illustrate the difference between spot market and forward market.
2. What do you understand by the term financial derivatives ?
3. What is the significance of a Stock Index?
4. What are future contracts and how do they differ from forward contracts?
5. Describe the various kinds of options contracts.
6. Evaluate the growth of derivatives market in India.
Lesson 11
Lesson 11
Treasury Management
LESSON OUTLINE
Treasury Management 349
LEARNING OBJECTIVES
Meaning and objectives of Treasury

Management
Treasury Management is an activity associated

with managements of cash and funds in an
organisation. It is one of the core and most
important activity of financial management and
a finance manager should be aware about core
aspects of treasury management.
Significance, Functions and Scope of

Treasury Management
Relationship
between
Treasury
Management and Financial Management;

understand
Role and Responsibilities of Chief Finance

Officer
Objectives of Treasury Management

Function and scope of Treasury
Management
Tools of Treasury Management;
Unit level
Internal Treasury Controls
Domestic level
International level
Liquidity Management
Treasury Management vis-a-vis Financial

Management
Regulation, Supervision and Control of

Treasury Operations
Role and responsibilities of Treasury

Managers
Implications of Treasury on International

Banking
Tools of Treasury Management

Zero based Budgeting
LESSOUN ROUND UP
Financial Statement Analysis
SELF TEST QUESTIONS
Internal Treasury Control

349
350 PP-FT&FM
INTRODUCTION- TREASURY MANAGEMENT

Treasure management means "To plan, organise and control cash and borrowings so as to optimise interest
and currency flows, and minimise the cost of funds " or in other words "the handling of all financial matters, the
generation of external and internal funds for business, the management of currencies and cash flows, and the
complex strategies, policies, and procedures of corporate finance" It involves ensuring that proper funds are
available with the company at the time of outflow required & also that funds are not kept untilised for a good long
time...this requires investing/disinvesting funds in open ended mutual fund schemes. The scope of Treasury
management includes the management of cash flows, banking, money-market and capital-market transactions;
the effective control of the risks associated with those activities; and the pursuit of optimum performance consistent
with those risks.
OBJECTIVES OF TREASURY MANAGEMENT

We have noted above that the main function of a treasury manager is the management of funds. While managing
these funds, the treasury manager seeks to fulfill the under-noted objectives:
1. Availability of funds in right quantity

The treasury manager arranges funds for the unit. It is the duty of the treasury manager to ensure that after the
funds have been arranged in required quantity. The term quantity refers to the amount of funds required for day
to day functioning of the unit. This quantity is available to the firm either as external loans or as internal generation.
The loans quantity is arranged in the form of working capital treasury against the security of inventory and trade
receivables.
Availability of funds in the right quantity is the core objectives of treasury management. Alongside, the treasury
manager has also to ensure that the funds are just adequate for the requirements, neither more nor less. In case
funds are kept in excess of the requirement, the excess portion imposes an opportunity cost over the system,
i.e. the cost represented by the earnings which these funds would have obtained instead of being left idle. Again,
the adequacy of funds has to be determined carefully. For this purpose, the cash flows for the relevant period
have to be accurately charted out. Cash flows are the actual cash flows in this case as there can be a lag in
terms of less realization of the projected flows. Thus actual cash flows only have to be considered while determining
adequacy. Further, while actual inflows should be ascertained, as regards outflows a margin of contingency
should be maintained to take care of the uncertainties. Cash is understood here to include both cash and bank
balances plus that portion of highly liquid securities that can be converted into cash within a stipulated time
period.
2. Availability of funds at right time

The requisite funds for day-to-day working of the firm should be available in time. Timely availability of funds
smoothens the operations of the firm and brings about certainty to the quantum of inflows that would be available
at a particular point in time. What is timely is a relative matter dependent upon the situation of each case. Again
the inflows have to be actual inflows at the determined time and not projected or anticipated flows. This is
because the element of uncertainty has to be accorded due consideration. In case of a firm having a large
number of transactions, timely availability of funds is extremely important because the execution of many
transactions would be dependent upon funds position. This is relevant also for transactions involving foreign
exchange. For the purpose of treasury operations, we consider foreign currencies at par with the domestic
currency. It is assumed that the regulatory mechanism for holding foreign currency and domestic currency is the
same and there is no constraint on holding or converting currencies. For foreign exchange transactions, funds
have to be made available for meeting many critical situations. The treasury manager ensures that all the
Lesson 11
receipts of funds are credited to the account of the firm well in time. Another way of ensuring timely availability of
funds is to park short-time surplus funds in liquid securities which can be sold conveniently and quickly to realize
cash. In this way, availability can be ensured without straining other resources.
3. Deployment of Funds in right quantity

Just as procurement of funds in right quantity is important for a treasury manager, equally important is to ensure
that the right quantity of funds is deployed. By deployment of funds, we mean earmarking of funds for various
expense heads, parking of short-term funds and investing surplus funds.
The expense heads can be capital expenditure and revenue expenditure. Capital expenditure involves allocation
of funds for acquisition of fixed assets. The amount involved per transaction in capital expenditure is large and
such expenditure is usually known well in advance. Revenue expenditure on the other hand is routine expenditure
for purchase of raw materials and making payment for utilities, wages and other miscellaneous items. The
number of transactions for revenue expenditure is large and the amount involved per transaction is smaller as
compared to the capital expenditure. Some items of revenue expenditure are in the form of cash payment but
the capital expenditure is mainly through bank account.
For deploying the right amount of funds, the treasury manager has to keep track of all receipts of funds.
Simultaneously, the time table of deployment of funds is to be drawn up. In this time table, the payees are
prioritized according to the urgency of their payments. There are certain expenses like important raw material
payments, utility payments etc. which have to be accorded top priority over others. Other payments like payment
to capital goods suppliers and financiers have also to be arranged in the right quantity. Apart from these payments,
some extra funds have to be kept available for meeting contingencies. The sum of all these deployments makes
the right quantum of funds to be deployed. For making the right development of funds at right time, it is necessary
to have a close tie-up with different department i.e. Purchase department, HR Department. Without this type of
tie-up, right quantity of funds cannot be deployed.
If the deployment is not in right quantity, the result can either be under deployment resulting in higher cost of
funds or over deployment resulting in funds remaining idle. In case all the requirements of deployment of funds
have been met and procurement of funds has been done in the right quantity, there is a possibility that some
amount of funds would remain in surplus with the treasury department. This surplus would be in excess of the
contingency requirements and as such can be deployed further on short term or long term basis depending
upon the quantum of funds. If the quantum of surplus is large enough, some amount from this can be earmarked
for long term deployment in investments etc. otherwise the entire surplus can be parked in short term securities.
Deployment of the right quantity of funds cannot be achieved in case the procurement of funds has not been
done in right quantity in the first place. This is because ultimately the inflows of funds shall be utilized for feeding
the outflows on whatsoever account. If the deployment has been done rightly, there shall be no bottlenecks in
the funds flow of the firm. The allocation and use of funds follow each other in a cyclical manner and both have
to be done in the right quantity for optimal use of the funds.
4. Deployment of funds at right time

A logical corollary of sourcing funds at the right time is that the funds should be deployed at the right time. The
description of the right time is a relative term and what amount of time is appropriate varies from firm to firm. The
span of time varies from a week to a month in case of purchase of fixed assets. However, in working capital
deployment, the range of time allowed may be quite narrow say 23 days only. The treasury manager has to
honour the outstanding commitments on working capital account within this short span of time. Payment for wages
and utilities etc. has to be made in time to avoid any defaults. Similarly, payment to trade creditors, domestic and
overseas, has to be made within a stipulated short period of time for avoiding interest payments etc.
Timely disbursement ensures that the funds are not left idle for the shortest span of time. In case the sourcing
352 PP-FT&FM
and deployment of funds is well organized, surplus of funds shall soon start emerging which can be deployed in
short term liquid investments. However, if the inflow and outflow of funds is not evenly matched in the time
dimension, bottlenecks and mismatch of funds are sure to emerge. Apart from causing administrative problems
and rationing of funds, such a situation also leads to increase in cost of funds. Thus the treasury manager seeks
to avoid such situations. Timely deployment of funds is a well planned activity requiring intra-organisation coordination and liaison with banks and financial institutions apart from forex dealers.
5. Profiting from availability and deployment

One of the prime objectives of a treasury manager is to ensure timely procurement of right amount of funds and
timely deployment of right amount of funds. This objective results in administrative smoothening and paves way
for easier achievement of performance targets of the firm. Modern day treasury manager has another objective,
which is to profit from such sourcing and deployment. Profit from this function is derived as under:
Sourcing of funds at the right time and in right quantity is a result of realization of debtors and financing of
borrowings. Realisation of debtors in time has a direct impact upon profitability of the firm through decrease in
cost of holding debtors. Financing of borrowings is a capital structure decision but the actual availment of these
borrowings is the domain of the treasury manager. Adequate and timely utilization of the borrowed funds results
in the avoidance of strain on other sources of funds.
Once the funds have been sourced in correct measure, the deployment adds further to the profitability of the firm
it has been done in tandem with the pace of sourcing. Correct deployment ensures that there is no unnecessary
accumulation of funds in the firm at any point in time. Needs of every department are met as per schedule. This
action results in avoidance of special and extraordinary costs, interests and the like. With costs being in control,
surplus funds emerge from the system which is deployed profitably either as long term investments or as shortterm parking tools. Both ways, the net result for the firm is an addition to profits.
ROLE OF TREASURY MANAGEMENT AND BENEFITS

In its broadest sense Treasury covers cash management, corporate finance and financial risk management. Closer
inspection reveals that the Treasury function undertakes a range of complex and skilled tasks; liaises with internal
and external stakeholders and plays a key role in the smooth functioning and value creation of an organization.
Although the role of the Treasury function is constantly evolving, it can be broken down into 6 broad but interlinked
categories:
1. Planning and Operations

Key Activities
Key benefits
Cash flow forecasting
Subsidiary and Group financial management
Risk forecasting
Risks are identified early and mitigated
Investment appraisal
Resources are directed to the best opportunities
Tax planning
Clear and quantifiable approach to the future
Pensions planning
Tested contingencies in the event of exceptions
Co-operate with Board on strategic development
Operational risk management
Choose and operate Treasury systems
Transaction costs minimized
Negotiate, analyze and manage the fees and

margins of service providers
Smooth operations
Ensure quality standards of service providers
Efficiency gains
Lesson 11
2. Cash and Liquidity Management

Key Activities
Key benefits
Manage internal capital market by investing and

lending to subsidiaries
Minimize external borrowing requirement
Work with the business to optimize commercial

cash flows
Optimize interest expense
Work with the business to optimize working capital
Optimize tax expense
Minimize idle cash through netting and cash

concentration
Avoid future liquidity problems
Confirmation and reconciliation of receipts
Create cash is king culture
Timely disbursement of payments
Smooth operations and supplier relationships
3. Funding and Capital Markets

Key Activities
Key benefits
Optimization of capital structure
Optimization of Weighted Average Cost of Capital

(WACC)
Manage short, medium and long-term investments Maximize yield on assets

Ensure adequate liquidity to support the business
Minimize interest expense
Ensure adequate liquidity to meet obligations as

they fall due
Access to capital at the right time, price and conditions
Arrange liquidity for strategic events such as

M&A, Divestiture and JVs
Removal of concentration risks
Diversify capital sources, partners and maturities
Ensure good credit ratings
Portfolio management of debt, derivatives and

investments
Ensure limits accurately reflected the borrowing

requirement (thus minimizing commitment fees)
Ensure contractual terms and covenants do not

constrain the business
Ensure hedging matches the funding profile (no over

hedging)
4. Financial Risk Management

Key Activities
Key benefits
Seek natural hedges and offsets within the business
Visibility of financial risks on an enterprise basis
Interest Rate risk management
Minimize external hedging requirement
FX risk management
Minimize impact of external risk on P&L and Balance

Sheet
Commodity risk management
Reduce volatility
Counterparty risk management
Credit risk management
Improve asset quality
Liquidity risk management
Create risk aware culture
354 PP-FT&FM
Pension risk management
Certainty facilitates better decisions
Work with the business to de-risk contracts and

avoid bad debts
Scenario planning and stress testing avoid surprises
5. Corporate Governance
Key Activities
Key benefits
Ensure accurate valuation of financial instruments Ensure the financial profile represents and true and
fair view
Ensure accurate accounting of Treasury
transactions
Adequate internal controls
Implement and manage treasury policies and

procedures
Demonstrate preparedness
Provision of covenant tests and information to

investors
Reputational risk management
Provision of compliance information to regulators

Ensure accurate transaction history and audit trail
Work with internal and external auditors
6. Stakeholder Relations
Key Activities
Key benefits
Provide performance and risk analytics to Board
Manage relationship with banks and other investors Relationship benefit from proactive communication
Manage relationship with credit rating agencies
Reputational risk management
Co-operate with Board and Investor Relations on

shareholder matters
Valuable knowledge and contacts from deep

involvement with financial markets
Ensure the Treasury function is understood and

valued within the business
Tangible financial results in the form of cost savings,

efficiency gains, yield enhancement and protecting
profitability
SIGNIFICANCE OF TREASURY MANAGEMENT FUNCTION

The Treasury function in any corporate has always been important in making sure that the business has sufficient
liquidity to meet its obligations, whilst managing payments, receipts and financial risks effectively. With the ever
increasing pace of change to regulation, compliance and technology in the financial sector, Treasury has
increasingly become a strategic business partner across all areas of the business, adding value to the operating
divisions of the company: for example, working with the sales department to establish good financial contract
terms so that any trade discounts offered and the payment method agreed are beneficial to the business.
Current market conditions also reinforce the need for corporates to ensure that their financial position is managed
as efficiently as possible, with no excess working capital tied up in the business - the old adage cash is king is
certainly as relevant today as it has always been.
Treasury departments need to cover the complete financial environment; from capital structure and long term
investments to liquidity and working capital management. If Treasury can drive improvements in the Purchase-
Lesson 11
To-Pay and Order-To Cash cycles, there can be a direct effect on the overall debt and investment requirements
and thus on the capital structure required in the business.
The question then is: if the Treasury function is becoming more of a business partner, how can the department
manage its time to ensure that day to day administration, processing and transaction execution is completed
using the minimum of resource? The answer is that larger companies automate the majority of their daily financial
processing and administration tasks, supported by policy standards, control and monitoring processes, embedding
financial best practices across the whole business. Integrating corporate systems with those of their banks can
achieve significant levels of automation, reducing the amount of time that needs to be spent on tasks such as
calculating the daily cash position.
At the same time, the efficient use of secure systems can minimise operational risk, increase operational security
and maximise straight through processing. Add to this automatic reconciliation of bank account data and Treasury
can then manage exceptions rather than every item, giving them the time to devote to delivering value-added
services across the company.
FUNCTIONS AND SCOPE OF TREASURY MANAGEMENT

Government sector, business sector and the foreign sector are the major sectors of countrys economy. For
macro operations of these sectors, there is requirement of cash, currency and credit. In broader terms, all
financial resources including foreign exchange are to be made available to the industrial or business units.
Similarly, at the macro level return flow of funds in the form of taxes and repayment of loans is needed. Such to
and from movement of funds is part of the financial functioning.
Any business enterprise requires finance to start business operations. The first requirement is in the form of
capital for setting up of the project. Project finance needs long term funds. These funds can be obtained from
equity and debt both. Equity and internal accruals are considered the owners contribution whereas debt is
treated as the outsiders stake in the project. Once the company starts operations of production and manufacture,
it needs working capital funds also. These funds are required to meet the payments for raw materials and other
inputs, spares, utilities etc. The quantum of funds needed for working capital depends upon nature of the companys
business and nature of its products or services.
The function of treasury management is concerned with both macro and micro facets of the economy. At the
macro level, the pumping in and out of cash, credit and other financial instruments are the functions of the
government and business sectors, which borrow from the public. These two sectors spend more than their
means and have to borrow in order to finance their ever-growing operations. They accordingly issue securities
in the form of equity or debt instruments. The latter are securities including promissory notes and treasury bills
which are redeemable after a stipulated time period. Such borrowings for financing the needs of the government
and the business sector are met by surplus funds and savings of the household sector and the external sector.
These two sectors have a surplus of incomes over expenditure. The micro units utilize these surpluses and build
up their capacities for production of output and this leads to the productive system and distribution and consumption
systems.
No company can operate in a vacuum. Its assets are both financial and human. As such, there are both quantifiable
and non-quantifiable factors involved in financial performance, forecasting and achievement of targets. The
companys treasury manager is the pivot around which day to day operations of the company revolve. His operations
and performance have an impact on the company itself and the financial system and the economy in the broad
sense. An analysis of the sources of funds of business units reveals that broadly there are three categories of
resources internal accruals of the unit, external sources from the capital and the money market and the external
sources. The same analysis holds good at the sectoral and national level. In fact, the emergence of international
financial markets can be traced to this sectoral inter-dependence, including the foreign sector and intra-national
dependence. Basically, as no country is self-sufficient, international economic and economic relations emerge.
356 PP-FT&FM
In a similar fashion, it would be appropriate to set out the pattern of use of funds of any company into various
sectors of the economy, including the foreign sector. Dispensation of funds for current or capital expenditures in
domestic and international markets can be separately set out. Such an analysis is particularly more relevant to
multinational corporations and branches or subsidiaries of foreign companies in whose case foreign markets
and foreign sources of supply play an important part. The head office or the holding company may spend apart
of its funds in investment in the host country, make inward remittances for working capital or investment purposes
and outward remittances for royalty and dividend payments or technical fees.
International financial markets emerged out of the need to facilitate operations of nations arising out of commercial
and financial transactions with the rest of the world. This emergence can be attributed logically to the interrelations of the economic unit with the corporate sector and of the latter with the other sectors of the economy,
including the foreign sector. It would be apt to set out here the inter-relations between micro level operations of
a treasury manager with the macro level working of the corporate sector and foreign sector. A treasury manager
is a micro unit in the financial sector. The environment he faces is competition from other similar units in the
corporate sector. Besides this, the corporate sector, in turn, is inter-linked with all other sectors of the economy.
The treasury manager is thus faced with a total environment of the economy which includes foreign sector and
it is thus necessary for him to be familiar with the international financial system, as much as to the domestic
financial system.
(1) Scope of Treasury Management of Unit Level

At the unit level, the treasury managers activities encompass all other management functions. The
performance of production, marketing and HRD functions is dependent upon the performance of the treasury
department. The lubricant for day-to-day functioning of a unit is money or funds and these funds are arranged
by the treasury manager. The treasury is involved in all the budgeting activities of the unit, whether these
are financial budget, costing budget, the marketing budget or the HRD budget. The feedback available
from interactions with the various departments of the company is utilized by the treasury department to fine
tune the overall performance targets of the company within the constraints of availability of currency, cash
and cash equivalents.
Treasury manager also monitors the cash flows of the unit on a continual basis. It is ensured by him that
adequate funds are made available for day-to-day working of the unit. In case there is genuine shortfall in cash
flows, the outflows are made in an order of priority with the more urgent payments being made first. The treasury
manager has two duties of taking decisions both in the areas of cash inflows and outflows. He has to integrate
the treasury function with with the production and marketing functions. The scope of the treasury management
function at the unit level can be better described in the following routine duties of the treasury manager:
1. Keeping a track, on monthly, fortnightly or weekly basis, of all cash inflows and outflows and their
variance with budget projections.
2. Maintaining a record of all receivables and payables, credit instruments, credit sales, deposits, loans
and advances etc.
3. Study regularly the quantity and quality of current assets and liabilities and position of current liquidity.
4. Assess from time to time the long-term and short-term solvency of the company and its overall solvency
position.
5. Keep liaison with stock exchanges, where the shares of the company are listed for a study of the share
price movements.
6. Keep liaison with banks and financial institutions for ant change in borrowing limits or to inform them of
any imminent changes in companys financial position or policies. Payments of interest and instalment
of principal are to be arranged at the right times.
Lesson 11
7. Keep liaison with Registrar of Companies and government departments concerned with the investment
and financing decisions for any information regarding policy changes.
8. Keep abreast with all legal and procedural requirements for raising funds and investment decisions.
9. Keep the top management or the board informed of any likely changes in the financial position of the
company due to internal factors.
(2) Scope of Treasury Management of Domestic Level

At the domestic or national level, the scope of treasury management function is to channelise the savings of
the community into profitable investment avenues. This job is performed by the commercial banks. Treasury
management is a crucial activity in banks and financial institutions as they deal with the funds, borrowing and
lending and investments. By nature of their activity, they earn their profits through operations in money or near
money claims. They borrow from the public in the form of deposits which along with other borrowings constitute
their liabilities. Their assets are mostly in the form of loans, advances and investments. As their liabilities are
mostly of short and medium term nature, funds management becomes critical for ensuring a proper matching
of assets and liabilities according to the maturity of each and their costing. Commercial banks being the
creators of credit have an additional responsibility of maintaining their image of creditworthiness, safety and
integrity.
Commercial banks are also required to observe capital adequacy norms and provide for non-performing
assets on a strict basis. Thus there are limits to which the banks can expand their credit portfolio. Banks are
also enjoined by regulations to maintain Cash Reserve Ratio (CRR) of a minimum of 3% and Statutory
Liquid Ratio (SLR) of 25% of their net demand and time liabilities. While the CRR is required to be maintained
with the RBI in the form of cash balances, the SLR is to be maintained in the form of investment in central
and state government securities. It has been observed that during times of slack credit demand, banks
invest in govt. securities to a higher extent than the statutory requirement of 25% of net DTL. This activity is
more pronounced when the interest rates are falling because the yields on govt. securities fall in such a
period, driving up their prices. Banks, which do their treasury management astutely, stand to gain
tremendously during such periods.
The gilt edged market has two formsprimary and secondary. The primary market is a wholesale market where
RBI is the underwriter and allots the securities to applicants on behalf of the government. On the same basis, the
RBI sells the repos (or repurchase agreements) of government securities to the institutions, banks, etc. to meet
the market demands. The interest rates are decided by the discounts quoted in these bids and these are market
related rates. In the primary market, RBI sells securities to banks, FIs, PF trusts, etc. RBI as the underwriter of
of government securities, makes up for any shortfall in subscription for them. But in the case of state government
securities, it only arranges for subscription.
The main features of the primary market are listed below:
New borrowings to be made on behalf of govt. is decided by RBI and terms such as tenor and coupon
rates are announced.
The RBI acts as underwriter and contributes to the loans unsubscribed by the public. Work of the RBI is
shared with a class of primary dealers.
The timing and conditions, and the amounts involved are discussed by RBI with banks and FIs and
sometimes prior commitments are enlisted.
The floatation of bonds is effected throughout the year depending on the conditions of the market and
requirements of the government.
358 PP-FT&FM
The timing and quantum is also adjusted having regard to overall liquidity in the market.
The subscription to the loans can be in cash as also in the form of rolling over of existing securities
which have fallen due for repayment.
In the secondary market, which is a retail market, trading is over the counter. Main operators in the secondary
market are the Discount and Finance House of India (DFHI), banks, FIs, PFs etc. This market is an over-the
counter (OTC) market where trading is done through phones, fax etc.
The concept of yields is important for understanding of the government securities market. Yield, as we know, is
the rate of return on an investment. In case of lending made by the banks, they stipulate a rate of interest per
annum which becomes the benchmark for their return. The actual yield may vary from the benchmark depending
upon whether the periodicity of interest is monthly, quarterly or half yearly basis. In case of government securities,
however, the yields are determined on the basis of the price at which the security is auctioned in the primary
market or the prices determined in the secondary market through sale and purchase.
Nominal Yield
Coupon rate is the rate of interest payable per annum per Rs. 100/- or the face value. If the purchase price is
different from the face value then the return is equal to (coupon rate/purchase price) x 100. This return is called
the normal yield.
Real Yield
Nominal yields deflated by the index of inflation rate, such as WPI or CPI will give real yields, which reflect the
true purchasing power of the return on these securities.
Net Yield
Nominal yields adjusted for the tax rate or payment of relevant taxes at which deduction of tax at source takes
place are called the net yield.
Current Yield
Coupon rate is the rate at which the bond carries interest. This is the nominal yield payable on on the face value
of the bond regularly and remains unaltered, say, for example 7.75% loan 2005. Current yield is equal to (coupon
rate x face value)/ cost or market price.
Redemption yield or yield to maturity
This takes into account the price paid for the bond, length of time to maturity and the coupon rate of the bond.
This is the yield which the holder gets per annum if he holds it until maturity and is the same as current yield if the
bond is purchased at par. Redemption yield is equal to current yield +/ average annual capital gain or loss (for
the bond purchased at a discount or premium as the case may be).
RBI is responsible for public debt management of the government. It does this by underwriting and subscription
to new issues not subscribed by public, by use of Open Market Operations (OMO) as a technique of sale and
purchase of government securities to control the liquidity and the interest rate structure and by use of SLR and
CRR as the method of controlling the liquidity of banking system and their contributions to government debt.
(3) Scope of Treasury Management of International Level

At the international level, the function of treasury management is concerned with management of funds in the
foreign currencies. Foreign exchange as a subject refers to the means and methods by which the rights to
income and wealth in one currency are converted into similar rights in terms of another countrys currency. Such
exchanges may be in the form of one currency to another or of conversion of credit instruments denominated in
different currencies such as cheques, drafts, telegraphic transfers, bills of exchange, trade bills or promissory
Lesson 11
notes. Exchange is done through dealers in foreign exchange regulated by the central bank of a country. Banks
are usually the dealers apart from other specialized agencies.
One of the important components of the international financial system is the foreign exchange market. The
various trade and commercial transactions between countries result in receipts and payments between them.
These transactions are carried out in the currencies of the concerned countries? any one of them or in a
mutually agreed common currency. Either way, the transactions involve the conversion of one currency to the
other. The foreign exchange market facilitates such operations. The demand for goods and services from one
country to another is the basis for demand for currencies in the market. Thus basically, demand for and supply
of foreign currencies arises from exporters or importers or the public having some transactions with foreign
countries.
Companies having an import or export component in their business profile have to frequently deal in forex
operations. Forex operations in a country being supervised by the central bank, reference to the central bank in
one form or the other is necessary to use foreign exchange. If the country on the whole is a net exporter of goods
and services, it would have a surplus of foreign exchange. If, on the other hand, it is a net importer then it would
have a shortage of foreign exchange. The extent of regulation of the forex market depends upon the availability
of foreign exchange in a country. If the forex is scarce, then holding and using it would be subject to a lot of
regulatory control. It also matters whether international trade forms a significant percentage of the GDP of a
nation. If it is so, then the awareness about forex regulations would be much more widespread as compared to
a situation when foreign trade forms an insignificant portion of GDP. Presently, however, with increasing
globalisation, forex dealing has become a normal part of treasury operations.
Every foreign exchange transaction involves a two-way conversion a purchase and sale. Conversion of domestic
currency into foreign currency involves purchase of the latter and sale of the former and vice versa. These
transactions are routed through the banks. The transactions take the shape of either outright release of foreign
currency for meeting travel and related requirements or payments to outside parties in the denominated currency
via the medium of correspondent banks. For effecting payment, following instruments are generally used:
Telegraphic transfers (TT)
A TT is a transfer of money by telegram or cable or telex or fax from one center to another in a foreign
currency. It is a method used by banks with their own codes and correspondent relations with banks and
abroad for transmission of funds. It involves payment of funds on the same day, it is the quickest means of
transmission of funds. As there is no loss of interest or capital risk in this mode, it enjoys the best rate for the
value of receipts.
Mail Transfers (MT)
It is an order to pay cash to a third party sent by mail by a bank to its correspondent or branch abroad. It is issued
in duplicate, one to the party buying it and the other to the correspondent bank. The amount is paid by the
correspondent bank to the third party mentioned therein in the transferee country by its own cheque or by
crediting the partys account. As the payment is made after the mail advice is received at the other end, which
will take a few days, the rate charged to the purchaser is cheaper to the extent of the interest gain to the seller
bank.
Drafts and cheques
Draft is a pay order issued by a bank on its own branch or correspondent bank abroad. It is payable on sight but
there is always a time lapse in the transit or in post between the payment by the purchaser of the draft to his
bank and the receipt of the money by the seller in the foreign center. As in the case of MT, there is risk of loss of
draft in transit or delay in release of payment to the beneficiary and loss of interest in the intervening period.
360 PP-FT&FM
Bills of exchange
It is an unconditional order in writing addressed by one person to another, requiring the person to whom the
order is addressed, to pay certain sum on demand or within a specified time period. If it is payable on demand,
it is called a sight bill. If it is payable after a gap of some time, it is called a usance bill. Such bills can be bankers
bills or trade bills. Bankers bills are drawn on banks abroad while trade bills are made between individual
parties.
There are four major components of the forex markets, depending upon the level at which the transactions are
put through. These can be either
Banks with public
Inter-bank deals
Deals with correspondents and branches abroad
Deals with RBI.
In the market, there is no physical exchange of currencies except in small denominations when travelers and
tourists carry them across national borders. The medium of exchange is credit instruments or book entries in the
books of concerned banks.
Exchange rates can be spot rates or forward rates. If an importer is paying on receipt of documents, then he can
buy a foreign currency say dollars on spot basis. It means that the exchange of Indian Rupee and Dollars is
proceeding on current basis. But if the importer agrees to pay three or six months hence, his demand for dollars
might arise only after three or six months. In such a situation, the transaction is carried out through forward
transaction. The exchange of Rupee and Dollar is to take place after the stipulated time period, though the
exchange price has been pre-decided.
Just as the banks are buying and selling spot, they also do business in forward currencies. Corresponding to the
spot rate of exchange, there is a forward rate for various periods. Currencies sold or bought in forward are
subject to the influences of interest rates? both domestic and international. Forward rates also depend upon the
elative position of currencies vis--vis other currencies. Hence there is an implicit risk that the forward rates
contracted today may be different from actual spot rates that would prevail three or six months hence. If any
bank succeeds in forward purchases with forward sales of the same currency, it avoids exposure to the exchange
rate risk. If the forward sales and purchases do not match, the bank may have an uncovered position which it
may cover with another bank which has a contrary position. If it fails to cover with a bank, it may still do so with
the central bank of the country or with a correspondent bank abroad. If a bank takes a position uncovered, it may
take a calculated risk in the hope that the rate may move in its favour or else it may have to bear the exchange
rate differential.
When foreign exchange markets operate in a free manner, the assumption is that the exchange rates between
various currencies would be quoted at the same level at all the trading centers throughout the world. But it
seldom happens and at the best of times, there are discernible differences in exchange values across centers.
Banks and other dealers take advantage of these differences and profit from the rate difference. This operation
is called arbitrage. For example, if the Dollar-Euro parity is 1.00 in New York and 1.05 in Frankfurt, then a dealer
can sell Euros in Frankfurt, purchase Dollars and with the Dollars, buy Euros again in New York thereby profiting
from the deal.
Operations in the forex market are exposed to a number of risks. These risks are as follows:
Credit risk arising out of lending to a foreign borrower whose credit rating is not known for certainty.
Currency risk of trading in a currency whose stability and strength is known to fluctuate.
Lesson 11
Country risks involved in dealing in the currency of a country whose political and economic stability is
uncertain.
Solvency risks due to mismatch between current assets and liabilities of dealers and resultant default in
meeting forward commitments.
In India, commercial and most of the co-operative banks have been authorized to deal in foreign exchange.
Banks finance huge amount of foreign trade. This trade is conducted on daily basis through purchase and sale
of foreign currencies. The demand and supply of active currencies is matched by the banks from their own
stock. There are cases when the bank needs some currencies or has a surplus of such currencies. These needs
are met by buying or selling such currencies to the RBI.
The foreign exchange department of every bank draws up a position sheet for each currency daily in which
purchases and sales of the currency are recorded. The banks generally avoid taking any exchange risk by
covering uncovered balances at the end of the day. When the purchases exceed sales, the credit balance is
plus and the position is overbought. This is to be covered by equal sales of that currency. When the sales
exceed purchases, it is a situation of overselling and the same is covered by purchases of that currency.
A typical dealer in Forex may be a bank having the controlling and supervisory authority and the head office.
Actual dealings in forex would take place through authorized branches. At these branches, there are dealing
rooms and back office operations. Dealing room would perform the following functions normally:
Quoting, negotiating and fixing rates of exchange for larger sized customer transactions involving
purchase or sale of foreign currencies.
Arranging cover against purchase and sale of foreign currencies.
Trading on own account, i.e. purchase/sale of foreign currencies for profit.
Mobilisation of required foreign currency funds by swapping arrangements or purchases from other
dealers.
Accepting customer forward contracts for purchase/sale of foreign currency and arranging cover against
the same.
The back office operations would comprise of the following:
Consolidation of all exchange deals and provide cover operations
Analysis of the structure of the deals for determining the future rates.
Processing of inter-bank deals, sending or receiving contract notes or confirmation of deals.
Follow-up work on contracts
Transfer of funds to correspondents and their branches.
RELATIONSHIP BETWEEN TREASURY MANAGEMENT AND FINANCIAL MANAGEMENT

Finance function is a key element in the corporate activity. Its main objective is to keep the firm in good financial
health. To secure financial health, the finance manager has to perform the following functions:
Investment functions and decisions
Financing function and decisions
Investment function elates to the efficient use of funds in alternate activities. The aim is to allocate funds to each
activity so as to obtain optimal returns from such allocation. The short-term and long-term investment strategy
has to be planned in line with the objective of maximization of wealth of shareholders. The utilization of funds, as
and when they accrue, should take care of two prime considerations. The first consideration is that there should
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not be any idle funds and second consideration is that there should be no threat of liquidity crisis. Idle funds
have their own cost and it results in lowering of profitability. Extreme tightness of funds, on the other hand, raises
the specter of default and loss of commercial reputation. So a delicate balance between these two conflicting
objectives has to be maintained by the finance manager. It is in this context that the function of finance becomes
crucial to the survival and growth of a firm.
The financing function refers to the securing of right resources of funds at an appropriate cost and at the right
time. Here the decision is to be taken about the least cost combination of funds for capital requirements and for
working capital needs. Whether owners equity should be used for financing or should the firm resort to external
financing? If owners equity is to be arranged, what returns are to be assured? If borrowing has to be done, then
what rate of interest is to be paid?
In line with the twin objectives of investment and financing, the finance manager has to take responsibility for all
decisions pertaining to these areas. In the finance function, a macro view of the requirements and uses of funds
is to be taken. The finance manager has to arrange the funds within the approved capital structure of the firm.
The funds may be debt or equity. Once the funds have been arranged, it is left to the treasury function to utilize
these funds according to the approved parameters. Financial management is also concerned with the overall
solvency and profitability of the firm. By overall solvency, we mean that the funds should be able at all times to
meet its liabilities. The liabilities can be short-term or long-term. The long-term liabilities pertain to payment of
long-term borrowings. Internal liabilities like payment to shareholders are a matter of consideration once external
solvency has been attained by the firm. Profitability means that the firm should run its affairs profitably. It may be
possible that some segments of the firm may at times face strain upon their profitability due to macro-economic
or internal causes. But the firm should be in a position to earn reasonable return on its investment on the capital
employed. Capital employed, as we know, is the sum of own funds and borrowed funds. Profitability of operations
of the firm means that both the own funds and borrowed funds generate adequate surpluses for the firm. This
can be ensured by investing the funds in such projects which provide optimal returns.
The treasury function is concerned with management of funds at the micro level. It means that once the funds
have been arranged and investments identified, handling of the funds generated from the activities of the firm
should be monitored with a view to carry out the operations smoothly. Since funds or cash is the lubricant of all
business activity, availability of funds on day to day basis is to be ensured by the treasury manager. The role of
treasury management is to manage funds in an efficient manner, so that the operations in the area of finance are
facilitated in relation to the business profile of the firm. The treasury function is thus supplemental and complemental
to the finance function. As a supplemental function, it reinforces the activities of the finance function by taking
care of the finer points while the latter delineates the broad contours. As a complementary function, the treasury
manager takes care of even those areas which the finance function does not touch. Looked at from this point of
view, the treasury function integrates better with manufacturing and marketing functions than the finance function.
This is because the treasury department of a firm is involved in more frequent interaction with other departments.
For the purpose of performing this role, the treasury manager operates in various financial markets including the
inter-corporate market, money market, G-sec market, forex market etc.
DIFFERENCE BETWEEN FINANCIAL MANAGEMENT AND TREASURY MANAGEMENT

Following differences can be observed between financial management and treasury management:
1. Control Aspects
The objective of financial management is to establish, coordinate and administer as an integral part of the
management, an adequate plan for control of operations. Such a plan should provide for capital investment
programs, profit budgets, sales forecasts, expenses budgets and cost standards.
The objective of treasury management is to execute the plan of finance function. Execution of the plan takes
care of the issues arising in routine operations of the firm which have a bearing upon the funds position.
Lesson 11
Thus the finance function of a firm would fix the limit for investment in short term instruments for a firm for
example. It is the treasury function that would decide which particular instruments are to be invested in within the
overall limit having regard to safety, liquidity and profitability. Again, the finance function would arrange the
borrowed funds for the firm but the treasury function would take care of day-to-day monitoring of the funds.
2. Reporting Aspects
Financial management is concerned with the preparation of overall financial reports of the firm such as Profit
and Loss account and the Balance Sheet. It also takes care of the taxation aspects and external audit. Based
upon the performance of the firm, budgets for the ensuing years are fixed. The reports are submitted to the top
management of the firm.
Treasury management is concerned with monitoring the income and expense budgets on a periodic basis vis-vis the budgets. The budgets are fixed department/ segment wise so as to dovetail with the overall corporate
budgets. Variances from the budgets are analysed by the treasury department on a continual basis for taking
corrective measures. The corrective measures that can be taken are pointing out of discrepancies to departmental
heads and refuse payments that are not according to approved procedures and guidelines. The treasury
department is also involved in the internal audit of the firm.
3. Strategic Aspects
The finance function is involved in formulating overall financial strategy for the firm. The top management chooses
the line of activity for the firm. The finance function firms up the investment and financing plans for the activity.
The strategic choices before the financial manager are the options of investment and financing. While making
these choices, the finance manager is taking a long-term view of the state of affairs. It is just possible that the
business of a firm may not be profitable in the initial years but it does not mean that the choice regarding
investing has been strategically incorrect. In fact, there are many mega projects where the gestation period is
even upto seven years. But given the correctness of the original assumptions, performance of the finance
function would be measured by the number of years that gets reduced in breaking even.
Strategy for treasury management is more short-term in nature. The treasury manager has to decide about the
tools of accounting and development of systems for generation of controlling reports. The maintenance of
proper systems of accounting is one of the objectives of treasury management. Another strategic objective for
treasury management would be maintenance of short-term liquidity. This is done through regulation of payments
and speedy realization of receivables.
4. Nature of assets
The finance manager is concerned with creation of fixed assets for the firm. Fixed assets are those assets which
yield benefit to the firm over a longer period of time. It can be said that the time span of a project coincides with
the span of the fixed assets. In case the fixed assets have depreciated physically by a significant measure, then
a decision has to be taken for upgradation and replacement of the assets.
The treasury manager is concerned with the net current assets of the firm. Net current assets are the difference
between the current assets and current liabilities of the firm, both normally realizable within a period of one year.
Current assets should always be more than the current liabilities for ensuring liquidity of the firm. Current assets
are the inventory, receivables and cash balances. Current liabilities are the trade creditors, statutory payables
and loan repayables within one year. To ensure a healthy level of net current assets, the treasury manager is to
ensure that the quality of the assets does not deteriorate.
As regards investments, the finance manager is concerned with long-term and strategic investments. These
investments could be funded from borrowed funds or from internal accruals. The investments are expected to
be held over a longer period of time as such day-to-day monitoring of the investments is not required. The
treasury manager is concerned with short-term investments. The tenor and quality of these investments has to
be constantly monitored by the treasury manager for ensuring safety and profitability.
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TREASURY ORGANIZATION: PICKING THE RIGHT MODEL

Organisations have extended debates on the kind of treasury they should have. The common themes include
services that the treasury should offer, the right size or structure, and the right spread of management control
There are many dimensions to the structure of a treasury organisation. Two key dimensions range of services
and extent of centralisation of management control define resultant organisation models. The relationship
between organisation models and factors that influence decisions on the right model to adopt.
There are various definitions of the word treasury. In its strictest sense, it refers to one function: asset liability
management, especially when used in the context of banks. In a wider sense, treasury includes a whole range
of activities encompassing various markets. A few significant activities are:
Asset liability management:
Maturity mismatch;
Interest rate and type mismatch; and
Currency mismatch.
Sales and trading:
Currency, interest rate, and credit products;
Money market and long-tenure instruments; and
Derivative products.
Risk management
Back office processing, settlement, and accounting; and
Customer and regulatory reporting.
Organisation Models: Dimensions

Any organisation can exercise its choice on the scope of the treasury functions it undertakes. In doing this, it
may be governed by a variety of considerations:
It may choose to handle only those needs driven by utilitarian motives such as liquidity support or, on
the other hand, it may consider treasury as a core organisational process and hence handle the full
range of services.
It may choose to outsource portions of the activities required or it may choose to foster these capabilities
in-house.
Independently, an organisation can also decide on the extent of centralisation of treasury management:
It may be efficient to centralise back office processing, while the front office may need to be decentralized
to aid speedy local decision-making.
It may be important to have a common risk management strategy, while execution may be decentralised.
A study of common practices relating to the two key influencers the range of activities supported and the
degree of centralization or decentralisation at treasury organisations globally suggests four models.
1. Full Service Global

Full service refers to a treasury that undertakes most, if not all, of the activities of treasury management. Global
treasury refers to one that either operates as the only treasury for all markets across the globe, or ultimately
combines all regional or local treasuries (that may exist due to legal or regulatory reasons) into a central treasury
Lesson 11
for pooling risks, for policies or strategies, or for both these. In this sense, management of the treasury function
in this model is very much centralised. Although this model readily lends itself to global organisations, it could
also be used by local businesses that need to access global markets.
2. Full Service Local

In this model, each treasury is a self-contained local unit dictated purely by the needs of the local business.
Thus, the treasury management function is, by and large, decentralised. While this sort of treasury is usually the
norm for a business with a local or regional spread, it may be adopted for a global organisation that operates as
a collection of highly independent business units. Again, the range of services offered is the full gamut, as
described in the full service global model above.
3. Limited Service Global

This model is different from the full service global model in that the range of services offered is limited. This could
largely be due to the fact that certain activities are kept outside the purview of treasury and are handled directly
by business units because the scale of these activities is not large enough to warrant the attention of the central
treasury. Examples are treasuries with limited or no foreign exchange trading activities, with the exposure being
either managed directly by the concerned export or import department or not managed at all. For those activities
that are included in the treasury in such a model, pooling is at a central level.
4. Limited Service Local

This model is akin to having virtually little or no treasury activities, beyond local cash and liquidity management.
These are very small decentralised treasuries where the concerned managers may also have other responsibilities
in the finance department.
ROLE AND RESPONSIBILITIES OF TREASURY MANAGER

The overall finance function starts with capital structuring, scouting for the least cost combination of internal and
external capital for financing of the project and forecasting the sources and uses of funds. In this function, one
has to coordinate with production and marketing functions and all others that constitute the management team.
The inflows and the outflows and their coordination and synchronization and meeting any gaps are the functions
of the finance manager. The treasury manager has a larger role of coordinating the apparently routine, yet
significant activities of the firm. The activities are apparently routine because a sense of repetition is involved in
these activities. Nevertheless, the activities are significant because smooth functioning of these activities paves
the way for eventual solvency and profitability of the firm. The role and responsibilities of the treasury manager
may be described as follows:
Role of a treasury manager

A treasury manager has a significant part to play in the overall functioning of the firm. At any point of time he is
engaged in a number of roles played. While the production manager or the marketing manager may be involved
in limited roles pertaining to their own fields, the roles of treasury manager intermingle with and overlap other
role sets. In any business entity which is engaged in marketing, a treasury manager could be performing a
variety of roles. The expected roles to be carried out by him would be slightly less in number in case the firm is
engaged in service activity but that does not deride the importance of treasury manager for a services organization.
The treasury manager has the following roles:
(a) Originating roles
The treasury manager inducts and originates system of accounting for the firm. Routine accounting of the firm is
then carried out along these established systems. These systems are the pivot around which the functioning of
the unit revolves. For operations of these systems, the treasury manager compiles exhaustive operations manual
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for the guidance of the users. It is expected that all the users shall comply with all important disclosure requirements
for endorsing the integrity and validity of the systems.
(b) Supportive Roles
The second role expected from a treasury manager is a supportive role. In this role, the treasury manager
supports the activities of other departments like manufacturing, marketing and HRD. The support is evidenced
through a meaningful and constructive coordination with the other departments. While doing this, the treasury
manager is acting as an extended arm of the finance manager. Allocation for expenses for every department is
made by the finance manager in the annual budget. It is the duty of treasury manager to ensure that each
department is able to spend the earmarked amount subject to completion of disclosure and documentation
formalities.
(c) Leadership Roles
The treasury manager also has a leadership role to play. This role comes into play during times of exigency. An
exigency could occur during times of systems break-down. During such periods, the treasury manager has to
make alternative arrangements for transaction processing. While doing this, he has to act like a leader and carry
the team along with him. Another example of exigency could be a situation when the firm is face to face with a
sudden and unexpected liquidity crunch. During such an eventuality, the treasury manager has to use his
ingenuity and leadership skills for tiding over the crunch. These skills could take the shape of postponing and
prioritizing payments and expediting recoveries.
(d) Watchdog Roles
The treasury department is the eyes and ears of the management. Every financial transaction passes through
his accounting system. As a processor of all the financial transactions, he keeps a watch on suspected bunglings
and frauds in the firm. He sets an example for other departments of the firm by adhering to sound accounting
practices and transparent dealings.
(e) Learning Roles
The accounting practices all over the world are in a state of constant flux due to evolution of new accounting
concepts and technological changes. The treasury manager accepts these changes with an open mind and
adopts the changes best suited to the organization. Simultaneously, he educates the other departments of the
firm also about the changes.
(f) Informative Roles
The treasury manager is the source of information for the top management regarding performance of the firm
vis--vis the budgets. For conveying this information, he develops a management information system suited for
the organization. This system provides concise and timely information on all the relevant parameters which
enable the top management to take decisions.
Apart from the above roles, the treasury manager has the under-mentioned responsibilities which he is expected
to shoulder along with his roles:
1. Compliance with statutory guidelines
While establishing operational systems for the firm, the treasury manager has a duty to ensure that the systems
comply with all statutory and regulatory guidelines. Particularly, he has to take care of provision regarding
taxation and other government dues. He must ensure that the system should be simple and not cumbersome.
The system should be transparent and it should protect the integrity of the transactions. Moreover, it should be
impersonal and capable of being operated on the basis of pre-established guidelines. It should be flexible also
to incorporate any subsequent changes in accounting and taxation norms.
Lesson 11
2. Equal treatment to all departments

While playing the supportive role, the treasury manager has a responsibility of professionalism and impartiality.
In accepting the demands for expenditure from various departments, the treasury manager has to ensure that
the role is carried out without any undue favour or bias. He has to keep the interest of the organization in mind
and not to promote intra-organisation conflicts. The support that he provides must be detached and objective.
3. Ability to network
While playing the leadership role in case of systems break-down or during periods of cash crunch, the treasury
manager should be able to exhibit traits of public relationship and networking. A crisis situation requires level
headedness and ability to think straight. What it also requires is the ability to provide comfort to all users of the
system. This can be done by exercising PR skills of a high order. Apart from this, the treasury manager should have
networking abilities for outsourcing some of the accounting work to outside agencies during the period of interruption.
4. Integrity and impartial dealings
Since the treasury manager is the watchdog of the management regarding honest and straight dealings, he has
to be impartial in his dealings. He must highlight the true state of affairs of the finances to the management. In
case of any inadvertent shortcoming on the part of his department, the same should be admitted and the whole
matter should be looked at in an impartial manner.
5. Willingness to learn and to teach
The treasury manager is required to keep himself of all the developments in the field. He should be able to pick
out the latest developments that are likely to help his organization. He must accept new ideas in an open minded
state rather than treating new ideas as a threat to his fiefdom. Simultaneously, he should be willing to teach and
inculcate the latest developments among his colleagues.
TOOLS OF TREASURY MANAGEMENT

Treasury manager is required to work in a fast changing and competitive environment. For carrying out his
activities, he has resort to certain tools and techniques. Most of the tools originate from the finance department
and as such can not be considered to be an exclusive prerogative of the treasury department. Yet it is the
treasury manager which is using these tools most extensively. The tools are being described below:
1. Analytic and planning tools

In treasury function, planning and budgeting are essential to achieve targets and to keep effective control on
costs. Analysis of the data and information is necessary for planning and budgeting. Performance budgeting is
referred to as setting of physical targets for each line of activity. The financial outlay or expenditure needed for
each is earmarked to choose the least cost mode of activity to achieve the targets. Productivity and efficiency
improves by decentralization of responsibility and that is achieved by performance budgeting, where each
department or section is made a profit center and is accountable for its targets, financial involvement and profits
in financial terms, relative to the targets in physical terms.
This type of planning involving performance budgeting is best suited for service industry say a financial services
company or bank where every department can function in a decentralized manner and achieve the targets.
2. Zero Based Budgeting (ZBB)

Another tool of analysis and performance is ZBB wherein each manager establishes objectives for his function
and gain agreement on them with top management. Then alternate ways for achieving these targets are defined
and most practical way for achieving the targets is selected. This alternative is then broken into incremental
levels of effort required to achieve the objective. For each incremental level of activity, costs and benefits are
assessed. The alternative with the least cost is then selected.
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3. Financial Statement Analysis

Financial analysis of a company is necessary to help the treasury manager to decide whether to invest in the
company. Such analysis also helps the company in internal controls. The soundness and intrinsic worth of a
company is known only by such analysis. The market price of a share depends, among other things on the
sound fundamentals of the company, the financial and operational efficiency and the profitability of that company.
These factors can be known by a study of financial statements of the company.
4. Internal Treasury Control

All economic units have the goal of profit maximization or wealth maximization. This objective is achieved by
short-term and long-term planning for funds. The plans are incorporated in the budget in the form of activities
and corresponding targets are fixed accordingly. The next step in the process is the control function to see that
the budgets are being implemented as per plans. Control is thus part of planning and budgeting in any organization.
Control is a process of constant monitoring to ensure that the activities are being carried out as per plans. It is
also noticed whether there is any divergence from the plans, what are the reasons for the divergence and what
remedial action can be suggested.
Internal treasury control is a process of self improvement. It is concerned with all flows of funds, cash and credit
and all financial aspects of operations. From time to time and on regular basis, the internal treasury control is
exercised on financial targets. The financial aspects of operations include procuring of inputs, paying creditors,
making arrangement for finance against inventory and receivables. The gaps between inflows and outflows are
met by planned recourse to low cost mix of financing.
The control aims at operational efficiency and removal of wastages and inefficiencies and promotion of cost
effectiveness in the firm. The control is exercised under phases of planning and budgeting. These phases
include setting up of targets, laying down financial standards, evaluation of performance as per these norms and
reporting in a standard format.
The quarterly and annual budgets would set the targets for each department and financial standards are set out
for each activity. Monthly budgets are evaluated by the performance sheets maintained daily and regular reports
go to the financial controller. Reporting and evaluation go together and on the basis of information system built
in the past, plans are prepared for the next period.
Following principles of internal control need to be mentioned here:
1. Control should be at all levels of management and participation should be from all cadres of personnel.
More important are specific levels of operations. The top management should concern itself with strategic
controls. The middle management is more concerned with segmental controls whereas the lower
management concerns itself with operational controls.
2. The management control can be decentralized or decentralized. In a decentralized form of control,
responsibility is given to lower managers to achieve the targets. A margin of deviation from the targets is
allowed but the basic objective of control is to see that activities are in the direction of the plan and the
budgetary targets are a guide.
3. For effective control, there has to be a system of building up of effective communication from top to
bottom and bottom to the top.
4. The control should be built upon the management information system. This function involves the collection
of data from all departments on their operations, analysis of operations and suggesting the methods of
improving the efficiency and productivity.
Lesson 11
ENVIRONMENT FOR TREASURY MANAGEMENT

Treasury management is carried out in the real corporate world and the corporate functioning is carried out in
the overall corporate environment. Environment for treasury operations can broadly be classified as under:
(a) Legal environment
By legal environment we refer to the legislations which govern corporate functioning. These legislations are the
one pertaining to company law, taxation, industrial regulation etc.
(b) Regulatory environment
The regulatory environment encompasses regulations regarding employment, wages, land laws, promotion of
units and closure of units etc.
(c) Financial environment
Financial environment pertains to policies regarding monetary and fiscal control, financial supervision, exchange
control etc.
ROLE OF INFORMATION TECHNOLOGY IN TREASURY MANAGEMENT

With the ever increasing pace of change to regulation, compliance and technology in the financial sector, treasury
has increasingly become a strategic business partner across all areas of the business, adding value to the
operating divisions of the company: for example, working with the sales department to establish good financial
contract terms so that any trade discounts offered and the payment method agreed are beneficial to the business.
The major role the information technology is playing in effective treasury management is as follows:
1. Automate repetitive tasks

Technology today is being leveraged to automate repetitive tasks such as data gathering, accounting, bank
polling, portfolio tracking and reporting. By automating these processes, the delays and the possibility of human
error may be minimized. Automation also facilitate information sharing across departments, offices and
geographies, and provide an accurate audit trail. Furthermore, automating these processes enable to focus on
more value added tasks, critical to providing effective decision support to management team.
2. Implement internal controls

To ensure compliance with rule and regulations, sound and effective internal controls must be implemented. The
focus should not only on system-related controls, but also on clear cut segregation of duties. In treasury
workstation, sophisticated rules must be implemented to ensure policy compliance. The solution that has obtained
a Internal audit and other compliance activities must be implemented.
3. Time saver and fraud & error detection Methodology

This best practice is a great time saver, especially when its time to close the books. On the first day of the accounting
close, there is a need to balance that days transactions, not the entire months. In treasury management system, the
source of cash transactions is the previous days bank data. Through the treasury management system, all repetitive
transactions are automatically tagged with the correct instructions. Most companies using a treasury management
system get 90-95% of their transactions automatically tagged accurately without any manual intervention.
4. Forecast cash flows

Effective forecasting helps manage financial risk by enabling to predict a cash shortfall or liquidity crisis, taking
into account interest rate changes and foreign exchange fluctuations. Forecasting also helps to enhance financial
returns, enabling to make more effective decisions regarding investments and borrowing needs. Finally, forecasting
helps maintain financial control by identifying unexpected occurrences for further review and action.
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5. Communicate with operating units

Operating units must be involved while building your forecasts to ensure incorporation of all the necessary and
up-to-date information. The past may not be indicative of the present so its important to have the latest and
updated information. There must be benchmarking resulted at the operating unit level, and the cash forecasting
results must be published. Its important to keep a two-way flow of information by providing feedback to the
operating units based on how the actuals compare to the forecasts. The treasury forecast performance matters
must be compared to forecasts generated by other groups and/ or divisions. Significant variances may be
indicators that treasury is not yet aware of all the information that should be included in the forecast.
6. Choose a Web-based treasury management system

The full benefits of technology without unnecessary costs or delays may be achieved by selecting a web-based
treasury management system. Web-based solutions significantly reduce implementation costs and timeframes,
and enable to access the system from anywhere at any time. Furthermore, any enhancements to the system are
automatically deployed to all users, thus eliminating the need to spend internal resources on hardware or software
acquisition, testing or downloads. To ensure the security of your information, select a system with two factor
authentication and encryption technology must be selected.
7. Rethink treasury processes

There should be reassessing of the treasury workstation at transparent intervals to evaluate processes and
identify how they can/should be revised to maximize efficiencies. While reevaluating treasury management
system, the focus should not only be on data, but on experience and knowledge.
8. Pay for performance

To reinforce the importance of forecasting, portfolio management, cash consolidation, and other value added
activities across treasury department, benchmarks should be defined. The proper and effective use of information
technology in treasury operation increases the efficiency and effectiveness of corporate officers across the
treasury, investor relations, corporate finance and corporate communication function.
LIQUIDITY MANAGEMENT VIS-A-VIS TREASURY MANAGEMENT

Liquidity management ensures that the right amount of cash is available, at the right time and in the right
place, is firmly positioned as a pivotal task for every treasurer. Over the past few years, many treasurers have
made substantial progress towards increasing the visibility of their cash flow and centralising cash within
countries or regions. However, industry surveys indicate year on year that liquidity management and particularly
cash flow forecasting remain the greatest challenges facing treasurers. With credit more expensive and elusive
for many companies, it is now imperative to tackle these challenges effectively. Working capital management
of a financial institution or bank or company is some how different to that of other trading units, the process
starts with tapping of funds at lower rate in shape of deposits/borrowing and ends with investing the same in
higher rate to earn profit out of business with a margin of small portion of cash-in-hand kept to meet day to day
operation.
Efficient account and cash pooling structures are key to efficient and cost-effective liquidity management. Every
investment has a cost to the company even the shares tapped from the share holders. Deposits are tapped in
exchange of payment of interest. Borrowing has cost of payment of interest to creditors. So every fund has
dividend/interest payment risks for the banks/company. So if funds tapped are not properly utilized, the banks/
company should suffer loss. Idle cash balance in hand has no yield. On the other hand if we do not keep
balanced liquid cash-in-hand, we may not be able to pay the demand withdrawal of depositors, as well as,
installment of creditors and untimely payment for other contingent liabilities. These will lead overtrading position
to the company. So there must be a scientific liquidity management policy for the company/bank/financial institution.
Lesson 11
Proper liquidity management can increase the turnover of business and also creates additional profit to the
company/banks. Liquidity management has great significance in modern days to the company/bankers/financial
institution, because they engage not only in retail business, but also deal in wholesale banking and investment
banking business.
Overliquidity on the other hand implies excess idle cash balance in hand. So every company should avoid both
the position and should manage the company without less/excess funds in hand i.e. just liquid position.
REGULATION & SUPERVISION OF TREASURY OPERATION

The Treasury Operations Department is responsible for treasury's middle and back office functions, all systems
services, and particularly cash management and banking relations services. Treasury operations cross-functional
staffs provide pricing and valuation, performance measurement, transaction and securities processing and
compliance support functions. The middle office provides quantitative analytics support and operational risk
reporting and coordinates treasury's control risk assessments related to internal corporate governance and risk
management functions.
Treasury Operations implements and manages information systems in support of treasury's asset management,
funding, pension investment, and cash operations functions.
The role of Treasury Manager, is to manage, mitigate and monitor financial risks arising due to differences in
currency basis and timing of pledges from donors, disbursements and debt service. The risk management tools
that are used include, among others, currency swaps and currency forwards, interest rate swaps and forward
rate agreements .Treasury Manager enters into a master derivatives agreement and hedges risk positions
using its counterparties in the market.
Risk management generally incorporates:
a prudent approach to balance sheet management, with the aim of mitigating and controlling financial
risks;
suitable risk limits and policies and procedures formulated to ensure that the limits are not breached;
and
appropriate systems, controls and reporting mechanisms for measuring and monitoring residual risks.
In this context, the role of treasury manager typically includes:
(a) Policy Analysis: develop the risk management framework, taking into account Boards risk preferences,
balance sheet dynamics and market limitations, as well as credit, interest rate, operational and foreign
currency risks, and the different instruments available for risk transfer.
(b) Strategy Design: advise on optimal risk transfer through a broad-based suit of risks to be hedged out
and the instruments available, based on modeling and evaluation of risk management options.
(c) Structuring, Negotiating and Executing transactions: The treasury manager is responsible to
efficiently remove interest rate and foreign currency exposure based on board-approved risk management
strategy; tactical decision-making on overall execution strategy and timing for transacting on the different
currencies to accommodate to market and liquidity limitations; benchmark counterpart market quotes
based on in-house models to negotiate prices and ensure best execution.
TREASURY CONTROL MECHANISM

Treasury management relates to most of the highly volatile instruments market dealing. The volume of transactions
involved in the dealings are usually heavy and risk in operation are also heavy. So any unorganisation operation
will create heavy loss for the institution. Generally control system may be related to :
372 PP-FT&FM
(a) Internal control of different, dealing rooms, settlement offices and control offices.
(b) Checking of unhealthy insider trading system.
(c) Mutual and ammicable solution of different conflicts of interest in dealing operation.
Internal Control System: It relates to forming policies to check leakage of profit for the institution. In treasury
operation, the role of Central Offices are vital. They should form suitable guidelines for the institution in respect
of various treasury dealing operations. There are advice dealing offices to bifract all treasury items into different
classes according to risk involvement. As treasury business is a risky business responsible positioned persons
should be delegated powers to deal in treasury operation with imposition of different limits on their discretionary
power.
Some important area should be taken (i) fixation of rates for each treasury items and (ii) fixing limits for dealers
to deal with different counterparties, with proper observation of confidentiality and adherance to best market
practice. Treasury executive should be ensured that the transactions were carried in correct manner by cross
checking during each dealing day.
For above facts the central offices should develop proper policies and guidelines for treasury operation and
should advice the dealers to deal according to policies of the following :
(i) restriction on deal in ones own account.
(ii) timely advice to dealing offices in respect of any adverse transactions received or excess reporting.
(iii) timely submission of returns to different statutory authorities.
(iv) review of security and contingency arrangement of different offices.
(v) proper verification of compliance given by lower offices for irregularities.
Insider Dealings
Insiders are those who are in management including near and dear; and their dealings means-taking advantages
of unpublished internal informations of the corporate body. These may create price sensex situation. So these
unadvantages dealings should properly efficient internal control system should be taken by the management to
eliminate insider dealing by fixing penalties for insider dealers.
TREASURY OPERATIONS IN BANKING

All banks/financial institution (core principals and brokers) should ensure that they should try to serve for giving
best service in the market operation within code of conduct issued for time to time. Core principals should be
conducted non-investment business with private individuals should segregate them into retail or wholesale for
smooth function of business within sound guidelines. It is essential that all staff should be familiar to code of
conducts, in professional manner while entering into dealing transactions. Banks/financial institution will be
responsible for dealing actions of the staff members. So it should be segregated work for the staff members
such as no staff member control the full operation. Banks/financial institution should identify any potential or
actual conflict of interest that might arise when undertaking wholesale market transactions; and take measures
either to eliminate these practices and provide fair treatment to counter parties. Banks/financial institution should
know their counter party and their credit worthiness before entering into contract. It is good practice for principals,
subject to their own legal advice, to alert counter party to any legal or tax uncertainty which they know are
relevant to a proposed relationship or transaction. All principals have the responsibility to assessing the credit
worthiness of their counter parties, or potential counter parties whether dealing directly or through a brokers/
firms. Bank/financial institution should take measure of risk control and meet proper legal obligation for each
contract to minimize the loss. It is better to prepare a dealing mandate for each transaction. The mandate will be
helpful to clarify the extent of a relationship between core principals and their customers with responsibility.
Lesson 11
Banks/financial institutions should observe confidentiality. It is essential for the preservation of reputable and
efficient market place for bank/financial institution. The transactions should not be dealt in non-market rates. So
this practice should be avoided. Adequate safeguards should be established to prevent abuse of informations
by staff members with respect to non-public price-sensitive informations.
PRESENT STATUS OF TREASURY MANAGEMENT IN INDIA

Treasury management is still in its infancy in India. It is still considered as a sub-function of the financial
management. In most of the companies, it is the finance manager which is also taking care of the treasury
function. Treasury operations are carried out professionally and systematically by some banks and financial
institutions. The first stage of evolution in treasury management is the establishment of a treasury function. The
second stage is running it as a profit center. In India, treasury operations at the micro level are expected to grow
at a fast pace with increasing integration of the Indian economy with the world economy.
Treasury management is the science of managing treasury operations of a firm. Treasury in its literal sense
refers to treasure or valuables of the Government. The valuables are nothing but the coins and the currency
which are the medium of financial transactions in the country. In the earlier days when the level of governmental
operations was comparatively smaller, there used to be a centralized treasury into which the revenue receipts of
the government were credited and from which the payments of the government were withdrawn. In a federal setup, both the central govt. and the state govts. had their treasuries for managing the inflows and outflows of
government finances.
As the size and spread of government revenues grew, it became difficult to manage the flows of cash into a
centralized treasury. The function of collecting revenues on behalf of the government was gradually shifted to
State Bank of India and other nationalised banks. These banks also started making payments on behalf of the
state governments through cash counters and through bank accounts of various government departments.
Simultaneously with the increase in size of government revenues, the corporate sector in India also grew manifold
in operations. There were companies with multi-locational set-up involving receipt and disbursement of cash
and cash equivalents at more than one places. In all such companies, the function of treasury management
developed analogous to the transfer of government treasury functions to Banks. Along with this growth evolved
the concept of profitable treasury management. Hitherto, the treasury management as practiced by the government
was a passive concept. The over-riding motive was to provide a platform for transactions and little effort was
made to evaluate the costs and expenses associated with managing large amount of currency, cheques and
other liquid instruments. Similarly, the opportunity available for making profits from holding large liquid funds
was not recognized. But with the arrival of corporate treasuries, the function of treasury management was
established as a profitable venture.
Today when we speak of treasury management, we refer to all activities involving the management of revenues,
inflows and outflows of government, banks and corporates etc. It is a general concept applicable to overall fund
management.
Government as the sovereign power is the fountainhead of all treasury operations. It creates money by printing
currency and minting coins. This money flows into various channels which take money to various users of
currency and coinage as a medium of exchange. Thus at the macro level, the treasury operations revolve
around Reserve Bank of India. RBI as a banker to the govt. creates the currency on behalf of the govt. and
manages public debt. It is also a banker to the banks and in this role, it controls the credit creation of banks.
At the micro level the concept of treasury and its management is mirrored in small corporate units which manage
the cash flows on a daily basis. As we move from the macro level to the micro level, the nomenclature of treasury
management becomes diffused. The terms treasury management and fund management are used almost
synonymously. Conceptually, the latter is a general term, applicable to the business sector, while treasury
management refers to the management of cash, currency and credit of sovereign power of the country. The
term currency here includes both national currency and the foreign currencies dealt with by the government.
374 PP-FT&FM
Historically, the treasury of a sovereign included gold, silver and other precious metals which were used as a
medium of exchange. As a ruler, the sovereign exercised un-challanged rights over all the precious metals
extracted from the earth. The booties earned from wars, foreign exploits and domestic plundering kept on
adding to the treasure chest of the sovereign. These metals were circulated in the form of coins which became
a medium of all commercial transactions in due course, replacing the earlier system of barter. The practice
continued till the nineteenth century when paper currency began to be issued.
Reserve Bank of India manages the macro treasury management of the country. This is done through
Issue of Currency notes
Distribution of small coins, one, two and five rupee coins and rupee notes on behalf of the government
Maintenance of currency chests.
The currency is issued by the Reserve Bank of India in terms of the Indian Currency Act whereas the small coins
and rupee coins are issued under the provisions of the Indian Coinage Act. The provision of adequate supply of
currency and coins is the responsibility of the government which was at first discharged by providing currency
chests at the branches of Issue Department of RBI and at branches of Imperial Bank of India (which later
became State Bank of India). SBI carried out the business of Government treasury and maintained the currency
chests at all district headquarters. Later on all the nationalized banks were also entrusted with the task of
maintenance of currency chests.
The basic objective of keeping the currency chests at various places in India is to facilitate quick disbursement
of currency and coins to far flung places and also to facilitate remittance to banks. This way, the banks can remit
surplus cash to the currency chests located in their region and avoid transportation of cash over long distances.
Also, the banks can draw from the currency chests during time of need. Currency chests are the agents of the
Reserve Bank of India for keeping custody of currency and coins. Any deposit of currency and coins into these
chests implies that the money circulation has been curtailed to that extent. Similarly, any disbursal from these
chests would expand their supply. Thus expansion and contraction of currency takes place on continual basis
due to operation of the currency chest.
Government as a sovereign power has control on cash and currency circulated in the country. The issue of
currency and coins is based on the treasures of the government in the form of gold and silver stocks which
are supposed to back such issue. More recently, government securities and their promissory notes became
the basis of such issue. In fact, the coins of gold and silver were first replaced by the paper currency on the
one hand and coins of base metals like copper, nickel, bronze, zinc etc., on the other. To supplement the
available currency and to facilitate trade and business, credit instruments came into vogue in the form of
promissory notes to pay at a future date by the trade and industry. Thus on the one hand, the government
promissory notes became the basis for coins and currency rather than precious metals like gold and silver;
and on the other hand, the promissory notes of trade and industry became the source of credit instruments.
These credit instruments, particularly the safest among them such as government securities, in fact became
the medium of parking of liquid funds over a period of time. Thus apart from handling cash and currency and
bank funds, the liquid investment in government securities and mutual funds became another function of
treasury management.
Treasury function is a part of the total managerial functions. Managerial function set-up can be classified into
three broad units, viz. production function, marketing function and finance function. Production function pertains
to the building up of capacities and generation of output. Marketing function is concerned with the marketing
of the output through establishment of the sales and marketing network. In the finance function, the manager
is concerned with financing of inputs and outputs and management of funds during the entire production
cycle.
Availability of cash, currency and credit by the government, business and foreign sectors is a must for macro
Lesson 11
operations of the economy. In broader terms, all financial resources including forex are to be made available to
the micro-economic units, i.e. the companies. Similarly, the operations at the national level involve return flow of
funds, repayment of loans, taxes, fees etc. to the government, business and foreign sector.
The finance function comes into play when the company is incorporated. With capital restructuring, efforts are
made for arriving at least cost combinations of capital for financing of a project and forecasting for working
capital. In this function, one has to coordinate with the production and operations manager, sales or marketing
manager and they together constitute the marketing team. Apart from arranging the requisite funds for
commencing an activity, the finance function is also concerned with managing the day-to-day finances of the
company. Whereas arranging project funds and working capital finance is a one-time assignment, management
of funds on daily basis is a much more astute activity requiring forecasting skills and prioritization ability of a
high order.
The inflows and outflows of funds, their coordination and synchronization and making arrangements for meeting
any gap between them is only one end of the spectrum of finance function. The other end of the spectrum is the
management of the surpluses and maximization of returns from short term funds. These two ends of the spectrum
form the core of activities of the finance function. But the handling of each of the activities requires further
specialization. Arranging of long-term funds is the domain of the proper finance function but the management of
funds required in and arising from the day-to-day activities of the firm is the domain of the treasury function.
These two have to be viewed together and analysed for overall assessment of financial efficiency. So a finance
manager need not have a treasury function or a treasury manager need not be bothered with long term
arrangement of funds. The finance manager can be termed as an arranger of funds whereas the treasury
manager can be viewed as a manager of funds.
Treasury management has both macro and micro aspects. At the macro level, the inflows and outflows of cash,
credit and other financial instruments are the functions of the government and the business sectors. These
inflows are arranged by them as borrowing from the public. In these sectors, the ratio of savings to investments
is less than one, i.e. the savings are inadequate to fund the investments. Hence the need for borrowing. They
accordingly issue securities or promissory notes which are part of the financial system. These borrowings for
financial needs are met by surplus savings and funds of the household and the foreign sector, where the ratio of
savings to investments is positive. The micro units utilize these inflows and build up their capacities for production
of output. This leads to establishment of a production system which logically leads us to the natural consequence,
i.e. the establishment of distribution and consumption systems. Once the production, distribution and consumption
systems are in place at the micro level, the generation of surpluses at the units begins. These surpluses are
channeled back into the macro system as outflows from the micro system. The inflows are the taxes paid to the
government and repayment of loans made to the banks and financial institutions. These inflows into the macro
level have to be managed by the treasury managers at the macro level.
While arranging funds for the micro unit, the finance manger aims at optimizing the value of his assets or wealth
and minimizing the burden of his liabilities. He may seek to maximise his operational profits and seek to maximise
the wealth of stakeholders of the micro unit. The basic objectives are economy, efficiency and productivity of
assets. These objectives can not be achieved at the one end of the finance spectrum unless the management
of funds at the other end of the spectrum, i.e. the treasury segment is equally triggered by the dictums of
economy, efficiency and productivity.
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LESSON ROUND-UP
Treasury management is the science of managing treasury operations of a firm. Treasury in its literal
sense refers to treasure or valuables of the Government.
Macro level: It is the inflows and outflows of cash, credit and other financial instruments are the functions
of the government and the business sectors. These inflows are arranged by them as borrowing from
the public. In these sectors, the ratio of savings to investments is less than one, i.e. the savings are
inadequate to fund the investments.
At micro level, the finance manger aims at optimizing the value of his assets or wealth and minimizing
the burden of his liabilities. He may seek to maximise his operational profits and seek to maximise the
wealth of stakeholders of the micro unit.
The availability of funds in right quantity, Availability in right time, Deployment in right quantity,
Deployment in right time and Profiting from availability and deployment are the main objective of the
Treasury Management.
At unit level, treasury managers activities encompass all other management functions.
Treasury manager monitors the cash flows of the unit on a continual basis. It is ensured by him that
adequate funds are made available for day-to-day working of the unit. In case there is genuine shortfall
in cash flows, the outflows are made in an order of priority with the more urgent payments being made.
At domestic level or national level treasury management function is to channelise the savings of the
community into profitable investment avenues.
At the international level, the function of treasury management is concerned with management of
funds in the foreign currencies
Analytic and planning tools, Zero Based Budgeting and Financial Statement Analysis are the various
Tools of treasury management.
Internal treasury control is a process of self improvement which is concerned with all flows of funds,
cash and credit and all financial aspects of operations.
Environment for treasury management can be broadly classified as Legal environment, Regulatory
environment and Financial environment
SELF-TEST QUESTIONS
1. What do you understand by treasury management? What are its main objectives?
2. What is the significant of treasury management for the top management of a company?
3. Distinguish between treasury management and financial management.
4. Describe the various tools of treasury management.
5. Bring out the importance of control in the treasury function.
Lesson 11
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Lesson 12
Lesson 12
Forex Management
LESSON OUTLINE
Forex Management 379
LEARNING OBJECTIVES
Nature, Significance and Scope of Forex

Management,
Forex management may be defined as the

science of management of generation, use and
storage of foreign currencies in the process of
exchange of one currency into other called
foreign exchange.
Foreign Exchange Market and its

Structure,
Foreign Exchange Rates and its
Determination,
Knowledge of the forex management can help

avoid harmful effects of international events and
perhaps even profit from these events. With the
advent of globalization and liberalization the
scope for international trade and international
financing has increased tremendously.
International trade has grown more quickly than
trade in general. This has necessitated the study
of Forex management by the finance
executives.
Exchange Rate Quotes;

Types of Exchange Rates;
Forex Trading; Currency Futures and
Options
Foreign Exchange Risk Exposures and
their Management
The study will enable the students to

understand:
Concept of Forex Management
Risk in Foreign Exchange Business
Scope and significance of Forex

Management
LESSON ROUND UP
Role of Forex Manager
SELF TEST QUESTION
Foreign Exchange Market

Determinants of Foreign Exchange Rates
Exchange Rate Quotes Direct or Indirect
Quotations.
Risks in Foreign Exchange Markets
Currency Exposure Management
Managing Foreign Exchange Rate Risk
Mechanics of Forex Trading
Capital Account Convertibility
Foreign Exchange Market in India
379
380 PP-FT&FM
INTRODUCTION
FOREX, an acronym for Foreign Exchange, is the largest financial market in the world. Every firm and individual
operating in international environment is concerned with foreign exchange i.e. the exchange of foreign currency
into domestic currency and vice-a-versa. Generally, the firms foreign operations earn income denominated in
some foreign currency; however, the shareholders expect payment in domestic currency and therefore, the firm
must convert the foreign currency into domestic currency. So, what is foreign exchange?
Exchange rate is the price of one countrys money in terms of other countrys money. When we say that exchange
rate of Indian rupee is 52.40 per US Dollar, we mean than 52.40 Indian Rupees are required to purchase one US
Dollar. When this exchange rate becomes 52.90 we say that the value of Indian Rupee has depreciated against
the US Dollar. On the other hand when the exchange rate becomes 52.10 we say that Indian Rupee has
appreciated against the US dollar. Assuming that there are no exogenous factors restricting the changes in
exchange rates, their movement can be traced to pure demand and supply. When Indian rupee depreciates
against the US Dollar, it indicates that demand for latter is more than its supply. Similarly when the supply of US
dollar is more than its demand, it declines in value against the Indian Rupee.
Currency of a country is used for transactions with foreigners. Each country in the world has its own currency.
Theoretically, a country should transact with all foreign entities on a one-to-one basis, i.e. for all imports from a
foreign country, a host country should pay in the currency of the former and for all exports, the host country
should be paid in its currency. But practically this is not possible because it involves keeping record of a multitude
of exchange rates and associated payment problems. Therefore, most of the countries choose a common
currency for trade amongst themselves. The U.S. dollar has emerged as the strongest international currency for
the past sixty years and as such is used as the payment medium for most of the world trade. In the European
Union the Euro has established itself as the common currency of about 25 countries.
It is clear that the currency of a country is evaluated against a common currency for external transactions. In
case of countries having dominant economic power, trade would be held in their currency. Hence a country is
required to trade in U.S. dollar or in other dominant currencies like Euro, Pound or the Japanese Yen. Account
of a countrys external trade is kept in the form of a Balance of payment account which is a double book entry
system. Receipts of foreign currencies are credited to this account while payments in foreign currency are
debited to this account. The balance in this account shows a positive or a negative figure depending upon
whether the receipts of foreign currency are more or less than the payments.
Other things being equal, the presumption is that a country having a deficit balance of payments position would
have a weakening national currency and vice versa. A deficit in the balance of payment account results in more
demand for foreign currencies. Hence their value vis--vis the domestic currency increases.
NATURE OF FOREX MANAGEMENT

Forex management may be defined as the science of management of generation, use and storage of foreign
currencies in the process of exchange of one currency into other called foreign exchange.
The above definition of forex management has the following essential elements:
(a) It is part of management science

Forex management is part of the broader management science. It is a scientific discipline requiring scientific
and analytic orientation. The techniques of management are applied to the broad spectrum of foreign currencies.
This broad spectrum refers to all the currencies of the world excluding the domestic currency. These techniques
include planning for forex, organization of forex and control of forex. We use the terms forex and foreign exchange
interchangeably. The planning part includes budgeting for forex, organization refers to utilization of forex and
control part focuses on creation of forex reserves.
Lesson 12
The tools of forex management are akin to domestic currency management but the level of analytical skills
required for it is slightly higher because of the existence of spot, forwards and futures markets unlike the domestic
currency area. Operations in the forex market require quicker response time because of the greater volatility in
exchange rates.
(b) It refers to generation of forex

Forex is generated from international trade transactions. When a country exports goods or services, it earns
forex. When goods or services are imported by a country, forex is consumed. If the exports of a country are more
than the imports, the forex would be accumulated in reserves of the country. If the imports are more than the
exports, the result would be a forex deficit which has to be met by international borrowings. Either way, the forex
needs to be generated. Generation of forex is a more difficult proposition because of variation in international
trade practices and extent of competition.
(c) It pertains to use of forex

Forex management is concerned with use of forex in meeting the requirements of the user group. The tools of
cash management come handy in using forex. The process of use of forex involves identification of suppliers of
goods and services, negotiation of terms and conditions of the transaction and culmination of transaction with
the exchange of goods and services with forex. Because of relative uncertainty about availability of forex and
volatility in its rates, advance tie-up of forex is made through forward purchase contracts. In this entire process,
close track of exchange rates needs to be maintained.
(d) It covers storage of forex

Forex management involving firm level forex storage could be done through forward purchase contracts or
through deposits in foreign currency bank accounts. At the national level, forex storage is done through forex
reserves which are held in the form of Gold, Special Drawing Right (SDRs) of IMF and foreign currencies. While
some amount of foreign exchange reserves need to be maintained to meet unforeseen contingencies, excessive
accretion to reserves involve a cost which is sometimes justified on other economic consideration at the firms
level. Forex is stored for meeting future import liabilities, whether certain or contingent. While storing forex, it is
important to bear in mind the actual cost of storage and the opportunity cost of not using the forex elsewhere.
Depending upon availability of forex, if the opportunity cost is more than the cost of storage, then it is better not
to store it.
SCOPE OF FOREX MANAGEMENT

Forex management has quite a wide scope of operation. We can cover in its ambit all those transactions which
involve use of forex. Let us consider the following illustrations:
A citizen of India travels abroad on a business visit and purchases foreign currency from an authorized
dealer.
An Indian citizen goes to USA for a period of three years under an employment contract. He periodically
remits US Dollars to his bank account in India.
An Indian student subscribes to a British scientific magazine and pays for it through an international
credit card held by him.
An Indian industrialist imports raw material from Malaysia for his plant under a Letter of Credit arrangement
provided by his bank.
A sports goods manufacturer of India exports his consignment to Europe and gets paid for it in foreign
currency received through banking channels.
382 PP-FT&FM
Indian subsidiary of a Multinational corporation imports white goods in completely knocked down (CKD)
from the Chinese affiliate. After reassembling these goods, the same are exported to Europe.
The World Bank disburses aid to an Indian State under an infrastructure development project.
The above illustrations show how individuals, companies and states transact in forex. When goods or services
are imported into a country, these are paid for in the currency of the country exporting these goods or services.
When an Indian traveler goes to a foreign country on a short visit, he needs foreign currency of that country for
meeting his expenses. When he stays in that country for a longer duration for employment purpose, he earns
foreign currency of that country. When an Indian firm exports goods to Europe, it is earning foreign exchange.
Thus when goods and services are sent abroad by India, foreign currencies are earned by them.
Forex management being involved in all the trade and non-trade transactions involving forex, it is essential to
have a broad idea of international banking and trading practices. Since the transactions are taking place among
counter parties from different countries, a standardized format of documentation is used to minimise errors.
Apart from the transaction value, forex management finds scope as a mode of investment. Because of the
frequent and often miniscule fluctuations in forex values, enough arbitrage and speculative opportunities crop
up in the forex market for astute investors. There are many expert forex dealers specializing in trading of forex.
SIGNIFICANCE OF FOREX MANAGEMENT

Business operations in countries across the globe have been in existence for centuries, but an unprecedented
growth in world wide production and distribution of a large number of capital, intermediate and consumer goods
has been witnessed in the past fifty years. At present most of the countries are economically related to each
other through a complex network of trade, foreign investment and international loans.
The emergence of WTO and the process of global integration has reinforced the importance of International
trade, cross border financial flows and consequently foreign currency transactions. Each country has its own
currency and each currency has different value in relation to a globally accepted standard. The significance of
forex management lies in the study and maintenance of the exchange levels.
Every good or service reaching us from abroad involves forex. Knowledge of the forex management can help
avoid harmful effects of international events and perhaps even profit from these events. With the advent of
globalization and liberalization the scope for international trade and international financing has increased
tremendously. International trade has grown more quickly than trade in general. This has put up both benefits
and challenges.
The principal benefit for international trade has been in the form of the gain in standard of living it has permitted.
The gain has come from exploiting relative efficiencies of production in different countries. The challenges of
international trade are the introduction of exchange rate risk and country risk. Various methods and markets
have evolved that allow firms to avoid or reduce these risks.
The after effect of development of international trade has been swift movement of funds from one finance centre
to the other. There has been investment by multinationals in the third world countries in the form of capital
outlays. All this has necessitated the need for a better understanding of the mechanism of forex flows.
Forex management has become a more important subject because of an increased globalization of financial
markets. The benefits of the increased flow of capital between nations include a better international allocation of
capital and greater opportunities to diversify risk. However, globalisation of investment has meant new risks
from exchange rates, political actions and increased interdependence of financial conditions in different countries.
FOREX MANAGER AND HIS SKILLS

The developments in international trade have resulted in the emergence of a new brand of manager called the
Lesson 12
forex manager. The forex manager is a category apart from the finance manager or the treasury manager. He
deals in currency and money but not of one country. He has to transact with a number of counter parts both in
the domestic country and abroad. He is face to face with special kind of risk. Yet his vocation is full of opportunities
and challenges.
For effective management of forex transactions, the forex manager is expected to have the following skills:
(a) Awareness of historical development of world trade
The forex manager must have a fair idea of as to how the world trade has reached its present status. The shifting
power alliances, emergence and decline of economic superpowers, present political situations, trade patterns
etc. should be known. This knowledge base enables the manager to view the current situation in proper
perspective.
(b) Ability to forecast future trends
The forex manager must be in a position to derive an accurate forecast of the future trends in international trade
flows and exchange rate patterns. This forecast helps the manager to prepare his forex budget.
(c) Comparative Analysis skills
The forex manager should be able to carry out a comparative analysis of costs of domestic and imported raw
materials, price of local sales and export sales, shipping rates, insurance costs etc. in order to determine whether
it is expedient to produce locally or to outsource
(d) In-depth knowledge of forex market
The forex manager is expected to have in-depth knowledge of functioning of foreign exchange markets, their
rules and regulations, the size of their operation, the profile of active currencies, strength and weakness of the
domestic currency etc. in order to achieve better pricing of deals.
(e) Knowledge of interest rates
Since interest rates have a direct bearing upon exchange values, awareness about domestic and international
interest rates enables the forex manager to form an accurate opinion about the forward premia.
(f) Willingness to undertake risk
Armed with the knowledge and awareness about international financial and trade patterns, currency positions
and interest rates, the forex manager should have the ability to undertake reasonable level of risks with a view
to profit from forex exposures.
(g) Hedging strategies
The forex manager should be in a position to hedge his positions to the best extent possible. To achieve this, a
sense of timing is essential in the background of ever changing world of exchange values.
FOREIGN EXCHANGE MARKET AND ITS STRUCTURE

The foreign exchange transaction (i.e., for the sale and purchase of foreign currencies) takes place in foreign
exchange market, which provides a mechanism for transfer of purchasing power from one currency to another.
This market is not a physical entity like the Mumbai stock exchange or a trading center; rather it is network of
telephones among banks, foreign exchange dealers and brokers etc. The market is an over the counter market.
The dealers sit in their dealing room of major commercial banks around the world and communicate with each
other through telephones, computer terminals and Society for Worldwide Inter bank Financial Telecommunication
(SWIFT) mechanism. This is a non-profit Belgian cooperative with main and regional centers around the world
connected by data transmission lines. Depending on the location, a bank can access a regional processor or a
main center which then transmits the information to the appropriate location.
384 PP-FT&FM
The forex market is a wholesale market called the inter-bank market. Commercial banks are the market makers.
Corporations use the foreign exchange market for a variety of purposes relating to their operation like payment
for imports, conversion of export receipts, hedging of receivables and payables, payment of interest on foreign
currency loans, placement of surplus funds etc.
Forex market operates at three levels. At the first level are the currency dealers or money changers who provide
for encashment of travelers cheques and release of small amount of forex to travelers. The money changers
quote the buying and selling rates for various currencies. An illustration of the quote is given below.
Far larger than the money changer market is the spot foreign exchange market which is at the second level. This
market is involved with the exchange of currencies held in different currency denominated bank accounts. The
spot exchange rate, which is determined in the spot market, is the number of units of one currency per unit of
another currency, where both currencies are in the form of bank deposits. The deposits are transferred from
sellers to buyers accounts. Delivery or Value or actual transfer is spot or immediate. Usually it takes one
or two days. This distinguishes the spot market from the forward market. Spot exchange rates are determined
by the demand supply equations of the currencies being exchanged.
The inter-bank foreign exchange market is the largest financial market in the world. The phenomenal size of this
market can be put in perspective by noting, for example, that foreign exchange turnover exceeds that of all the
worlds stock markets combined. Indeed it takes over 2 months average trading on the New York Stock Exchange
to match 1 day of trading in forex.
The forex market is an informal arrangement of the larger commercial banks and a number of foreign exchange
brokers. The banks and brokers are linked by telephone, telex, computers and a satellite communications
network called the Society for Worldwide International Financial Telecommunications (SWIFT). Because of
speed of communications, significant events have virtually instantaneous impacts everywhere in the world.
The efficiency of the spot forex market is revealed in the extremely narrow spreads between buying and selling
prices. These spreads can be smaller than a tenth of a percent of the value of currency exchanged.
ORGANISATION OF FOREIGN EXCHANGE MARKET IN INDIA

The statutory basis for administration of foreign exchange in India is the foreign Exchange Management Act,
1999. The Central Government has been empowered under Section 46 of the Act to make rules to carry out the
provisions of the Act. Similarly, Section 47 empowers the Reserve Bank to make regulations to carry out the
provisions of the Act and the rules made thereunder. Further, Section 41 provides that the Central Government
may from time to time, give to the Reserve Bank such general or special directions as it thinks fit, and the
Reserve Bank shall comply with such directions. Thus, ultimately the Reserve Bank has been charged with the
powers as well as the responsibility to administer foreign exchange in India.
The Forex market in India is regulated by Reserve Bank of India. Participants in this market are the Authorised
Money Changers and the Authorised Dealers.
While the Reserve Bank has the authority to administer foreign exchange in India, it is recognized that it cannot
do so by itself. Foreign exchange is received required by a large number of exporters and importers in the
country spread over a vast geographical area. It would be impossible for the Reserve Bank to deal with them
individually. Therefore provision has been made in the Act (Section 10), enabling the Reserve Bank to authorize
any person to be known as authorized person to deal in foreign exchange or in foreign securities, as an authorized
dealer, money change or off-shore banking unit or in any other manner as it deems fit.
Lesson 12
FOREIGN EXCHANGE MANAGEMENT ACT
CENTRAL GOVERNMENT
RESERVE BANK OF INDIA

AUTHORIZED PERSONS
FOREIGN
EXCHANGE
DEALERS ASSN OF INDIA
AUTHORIZED MONEY
CHANGERS
AUTHORIZED
DEALERS
RESTRICTED
FULL FLEDGED
Foreign Exchange Market in India
PARTICIPANT IN FOREX MARKET

Authorised Money Changers
In order to provide facilities for encashment of foreign currency to visitors from abroad, especially foreign tourists,
Reserve Bank has granted licences to certain established firms, hotels and other organisations permitting them
to deal in foreign currency notes, coins and travellers cheques subject to directions issued to them from time to
time. These firms and organisations who are generally known as authorised money changers fall into two
categories, viz. Full-fledged money changers who are authorised to undertake both purchase and sale
transactions with the public and Restricted money changers who are authorised only to purchase foreign
currency notes, coins and travellers cheques, subject to the condition that all such collections are surrendered
by them in turn to an authorised dealer in foreign exchange/full fledged money changer.
Authorised Dealers in Foreign Exchange

A major portion of actual dealing in foreign exchange from the customs (importers, exporters and others receiving
or making personal remittances) is dealt with by such of the banks in India which have been authorized by the
Reserve Bank to deal in foreign exchange. Such of the banks and select financial institutions who have been
authorized to deal in foreign exchange by the Reserve Bank are known as authorized dealers. An authorized
dealer should comply with the directions and instructions of the Reserve Bank given from time to time. With the
coming into effect of the FEMA, the Reserve Bank has issued a series of regulations under the Act.
Foreign Exchange Dealers Association of India

FEDAI was established in 1985 as an association of al authorized dealers in India. All authorized dealers,
386 PP-FT&FM
currently numbering over 70, are its members. It has its headquarters at Mumbai and local offices at Bangalore,
Calcutta, Chennai and New Delhi. The affairs of FEDAI are managed by a Managing Committee at the Head
Office and respective Local Committees at local offices. The Committees are represented equally by banks
incorporated in India and outside India. The principal functions of FEDAI are:
(a) To frame rules for the conduct of foreign exchange business in India. These rules cover various aspects
like hours of business, charges for foreign exchange transactions, quotation of rates to customers,
interbank dealings, etc. All authorized dealers have given undertakings to the Reserve Bank to abide by
these rules. Provisions of FEDAI rules have been considered at appropriate places in the relevant
chapters of this book.
(b) To coordinate with Reserve Bank of India in proper administration of exchange control.
(c) To circulate information likely to be of interest to its members. (Information of international trade received
from organizations like the International Chamber of Commerce is passed to the members. It also acts
as a clearing house for exchange of information among members.)
Thus, FEDAI provides a vital link in the administrative set-up of foreign exchange in India. It is the mouthpiece of
the authorized dealers, representing their views to the Reserve Bank and other international agencies.
Why Participate in the Foreign Exchange Market

Due to its vast volume and large number of participants, no individual or single company has complete control
over which way the market will sway. Historically, Forex has been dominated by commercial banks, money
portfolio managers, money brokers, large corporations, and very few private traders.
Lately this trend has changed. While there are many reasons for participating in foreign exchange including
facilitating commercial transactions, corporations converting its profits, or hedging against future price drops,
more and more people are getting involved in the market for the purposes of speculation.
(a) Exporting and Importing Companies: Large multinational corporations influence the foreign exchange
market as they purchase and sell goods and materials between different countries. Importing companies
affect the demand of a currency as well. For example, an American retailer features Japanese furnishings
and pays its suppliers in Japanese yen. If consumers like these products then they will indirectly contribute
to an increase in demand for the yen as the American retailer will have to buy more merchandise from
Japan. As the retailer purchases the yen and sells the dollar on the exchange market, the yen appreciates.
(b) Foreign Investment Flows: Foreign investment has many aspects, having to do with goods, services,
stocks, bonds, or property. Suppose a Canadian company wants to open a factory in America. In order
to cover the costs of the land, labour and capital the firm will need dollars. Suppose the company holds
most of its reserves in Canadian dollars. It must sell some of its Canadian dollars to buy US dollars.
The supply of Canadian dollars on the foreign exchange market will increase and the supply of US
dollars will decrease, which causes the US dollar to appreciate against the Canadian dollar. On the flip
side, foreign investors are also increasing or decreasing the demand for the currency of the country in
which they are interested in investing.
(c) Banks: For a long time the foreign exchange market has been associated with the term interbank
market. This term was employed to capture the nature of the foreign exchange market when it
predominantly dealt with banks. Banks include central bank, investment banks and commercial banks.
(d) Speculators - Investment Management Firms, Hedge funds, and Retail Traders: Many financial
institutions use currency exchange as a method to generate income. There are also many individuals
who try to do the same thing. The currency markets move in one direction only when many investors act
together. An individual investor cannot move the exchange rate of a currency but many traders, investment
funds, and banks may collectively move it.
Lesson 12
If speculating traders think the Japanese Yen is going to weaken in the near future due to poor economic data or
a change in interest rate policy, then they sell the yen on the foreign exchange market relative to another stronger
currency. The supply of yen will increase and cause the currency to depreciate. If many investors feel that a
particular currency will depreciate in the near future, their collective selling of that currency will move its price down.
Similarly, if speculators feel that a currency is going to appreciate in the near future then they will buy that currency
today and cause it to experience a higher demand which causes its price to go up. Investors help materialize their
predictions by acting in a herd mentality, and in some peoples eyes bring about a self fulfilling prophecy.
Different Currencies and their symbols
Country
Currency
Symbol
Australia
Dollar
A$
Canada
Dollar
Can $
Denmark
Krone
Dkr
EMU
Euro
Finland
Markka
FM
India
Rupee
Iran
Rial
RI
Japan
Yen
Kuwait
Dinar
KD
Mexico
Peso
Ps
Norway
Krone
NKr
Saudi Arabia
Riyal
SR
Singapore
Dollar
S$
South Africa
Rand
Sweden
Krona
Skr
Switzerland
Franc
SFr or CHF
United Kingdom
Pound
United States
Dollar
MECHANICS OF FOREX TRADING

Forex trading concerned with various forex operations including purchase and sale of currencies of different
countries in order to meet payments and receipts requirements as a result of foreign trade. Forex trading is done
either in retail market or in whole sale market (also called inter bank market). Under retail market, the traveler
and tourists exchange one currency for another in form of currency notes or traveler cheques. Here, the total
turnover and average transaction size are very small. The spread between buying and selling price is large.
Whereas wholesale market or inter bank market is a market with huge turnover. The major market participants
of this market include commercial banks, corporation and central banks.
Suppose bank A wishes to buy the British pound sterling against the US dollar. A trader in bank A might call his
counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to do the deal and
both will enter the details the amount bought/sold, the price, the identity of the counter party etc. in their
388 PP-FT&FM
respective banks computerized records systems and go on to the next transaction. Subsequently, written
confirmations will be sent containing all the details. On the day of settlement, bank A will turn over a US dollar
deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is
agreed upon and entered in the record systems. This enables them to do deals very rapidly. At the international
level inter-bank settlement is effected through the Clearing House Inter Bank Payment System (CHIPS), located
at New York.
When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader gives a twoway quote i.e. he quotes two prices: a price at which he will buy a sterling in exchange for dollars and a price at
which he will sell a sterling for dollars. In a normal two-way market, a trader expects to be hit on both sides of
his quote in roughly equal amounts. That is, in the pound-dollar case above, on a normal business day the
trader expects to buy and sell roughly equal amount of pounds (and of course dollars). The Banks margin would
then be the bid-ask spread.
But suppose during the course of trading a trader finds that he is being hit on one side of his quote much more
often than the other side. In our pound-dollar example this means that he is either buying many more pounds
vice versa. This leads to the trader building up a position. If he has sold (bought) more
pounds than he had bought (sold) he is said to have net short position (long position) in pounds. Given the
volatility of exchange rates, maintaining a short or long position for too long can be a risky proposition. For
instance, suppose that a trader has built up a net short position in pounds of 1,00,000. The pound suddenly
appreciates from say $1.7500 to $1.7520. This implies that the banks liability increases by $2000 ($0.0020 per
pound for 1 million pounds). Of course, a pound depreciation would have resulted in a gain. Similarly, a net long
position leads to a loss if it has to be covered at a lower price and a gain if at a higher price. (By covering a
position we mean undertaking transactions that will reduce the net position to zero. A trader net long in pounds
must sell pounds to cover; a net short must buy pounds).
t
The potential gain or loss from a position depends upon the size of the position and the variability of exchange
rates. Building and carrying such net positions for long durations would be equivalent to speculation and banks
exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of
net positions a trader can building up during a trading day and how much can be carried overnight.
How Trading Works

So how does the actual trading work? A complete transaction is the buying of one currency and selling of
another at the same time. In this chapter, we will be focus on spot transactions only and other forms of Forex
transaction (i.e. futures, options) are not covered. The technical definition for a spot contract is a transaction at
the current market rate with a settlement that takes place within two business days. However, in a practical
sense, when trading Forex, a position is opened at the current rate and can then be closed any time afterwards,
at that next moments rate. Positions that are not closed within the two business days are automatically rolled
over, meaning the Forex dealer with which the position is open will keep automatically renewing your spot
contract for you until it is closed.
Any trading has two aspects (i) purchase, and (ii) sale. A trader has to purchase goods from his suppliers
which he sells to his customers. Likewise, the bank (which is authorized to deal in foreign exchange) purchase
as well as sells its commodity the foreign currency. Two points need be constantly kept in mind while talking of
a foreign exchange transaction:
(i) The transaction is always talked of from the banks point of view; and
(ii) The item referred to is the foreign currency.
Therefore, when we say a purchase, we imply that
(i) the bank has purchased; and
Lesson 12
(ii) it has purchased foreign currency.

Similarly, when we say a sale, we imply that
(i) the banks has sold; and
(ii) it has sold foreign currency.
In a purchase transaction the bank acquires foreign currency and parts with home currency.
In a sale transaction the bank parts with foreign currency and acquires home currency.
This is further illustrated with the help of an illustration.
Problem : Determine which of the following transactions constitute (i) purchase, and (ii) sale of foreign exchange:
(a) The bank issues a demand draft on London for GBP100.
(b) the customer of the bank purchases a telegraphic transfer on New York for 500.
(c) A traveler encashes at the bank a traveler cheque for GBP 50.
(d) The bank purchases a demand draft drawn on London for GBP 500.
Solution: (a) and (b) sales; (c) and (d) purchases.
More Trading Terminology

(a) PIP : A change in price of one point in Forex trading is referred to as a pip, and it is equivalent to the
final number in a currency pairs price. For pairs that involve the Yen (like in our USD/JPY example), a
pip is counted from the second decimal place, 120.94. For all pairs that dont involve the Japanese Yen
a pip is the fourth decimal place, 1.3279. For the EUR/USD pair that rate would mean that it takes
1.3279 Dollars to get 1 Euro.
(b) Going Long or Short: A long position is a situation in which one purchases a currency pair at a certain
price and hopes to sell it later at a higher price. This is also referred to as the notion of buy low, sell high
in various trading markets. In Forex, when one currency in a pair is rising in value, the other currency is
declining, and vice versa. If a trader thinks a currency pair will fall he will sell it and hope to buy it back
later at a lower price. This is considered a short position, which is the opposite of a long position.
On every exchange, a trader has a long position on one currency of the pair and a short position on the
other currency. A trader defines his or her position as an expression of the first currency of the traded pair.
The first currency in a pair is known as the base currency. The second currency in the pair is called the
counter currency. When a trader buys the base currency he or she takes a long position on a pair, if a
trader sells the base currency he or she shorts the pair. Lets look at a Forex chart and visualize this idea.
(c) Spot Exchange Rates: A spot exchange rate is a rate at which currencies are being traded for delivery
on the same day. For example, an Indian Importer may need U.S. $ to pay for the shipment that has just
arrived. He will have to purchase the $ in the market to make payment for the import. The rate at which
he will buy the $ in the market is known as the spot exchange rate. He will make the payment in terms
of and gets in turn the U.S. $ which will be paid to the foreign exporter. The spot exchange rate therefore,
for a currency is the current rate at which one currency can be immediately converted into another
currency. For example, a spot rate of $ 0.99/Euro indicates that one Euro can be converted into $0.99 in
the market place at present. In most of the cases, the spot exchange rates are set by the demand and
supply forces in the foreign exchange market.
(d) Forward Exchange Rate: Imagine a New York City firm exports its products to a German company.
The business transaction will be settled in dollars so the American firm obtains revenue in its own
currency and can pay its employees salaries in dollars. If the payment by the German company is
390 PP-FT&FM
coming 6 months later, it introduces the risk that the amount of dollars they would receive for a certain
amount of euros today will not be the same in 6 months time. A company may want to limit, or hedge,
this exchange rate risk by immediately converting their euro into dollars, or by purchasing forward
contracts in the foreign exchange market. A forward contract is a contract to convert euros into dollars at
a future date at a set price.
In this way, the forward rate is a price quotation to deliver the currency in future. The exchange rate is
determined at the time of concluding the contract, but payment and delivery are not required till maturity.
Foreign exchange dealers and banks give the forward rate quotations for delivery in future according to
the requirements of their clients. Generally, the forward quotations are given for delivery in 30 days, 90
days, and 180 days, But, the quotations may be given up to 2 years. Sometimes, forward contracts with
maturities exceeding two years are also arranged by the dealers to meet specific requirements of their
clients. Quotations are normally given for major currencies, but dealers also provide forward quotations
for other currencies on the specific request of their clients.
The forward rate for a currency may be higher or lower than the spot rate. Forward rate may be higher
than the spot rate if the market participants expect the currency to appreciate vis--vis the other currency,
say US dollar. The currency, in such case is called trading at a forward premium. If the forward rate is
lower than the spot rate, the participants expect the currency to depreciate vis--vis the US dollar. The
currency in this case, is said to be trading at forward discount.
(e) Forward premium or discount is generally calculated as percentage per annum. This percentage
helps in making a comparative analysis of the interest rate differential between the two countries whose
currencies are quoted. The forward premium (or discount) is generally calculated by the following formula:
Forward premium (or discount) in percent per annum
(Forward Rate Spot Rate) 12
100
Spot Rate
n
Where n is the number of months till maturity of the forward contract

For example, suppose that the forward rate (60 days) for the Rupee is 49.05/$ whereas the spot rate for
it is 48.20/$ . The forward discount on Indian Rupee will be
49.05 48.20
48.20
6
100
1
= 10.58% (discount)
If, on the other hand, the forward rate for the Rupee is 47.80/$, the forward premium on it will be
47.80 48.20
48.20
6
100
1
= 4.97% (premium)
Relationship between Spot and Forward Rates

A study of the relationship between spot and future rates would help in determining the degree and the extent of
predictability of the former on the basis of the latter.
The collective judgment of the participants in the exchange market influences the appreciation or depreciation in
the future spot price of a currency against other currencies. The forward premium or discount is also affected by
the interest rate differential between two countries, differences in the rates of inflation between them, and the
degree to which inflation rate differential is translated into interest rate differential in the expected time horizon.
Moreover, the relationship between spot and forward rates may be affected by the efficiency of the financial and
Lesson 12
exchange markets in two countries. Controls, restrictions and other interventions which can affect adjustments
in exchange, and interest and inflation rates differential also influences the spot and forward rates.
Theoretically, in the (i) efficient market and (ii) absence of intervention or control in the exchange or financial
markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally,
satisfied if the following three conditions are found:
(i) Interest Rate Parity: According to interest rate parity principle, the forward premium (or discount) on
currency of a country vis--vis the currency of another country will be exactly offset by the interest rate
differential between the countries. The currency of the country with lower interest rate is quoted at a
forward premium and vice-versa.
(ii) Purchasing Power Parity (PPP): According to the PPP Principle, the currency of a country will depreciate
vis--vis the currency of another country on the basis of differential in the rates of inflation between
them. The rate of depreciation in the currency of a country would roughly be equal to the excess inflation
rate in the country over the other country.
(iii) International Fisher Effect: The interest rare differential between two countries, according to the Fisher
effect, will reflect differences in the inflation rates in them. The high interest country will experience
higher inflation rate.
It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical
to the forward rate. Random differences between the two rates may be found.
INTER-RELATIONSHIP OF DIFFERENT VARIABLES IN FOREIGN EXCHANGE TRANSACTIONS

Interest rates, inflation rates, forward margins, exchange rates and expectations across nations are inter-related
as shown in the diagram. The diagram suggests that interest rates vary across countries because of varying
expectations with regard to their rates of inflation. Under perfect competition, funds would move to a country
where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply
equilibrate them. In other words, the difference in interest rates between two countries is equal in equilibrium to
the expected difference in the inflation rates.
The expected difference in inflation rates between two countries equals, in equilibrium, the expected movement
in spot rates. The forward rate for a given period, say 6 months, should equal the spot rate 6 months hence. The
difference between the forward rate and the present spot rate represents the interest element for the period of
the forward rate. In reality, however, the future spot rate would usually be higher or lower than the forward rate.
Differences in
interest rates
(Fisher effect)
Differences in
expected inflation
rates
Interest rate parity
Differences between
forward and spot rates
Therefore equals
(Expectations theory)
Expected changes
in spot rates
392 PP-FT&FM
Exchange rate movements overtime are influenced by various factors not only those mentioned above but also
by market imperfections arising out of official intervention in markets, exchange control restrictions, customs
barriers, etc.
EXCHANGE RATE QUOTATIONS AND ARBITRAGE

Although the term market rate is often used it is not true that all banks will have identical quotes for a given pair
of currencies at a given point of time.
For example if Bank A gives the quote given above:
` /$ : 34.85/34.92
At the same time Bank B quotes
` /$ : 34.75/34.82
Such a situation will give rise to an arbitrage opportunity. Dollars can be bought at ` 34.82 from Bank B and sold
at 34.85 to bank A. Thus giving a net profit of ` 0.33 per dollar without any risk or commitment of capital. This
would lead to a situation where every dealer would like to buy from Bank B and sell to Bank A. However, in an
efficient market this would not be allowed to prevail, if at all it does prevail it will be only for a few moments.
Two Point Arbitrage

If dollars are available in India at ` /$ : 34.60/34.75 and at the same time Rupees are available in U.S.A at $/` :
0.0285/0.0287.
In such a situation a trader can buy $ from India at 34.75 and sell it at U.S.A for 34.84 (1/0.287). Thus making a
net profit of ` 0.09 per dollar. This arbitrage transaction in which the trader buys a currency in one market and
sells it at a higher price in another market is called Two Point Arbitrage.
The bid and risk rate for dollars in terms of ` in U.S.A is computed as follows:
($/` )bid
1/(` /$)ask
($/` )ask
1/(` /$)bid
The ask on the rupee being the bid on the dollar and vice-versa.
Problem :
A bank in Canada displays the following spot quotation.
C$/$ : 1.3690/1.4200
At the same time a bank in New York quotes
$/C$ : 0.7100/0.7234
(a) Is there an arbitrage opportunity?
(b) If the Canadian bank lowers its ask rate to 1.3742, Is there an arbitrage opportunity?
(c) If you buy one million U.S. $ from Canada and sell them in U.S.A after the Canadian lowers its ask rate.
What is the riskless profit you will make?
Solution:
(a) If we buy U.S. dollars from Canada we will pay C$ 1.4200 per U.S. dollar. This can be sold in U.S.A for
1.4085 only there by leaving us with a loss. Hence there is no arbitrage opportunity.
$/C$
0.7100/0.7234
Lesson 12
C$/$
[1/($/C)ask]/[1/($/C$)bid]
[1/0.7234]/[1/0.7100]
1.3824/1.4085
(b) If the Canadian bank lowers its ask rate to 1.3742 we can buy U.S. $ from Canada for C$ 1.3742 and
sell them in U.S.A for C$ 1.4085 per U.S. dollar. Thus making an arbitrage profit of 0.0343 Canadian
dollars on every U.S. dollar.
(c) 10,00,000
1.3732
14,08,500
10,00,000
1.4085
-13,73,200
35,300
Thus if one million U.S. dollars are bought from Canada and sold in America after the Canadian bank lowers its
ask rate, the riskless profit that can be made is C$ 35,300.
Three Point Arbitrage

Three point arbitrage refers to the transactions wherein a trader deals with three currencies, he starts with
currency X, sells it for currency Y, sells currency Y for currency Z, and finally sells currency Z for currency X. After
this process he should have more of Z than he began with.
For three currencies X, Y and Z
The no Arbitrage opportunity condition implies:
(X/Y)bid < (X/Z)ask
(Z/Y)ask
(X/Y)ask > (X/Z)bid
(Z/Y)bid
Problem :
A bank in Wales is currently offering the following quotes:
FFr/
7.9970/7.9990
HK$/
11.9071/11.9091
At the same time a bank in Hong Kong is quoting

FFr/HK$
0.6750/0.6770
Is there an Arbitrage opportunity?

Solution:
One FFr gets [1/(FFr/)ask]
=(1/7.9990)
=0.1250
[1/(FFr/)ask] gets HK$[1/FFr/)ask] [(FFr/)bid]
=(1/7.9990) (11.9071)
=1.4884
And finally the amount of FFr is obtained
FFr{[1/(FFr/)ask][(HK$/)bid(FFr/HK$)bid]}
394 PP-FT&FM
FFr [(1/7.9990) (11.9071) (0.6750)] = FFr 1.0048
There is an arbitrage opportunity.
A riskless profit of FFr 1.0048 per French Franc.
Note: Problems given above are not real life situations, these type of arbitrage opportunities seldom appear in
the market. Even if it does it will only be for a few moments and efficient traders are bound to take advantage of
this situation.
Covered Interest Arbitrage

Investments abroad have to be converted into home currency on maturity. Exchange rate may have changed in
the meanwhile. An investor may make a forward sale of funds to be repatriated on maturity. The process of
investing abroad for higher returns and making a forward sale of the proceeds is known as covered interest
arbitrage. An investment abroad will be undertaken if the return from interest rate differential exceeds the forward
margin (difference between the forward and spot exchange rates). In general terms, the forward rate of the
foreign currency will contain a discount (premium) if its interest rate is higher (lower) than that of the home
currency. Covered interest arbitrages will go on fill the market forces realign the forward margins with the interest
rate differentials.
Problem : If,
Spot rate: ` 42.0010 = $ 1
6 month forward rate: ` 42.8020 = $ 1
Annualised interest rate on:
6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution:
The rule is that if the interest rate differential is greater than the premium or discount, place the money in the
currency that has a higher rate if interest or vice versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12

Spot rate 6
= 42.8020 42.0010* 100 * 12 = 3.8141 %
42.0010 6
Negative interest rate differential> forward premia, therefore, there is a possibility of arbitrage inflow in India.
Suppose, investment = $1000 by taking a loan @ 8% in US. Invest in India at spot rate of ` 42.0010 @ 12 % for
six months and cover the principal + interest in the six month forward rate. Principal= $ 1000 = ` 42001.
Interest on investment for six months = ` 42,001 * 12/ 100* 6/12
= ` 2520.06
Amount at the end of six months = Interest + Principal
= ` 42001+ 2520.06
Lesson 12
= ` 44,521.06
Converting the above in dollars at the forward rate = $ 44,521.06 / 42.8020
= $ 1,040.16
The arbitrageur will have to pay at the end of six months = $1,000+ ($1000* 8/100 *6 /12)
Hence, the arbitrageur gains ($1040.16 -$1040) = $ 0.16 on borrowing $1000 for six months.
Problem : If,
Spot rate: ` 44.0030 = $ 1
6 month forward rate: ` 45.0010 = $ 1
Annualised interest rate on:
6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution:
The rule is that if the interest rate differential is greater than the premium or discount, place the money in the
currency that has a higher rate if interest or vice versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12

Spot rate x 6
= (45.0010 44.0030) * 100 * 12 = 4.5361%

44.30 x 6
Here, Negative interest rate differential< forward premia, therefore, there is a possibility of arbitrage inflow in
US.Suppose, investment = ` 10,000 by taking a loan @ 12% in India. Invest in US at spot rate of ` 44.0030 @
8 % for six months (US $ 227.257) and cover the principal + interest in the six month forward rate.
Amount at the end of six months = Interest + Principal
= ($227.257* 8)/ (100* 6/12)
= $ 236.3473
Sell US $ at 6 month forward to receive 236.3473* 45.0010= ` 10635.865
Return the rupee debt borrowed at 12%. The amount to be refunded is ` 10,600
Profit= ` 10635.865 - 10600= ` 35.865
FOREIGN EXCHANGE RATES

An exchange rate is the price of one countrys money in terms of other countrys money. When we say that
exchange rate of Indian rupee is 48.40 per US Dollar, we mean than 48.40 Indian Rupees are required to
purchase one US Dollar. When this exchange rate becomes 48.90 we say that the value of Indian Rupee has
depreciated against the US Dollar. On the other hand when the exchange rate becomes 48.10 we say that
Indian Rupee has appreciated against the US dollar. Assuming that there are no exogenous factors restricting
the changes in exchange rates, their movement can be traced to pure demand and supply. When Indian rupee
396 PP-FT&FM
depreciates against the US Dollar, it indicates that demand for latter is more than its supply. Similarly when the
supply of US dollar is more than its demand, it declines in value against the Indian Rupee.
Currency of a country is used for transactions with foreigners. Each country in the world has its own currency.
Theoretically, a country should transact with all foreign entities on a one-to-one basis, i.e. for all imports from a
foreign country, a host country should pay in the currency of the former and for all exports, the host country
should be paid in its currency. But practically this is not possible because it involves keeping record of a multitude
of exchange rates and associated payment problems. Therefore, most of the countries chose a common currency
for trade amongst themselves. The U.S. dollar has emerged as the strongest international currency for the past
sixty years and as such is used as the payment medium for most of the world trade. In the European Union the
Euro has established itself as the common currency of about 25 countries.
It is clear that the currency of a country is evaluated against a common currency for external transactions. In
case of countries having dominant economic power, trade would be held in their currency. Hence a country is
required to trade in U.S. dollar or in other dominant currencies like Euro, Pound or the Japanese Yen. Account
of a countrys external trade is kept in the form of a Balance of payment account which is a double book entry
system. Receipts of foreign currencies are credited to this account while payments in foreign currency are
debited to this account. The balance in this account shows a positive or a negative figure depending upon
whether the receipts of foreign currency are more or less than the payments.
Other things being equal, the presumption is that a country having a deficit balance of payments position would
have a weakening national currency and vice versa. A deficit in the balance of payment account results in more
demand for foreign currencies. Hence their value vis--vis the domestic currency increases.
FACTORS AFFECTING FOREIGN EXCHANGE RATES

Foreign Exchange being a commodity likes any other commodities the exchange rates tend to fluctuate from
time to time. There are various factors that cause the fluctuations in the rates of exchange. These factors can be
divided into several following groups. These groups can affect the exchange rates on a short term as well as
long-term basis.
1. Fundamental Factors
The fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned
government. These factors normally affect the long-term exchange rates of any currency. On short-term basis
on many occasions, these factors are found to be rather inactive unless the market attention has turned to
fundaments. However, in the long run exchange rates of all the currencies are linked to fundamental causes.
The fundamental factors are basic economic policies followed by the government in relation to inflation, balance
of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things
remaining constant the currencies of the countries that follow sound economic policies will always be stronger.
Similarly for the countries which are having balance of payments surplus, the exchange rate will always be
favorable. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse.
Continuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned
and the dis-equilibrium created can be remedied through devaluation.
2. Political and Psychological Factors

Political and psychological factors are believed to have an influence on exchange rates. Many currencies have
a tradition of behaving in a particular way for e.g. Swiss franc as a refuge currency. The US Dollar is also
considered a safer haven currency whenever there is a political crisis anywhere in the world.
3. Technical Factors
The various technical factors that affect exchange rates can be mentioned as under:
Lesson 12
(a) Capital Movement: The phenomenon of capital movement affecting the exchange rate has a very
recent origin. Huge surpluses of petroleum exporting countries due to sudden spurt in the oil prices
could not be utilised by these countries for home consumption entirely and needed to be invested
elsewhere productively. Movement of these petro dollars, started affecting the exchange rates of various
currencies. Capital tended to move from lower yielding to higher yielding currencies and as a result the
exchange rates moved.
(b) Relative Inflation Rates: It was generally believed until recently that one prima-facie direction for
exchange rates to move was in the direction adjusted to compensate the relative inflation rates. For
instance, if a currency is already overvalued, i.e., stronger than what is warranted by relative inflation
rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary
to note that exchange rate is a relative price and hence the market weighs all the relevant factors in a
relative term, (in relation to the counterpart countries). The underlying reasoning behind this conviction
was that a relatively high rate of inflation reduces a countrys competitiveness in international markets
and weakens its ability to sell in foreign markets. This will weaken the expected demand for foreign
currency (increase in supply of domestic currency and decrease in supply of foreign currency). But
during 1981-85 period exchange rates of major currencies did not confirm the direction of relative inflation
rates. The rise of the dollar persistently for such a long period discredited this principle.
(c) Exchange rate policy and intervention: Exchange rates are also influenced in no small measure by
expectation of changes in regulation relating to exchange markets and official intervention. Official
intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities
attempt half-heartedly to counter the market sentiments through intervention in the market, ultimately
more steep and sudden exchange rate swings can occur. In the second quarter of 1985 the movement
of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated
exchange market intervention as a measure to bring down the value of the dollar.
(d) Interest rates: An important factor for movements in exchange rates in recent years has been difference
in interest rates; i.e. interest differential between major countries. In this respect the growing integration
of the financial markets of major countries, the revolution in telecommunication facilities, the growth of
specialized asset managing agencies, the deregulation of financial markets by major countries, the
emergence of foreign exchange trading etc. having accelerated the potential for exchange rates volatility.
4. Speculation
Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate
movements. The total foreign exchange turnover worldwide is many a times the actual goods and services
related turnover indicating the grip of speculators over the market. Those speculators anticipate the events even
before the actual data is out and position themselves accordingly to take advantage when the actual data
confirms the anticipations. The initial positioning and final
profit taking make exchange rates volatile. These speculators many a times concentrate only on one factor
affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor
neglecting all other factors that have equal bearing on the exchange rate movement. Under these circumstances
even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor
that the market is concentrating comes out positive the currency strengthens.
5. Others
The turnover of the market is not entirely trade related and hence the funds placed at the disposal of foreign
exchange dealers by various banks, the amounts which the dealers can raise in various ways, banks attitude
towards keeping open position during the course of a day, at the end of the day, on the eve of weekends and
holidays, window dressing operations as at the end of the half year or year, end of the month considerations to
398 PP-FT&FM
cover operations for the returns that the banks have to submit the central monetary authorities etc. all affect
the exchange rate movement of the currencies.
Exchange Rate Quotes:

The rate of exchange for a currency is known from the quotation in the foreign exchange market. The banks
operating at a financial centre, and dealing in foreign exchange, constitute the foreign exchange market. As in
any commodity or stock market, the rates in the foreign exchange market are determined by the interaction of
the forces of demand for and supply of the commodity dealt in, viz., foreign exchange. Since the demand and
supply are affected by a number of factors, both fundamental and transitory, the rates keep on changing frequently,
and violently too.
When asked to give a quote the trader generally quotes two prices.
The trader may give a quotation
` /$ : 34.85/34.92
This is the price of one dollar in terms of rupees.
The number on the left side of the hyphen or slash (34.85) is the traders bid rate i.e., the number of Indian
rupees a trader or the bank is willing to pay to sell an American dollar. The number on the right side of the
hyphen (34.92) is the traders ask rate (also called the offer rate) i.e., the amount of rupees the trader or bank will
require to buy an American dollar.
The difference between the bid and the ask rate is known as the bid-ask spread. In the quote given above the
bid-ask spread is 0.07 (34.92-34.85). This is the market makers compensation for the costs incurred and the
normal profit on capital invested in the dealing function.
The ask-bid spread depends upon the breadth and depth of the market for that currency and the volatility of the
currency. In case, when there is a large volume of transactions and the trading is continuous in any currency, the
spread is small and may range between 0.1% to 0.5%. The spread is much higher for infrequently traded
currencies. This spread compensates the dealer for holding the risky foreign currency and for providing the
service of converting currencies. The bid spread is usually stated as a percentage cost of transacting in the
foreign exchange market and may be computed as follows:
% Spread =
Ask Price Bid Price

100
Ask Price
For example, if the ask price of $/ is $1.6646 and the bid price is $1.6629, then the % spread may be ascertain
as follows :
% Spread =
16646
.
16629
.
100
16646
.
= 0.1%
The two ways in which exchange rates are quoted are:

Direct Quotes : Direct quotes of a country are those that give units of currency of that country per unit of foreign
currency.
In the quotation given above, ` 34.85/$ is a direct for India.
Indirect Quotes : Indirect quotes are the number of units of a foreign currency per unit of home currency. If the
quotation given above is reversed to $/` it will become an indirect quote for India.
So, Indirect Quote =
1
Direct Quote
Lesson 12
There are two major ways of offering exchange rate quotes. These are called the direct quote and indirect
quote.
Cross Rates
If X, Y and Z are three different currencies and quotes are given in terms of:
X/Y
Z/Y
Then the computation of X/Z is given by:
X/Y
Z/Y
Thus attaining
X/Z
Thus the X/Z rate derived from the Y/X and Y/Z is called the Cross rate.
Problem :
Consider the following quotes:
$/SFr
0.7935
C$/SFr
1.0866
Compute the quote for $/C$.

Solution:
Since SFr
Then $0.7935 =
Finally $/C$
$0.7935 and FFr
= C$ 1.0866
C$ 1.0866
= 0.7303
In international transactions, both the direct quote and indirect quote are used. For example, if the direct quote
of Euro in U.S. is Euro/$ = Euro 1.037 and American importer has to pay Euro 1,000 to a German Firm, then how
many $ will be required by the American importer ? In this, case, the quote for $/Euro may be obtained as the
inverse of Euro/$ i.e., 1/1.037 = 0.9643. So, he will require $0.9643 x 1,000 = $964.32 to pay for the German
firm.
In an ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itself is the transaction
cost. Also, unlike the money or capital markets, where different rates of interest are charged to different borrowers
depending on their creditworthiness, in the wholesale foreign exchange market no much distinction is made.
Default risk the possibility that the counter party in a transaction may not deliver on its side of the deal is
handled by prescribing limits on the size of positions a trader can take with different corporate customers.
Determination of Exchange Rates

There is no generally accepted theory or model to determine exchange rates. However, there are certain
approaches which provide a general frame-work for analysis of exchange rates which are discussed below:
(a) Balance of payments: If payments by a country for its imports of goods and services and invisibles are
out of step with its receipts for exports of goods and services and invisible, two possibilities arise. One,
foreign currency payments exceed receipts and there is a deficit. This puts the home currency of the
country under downward pressure against foreign currencies. Two, there is a surplus and there is an
400 PP-FT&FM
upward pressure on the home currency. In the former case, the home currency tends to depreciate, and
in the latter to appreciate, against foreign currencies.
(b) Demand and supply: The demand for a foreign currency to pay for imports, etc. and the supply of a
foreign currency by way of receipts on account of exports, etc. vary at various rates of exchange. The
rate which equilibrates the demand and supply should be the rate of exchange. Imagine a New York
City firm exports its products to a German company. The business transaction will be settled in dollars
so the American firm obtains revenue in its own currency and can pay its employees salaries in dollars.
To facilitate the transaction, the German firm needs to convert some of its capital from euros to dollars
on the foreign exchange market. The supply of euros increases leading to an appreciation of the dollar
and depreciation of the euro. It can also be said that the German firm increases the demand for dollars,
again causing the dollar to appreciate in comparison to the euro. This transaction would have to be for
a very large contract in order for the exchange rate to actually move a pip up or down.
(c) Purchasing power parity: This theory maintains that free international trade equalises prices of tradable
goods in different countries. So, a product will sell for the same price in common currency in all countries.
Different rates of changes in prices i.e. different inflation rates must eventually induce off-setting changes
in exchange rates in order to restore approximate price equality. Mathematically, the rate (or the expected
rate) of change of the exchange rate should equal the rate (or the expected rate) of change of the
inflation rate. Evidence shows that there do exist disparities between changes in observed exchange
rates and those in inflation rates in the short-run. But, the theory should hold in the long-run.
(d) Interest rate: Interest rates are often highly related with inflation rates, and interest rate differentials
between countries may be the result of inflation rate differentials. Therefore, interest rate differentials
are also used as an important determinant of exchange rates.
Interest rates in a country are determined, under free market conditions, by supply of and demand for
money. Funds flow across countries in search of opportunities for higher returns. These flows between
any two countries cause opposite changes in demand of and supply for their respective currencies.
According to the theory of International Fisher Effect, the exchange rate of a currency with higher interest
rate will depreciate to offset the interest rate advantage achieved by foreign investments till an equilibrium
is achieved.
(e) Relative income levels: If income level in a country rises and that in her trading partner remains
unchanged, the demand by the former for the goods of the latter may increase. That is, the former would
need more units of currency of the latter, while their supply remains unchanged. This would put upward
pressure on the exchange rate of the latter. There can be different configurations of the relative income
levels and of corresponding exchange rates.
(f) Market expectations: Like other financial markets, foreign exchange markets react to any news that
may have an effect on exchange rates in future. Expected developments regarding polity, economy etc.
of a country is used to figure out how exchange rates would move. These peeps into the future impinge
on the present as well as the future spot rates.
FOREX TRADING; CURRENCY FUTURES AND OPTIONS

Currency Derivatives Trading
A Currency market is a market in which one Currency is traded for another. The Spot exchange rate refers to the
prevailing exchange rate at which a Currency can be bought or sold for another. The Forward exchange rate
refers to the exchange rate for the future delivery of the underlying Currencies.
A Currency Futures contract, traded on Exchanges, is a standardised version of a Forward contract. The only
Lesson 12
difference between a Forward contract and the Futures contract is that the Forward contract is an over-thecounter (OTC) product. The main advantages of Currency Futures over Forwards are price transparency,
elimination of counter-party credit risk and greater accessibility for all.
The Futures contract is an agreement to buy or sell the underlying Currency, on a specified date in the future,
and at a specified price. The underlying asset for a Currency Futures contract is a Currency. The Exchanges
clearing house acts as a central counter-party for all trades and thus provides a performance guarantee.
Currency Futures can be bought and sold on the Currency Exchanges through members of the Exchange.
MCX-SX, NSE and USE all offer Currency Futures in India. Before trading, the investor/trader/speculator needs
to open a trading account and deposit the stipulated cash and/or collaterals with the trading member. The
average daily turnover in global Forex and related markets is trillions of US Dollars
Participates in the Currency Futures market

Any Indian resident or company, including banks and financial institutions, can participate in the Currency Futures
market. At present, Foreign Institutional Investors (FIIs) and Non-Resident Indians (NRIs) are not permitted to
participate in the Currency Futures market in India. Participants in the Currency Derivatives segment can be
classified in three broad categories:
(A) Hedgers
Foreign Currency markets have been volatile in recent times due to various geo-political uncertainties. In order
to ensure that profits for any business are not depleted due to fluctuations in the Currency exchange rate,
hedging Currency risk can be an excellent tool.
Large corporates, small and medium enterprises (SMEs) and individual businessmen, apart from the general
investing public, are increasingly exposed to the global markets. Hence, protecting against Forex risk is becoming
more significant.
(B) View-based traders
Currency Futures provide view-based traders with an efficient platform to observe the movements of the local
Currency (INR) against other Currencies. These traders can trade based on various technical indicators,
fundamental factors, economic and policy-based news and developments on the global stage.
(C) Arbitragers
Currency Futures provide an opportunity for arbitrage trading by taking advantage of price differences between
similar products and/or markets by choosing a combination of matching deals and capitalising on the imbalance
without any additional market risk.
How do Exchange Traded Currency Futures enable hedging against Currency risk?
On a Currency exchange platform you can buy or sell Currency Futures. If you are an importer, you can buy
Futures to lock in a price for your purchases at a future date. You thus avoid exchange rate risk. If you are an
exporter, you sell Currency Futures on an exchange platform and lock in a sale price at a future date.
How Does Currency Derivatives Trading Work?

Presently, all Futures contracts on Exchanges are settled in cash. There are no physical contracts.
All trades on Currency Exchanges take place on their respective nationwide electronic trading platforms.
These can be accessed from dedicated member terminals at various locations across India.
All participants on the Currency Exchange trading platform can participate only through trading members
of the Exchange.
Participants have to open a trading account and deposit stipulated cash and/or collaterals with the
trading member.
402 PP-FT&FM
Exchanges stand in as the counter-party for each transaction. Therefore, participants do not need to
worry about defaults.
In the event of a default, Exchanges will step in and fulfil the obligations of the defaulting party, and
then proceed to recover dues and penalties from them.
Those who enter the market either by buying (long) or selling (short) a Futures contract can close their
contract obligations by squaring-off their positions at any time during the life of that contract by taking an
opposite position in the same contract.
Participants have to open a trading account and deposit stipulated cash and/or collaterals with the
trading member.
A long (buy) position holder has to short (sell) the contract to square-off their position and vice
versa.
Participants will be relieved of their contract obligations to the extent they square-off their positions.
All contracts that remain open at expiry are settled in INR in cash at the reference rate specified by the
Reserve Bank of India.
FOREIGN EXCHANGE CURRENCY OPTIONS

Foreign exchange (FX) options are contracts that give the buyer the right, but not the obligation, to buy or sell
one currency against the other, at a predetermined price and on or before a predetermined date.
The buyer of a call (put) FX option has the right to buy (sell) a currency against another at a specified rate. If this
right can only be exercised on a specific date, the option is said to be European, whereas if the option can be
exercised on any date till a specific date, the option is said to be American. Currently only USD INR options are
permitted for trading in India and the clients can trade currency options through NSE and USE.
Exchange traded currency options

Exchange traded currency options are standardized products with pre-defined maturities. They are easily
accessible with OTC derivatives contracts. Now individuals and corporate can reap benefit out of the currency
options. Options are like insurance contracts, they protect you from the downside at the same time allowing you
to reap the benefits of any upside. Rupee options would introduce greater flexibility in risk management of
corporate and cost control.
Advantages of Currency Options

Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront.
This would be a big advantage for importers, exporters (of both goods and services) as well as businesses with
exposures to international prices. Currency options would enable Indian industry and businesses to compete
better in international markets by hedging currency risk.
Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures e.g.
If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the
costs would be in rupees, then the company runs a risk till the contract is awarded. Using forwards or currency
swaps would create the reverse positions if the company is not allotted the contract, but the use of an option
contract in this case would freeze the liability only to the option premium paid up front.
The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows.
Option structures can be used to hedge the volatility along with the non-linear nature of payoffs.
Attract further forex investment due to the availability of another mechanism for hedging Forex risk.
Lesson 12
Features of currency option contracts

Standardized exchange traded currency options have the following features:
The underlying for the currency option shall be US Dollar Indian Rupee (USD-INR) spot rate.
The options shall be premium styled European call and put options.
The size of each contract shall be USD 1000. The premium shall be quoted in Rupee terms. The
outstanding position shall be in USD
The maturity of the contracts shall not exceed twelve months.
The contracts shall be settled in cash in Indian Rupees.
The settlement price shall be the Reserve Banks Reference Rate on the date of expiry of the contracts.
Factors influencing Currency Options Prices

Parameter
Call Premium
Put Premium
Exchange Rate
As exchange rate increases call

premium also increases
As exchange rate increases put premium

decreases.
Strike Price
As strike rate increases call premium

decreases
As strike rate increases put premium also

increases
Risk Free Interest As the interest rate in the economy

Rate
increases, value of call option
increases
As the interest rate in the economy increases,

value of Put option decreases
Time to maturity
Call & Put options become more valuable as time to maturity increases, it is because of
Risk as the time increases.
Volatility
As volatility increases there is high degree of uncertainty about the rate of the currency
and hence on the option. The owner of the call benefits from the rate increase and that
of the put benefits from the rate decreases.
Options Strategy for Traders

A trader having a Long directions view on the Currency can buy a Call option or Sell a Put Option. Similarly a
trader having a Short directional view on the Currency can Sell a Call Option or Buy a Put option. In case
where Call or Put Option is being bought, the downside risk is limited only upto the amount of Premium paid, the
upside is unlimited in this case. In case where Call or Put option is being sold, the Downside risk is unlimited and
Upside potential is capped upto the Premium amount.
FOREIGN EXCHANGE RISK EXPOSURES AND THEIR MANAGEMENT

Foreign Exchange Exposure is the sensitivity of the real domestic currency value of assets, liabilities, or operating
incomes to unanticipated changes in exchange rates. Foreign Exchange Risk is measured by the variance of
the domestic - currency value of assets, liabilities, or operating income that is attributable to unanticipated
changes in exchange rates
There are three important Facts about foreign exchange risk exposure:
1. Changes in the nominal exchange rate are not offset by corresponding changes in prices at home and
abroad: there is real exchange rate risk
404 PP-FT&FM
2. Neither the forward rate is successful in forecasting the exchange rate nor are other fundamental variables
3. Given the various market imperfections in the real world, hedging exchange rate risk can lead to an
increase in the value of the firm
Exposure of Foreign Exchange Risk

There are three types of Foreign Exchange Risk Exposure:
Translation or Accounting Exposure
Transaction or Contractual Exposure
Operating or Economic Exposure
A transaction exposure occurs when a value of a future transaction, through known with certainty, is denominated
in some currency other than the domestic currency. In such cases, the monetary value is fixed in terms of foreign
currency at the time of agreement which is completed at a later date.
For example, an Indian exporter is to receive payment in Euros in 90 days time for an export made today. His
receipt in Euros is fixed and certain but as far as the Re. value is concerned, it is uncertain and will depend upon
the exchange rate prevailing at the time of receipt. All fixed money value transactions such as receivables,
payables, fixed price sale and purchase contracts etc. are subject to transaction exposure. The transaction
exposure looks at the effects of fluctuations in exchange rates on the transactions that have already been
entered into and have been denominated in foreign currency.
Transaction exposure refers to the potential change in the value of a foreign currency denominated transaction
due to changes in the exchange rate. Credit purchases and sales as well as borrowing and lending denominated
in foreign currencies, and uncovered forward contracts are some examples of transaction exposure.
Transaction exposure basically covers the following:
(a) Rate Risk: this will occur
(i) When there is mismatch of maturities and borrowings:
(ii) In foreign exchange, it results in net exchange positions (long or short).
(b) Credit Risk: A situation when the borrower is not in a position to pay.
(c) Liquidity Risk: Same as in the case of credit risk.
To illustrate, suppose an Indian company, XX India Ltd., contract with a US company, YY US Inc., to sell 1000
sets of machines for delivery one year from now. XX India Ltd. wants to realize ` 2000 million from this sale. The
US company has indicated that it will enter into the contract if the price is stated in US$. The one-year forward
rate is ` 49/$1. Hence XX India Ltd. quotes a price of $41 million. The Indian company faces transaction
exposure. If, for example, the value of rupee increases to ` 47/$1, the Indian company would receive ` 1,927
million ($41 million x ` 47) rather than ` 2000 million which it was expecting. Foreign currency depreciation will
result in exchange loss if the exposed receipts are greater than the payments. Foreign currency appreciation, on
the other hand, will cause exchange loss if exposed receipts are smaller than exposed payments. The company
may hedge its position or take some other action to guarantee its future rupee proceeds from sale. The company
may, otherwise lose on the transaction if the value of the dollar weakens. The concept of hedging can be
understood with the help of following problem.
Problem : Ankush Ltd. has a plan to raise an amount of ` 50 crore for a period of 3 months, 6 months from now.
The current rate of interest is 9% but it may rise in 6 months time. The company wants to hedge itself against the
Lesson 12
increase in interest rate. Bank of India has quoted a forward rate agreement (FRA) at 9.1% per annum. Find out
the effect of FRA and actual interest cost to Ankush Ltd., if the actual rate after 6 months happens to be 9.5% or
8.5%.
Solution: If actual rate is 9.5%.
In this case, the bank, shall pay a differential of 0.4% (9.5%-9.1%). The cash flow is
Cash Flow = 50 Crores x 0.4% x 0.25 = ` 5,00,000
This amount is paid up front to Ankush Ltd., which can invest it @9.5% for 3 months period at 6 months from
now. Total accumulation is
Total amount = ` 5,00,000 x (1.095/4)= ` 5,11,875
At the end of the borrowing period Ankush Ltd. will pay interest @9.5% on ` 50 Crores
Interest = ` 50 Crores x 0.095 x .25 = ` 1,18,75,000
Net Cost to XYZ = ` 1,18,75,000 ` 5,11,875 = ` 1,13,63,125
This is 9.1% of the total borrowing for a period of 3 months. So, by entering into Forward Rate Agreement (FRA),
Ankush Ltd. has restricted its cost at 9.1% p.a.
If actual rate is 8.5%
If the rate is 8.5%. Ankush Ltd. will be required to pay up front 0.6% to the bank i.e. the amount of ` 7,50,000. On
the due date, interest on ` 50 Crores is payable @8.5% i.e. ` 1,06,25,000. The total cost to Ankush Ltd. is `
1,13,75,000 which is 9.1% of total funds.
It may be noted that the amount of ` 7,50,000 is to be borrowed at 8.5% p.a. for a period of 3 months. This will
be paid to the bank. The borrowing of ` 7,50,000 will be repaid as ` 7,65,938 after 3 months inclusive of interest.
Problem : Silver Oak Ltd., an Indian company, is mainly engaged in international trade with US and UK. It is
currently 1st January. It will have to make a payment of $7,29,794 in the coming six months time. The company
is presently considering the various alternatives in order to hedge its transactional exposure through its London
office. The following information is available :
Exchange Rates :
$/ Spot rate : 1.5617 - 1.5773
6-month $ forward rate : 1.5455 - 1.5609
Money Market Rates:
Borrow
Deposit
(%)
(%)
US Dollar
4.5
Sterling
5.5
Foreign currency option prices (Cents per for contract size 12,500) :
Exercise Price
Call Option (June)
Put Option (June)
3.7
9.6
$1.70/
Suggest which of the following hedging option is the most suitable for Silver Oak Ltd. :
(i) Forward exchange contract
406 PP-FT&FM
(ii) Money market
(iii) Currency option
Solution:
(i) Using Forward Exchange Contract
$ 729794/1.5455 = 472206
(ii) Using Money Market
Silver Oak Ltd. must make a deposit now
Six months dollar deposit rate : 4.5/2 = 2.25%
Z X 1.0225 = $ 729794
Z = $ 729794/1.0225
= $ 7,13,735
Hence amount required to be deposited @ 4.5% = $ 713735
Cost of buying $ 713735 at current spot rate is 713735/1.5617 = 457024
Six months sterling borrowing rate = 7/2 = 3.5%
Interest for six months on 457024 = ( 457024 X 0.035) = 15996
Total Cost = 457024 + 15996 = 473020
(iii) Using Currency option
Each contract will deliver = 1.7 x 12500 = $ 21250
No. of put option contract required = 729794/21250 = 34.34 or 34
Cost of total contracts = 0.096 x 12500 x 34 = $ 40800
Sterling cost of option = 40800/1.5617 = 26,125
Sterling required = 34 x 12500 = 425000 to buy $ 722500 @ $ 1.70
Shortfall = 729794 722500 = 7294
Cost of sterling using forward rate = 7294/1.5455 = 4720
Total cost using option = 26125+425000+4720 = 455845
Therefore currency options are the cheapest mode of hedging transaction exposure.
This is also called the accounting exposure. It refers to and deals with the probability that the firm may suffer a
decrease in assets value due to devaluation of a foreign currency even if no foreign exchange transaction has
occurred during the year. This exposure needs to be measured so that the financial statements i.e the balance
sheet and the income statement reflect the change in value of assets and liabilities. It may be noted that the
assets and liabilities are considered exposed to foreign exchange risk if their values are to be translated into
parent company currency using the exchange rate effective on the balance sheet date. Other assets and liabilities
and the capital that are translated at the historical exchange rates i.e., the rate in effect when these items were
first recognized in the balance sheet, are not considered to be exposed.
The translation exposure occurs when the firms foreign balances are expressed in terms of the domestic
Lesson 12
currency. Changes in exchange rates can therefore, alter the values of assets, liabilities, expenses and profits of
foreign subsidiaries. Two related decision areas are involved in translation exposure management:
(i) Managing balance sheet items to minimize the net exposure,
(ii) Deciding how to hedge against this exposure
Financial managers should attempt to keep a rough balance between exposed assets and liabilities. Such a
balance would bring about offsetting changes in values when the balance sheet of a foreign subsidiary is translated.
If the value of the currency declines relative to the currency of the home country, then the translated value will be
lower and simultaneously the translated liabilities would also be lower. An asset denominated in terms of foreign
currency will lose value if that foreign currency declines in value. A firm would normally be interested in its net
exposed position for each period in each currency. Although, expected changes in exchange rates can often be
included in the cost benefit analysis relating to such transactions, still there is an unexpected component in
exchange rate changes.
This exposure is particularly relevant for the companies which have subsidiaries in other countries. These
companies have to translate the financial statements of their subsidiaries that are prepared in a foreign currency
into the currency of the home country to prepare the consolidated statements. Foreign currency depreciation
results in exchange losses if the exposed assets are greater than exposed liabilities. Foreign currency appreciation,
on the other hand, will produce exchange gains.
The calculation of translation gains and losses is an exercise on paper only. These gains and losses do not
involve any actual cash flow. Some companies, however, are concerned about this risk because it affects their
cost of capital, earnings per share, and the stock price, besides the ability to raise capital in the market.
To illustrate the translation risk, assume that XYZ (India) Ltd., has a wholly owned subsidiary, YZ Inc. in USA.
The exposed assets of the subsidiary are $200 million and its exposed liabilities are $100 million. The exchange
rate changes from $0.020 per rupee to $0.021 per rupee. The potential foreign exchange gain or loss to the
company will be calculated as follows:
In this case, the net exposure is
Exposed assets
$200 million
Exposed liabilities
$100 million
Net exposure
$100 million
Pre-devaluation rate ($0.020 = ` 1) $100 million
` 2.400 million
Post-devaluation rate ($0.021 = ` 1) $100 million
` 2.500 million
` 0.100 million
If the post-devaluation rate is less than the pre-devaluation rate ($0.20 = Re. 1), the net result will be potential
exchange loss. In this case, an unrealized translation loss of ` 0.100 million would have been incurred. In the
example given above, the transactions are fairly straightforward. But, when different types of assets and liabilities
are involved, conceptual problems emerge about the true home-currency value of these items. Four different
methods are used to translate assets and liabilities of the subsidiary into the currency of the parent company,
namely, current/ non-current method, monetary/non-monetary method, temporal method, and current-rate method.
Economic Exposure
The economic exposure refers to the probability that the change in foreign exchange rate will affect the value of the
firm. Since the intrinsic value of the firm is equal to the sum of the present values of future cash flows discounted
at an appropriate rate of return, the risk contained in economic exposure requires a determination of the effect of
changes in exchange rates on each of the expected future cash flows. The firms economic exposure may be
408 PP-FT&FM
greater or lesser than its translation exposure since the present value of future cash flows can neither be increased
nor decreased by a revaluation of the currency. The measurement of economic exposure requires that a detailed
analysis of the effects of exchange rates changes on each of the future cash flows should be made.
Economic, operating, competitive, or revenue exposure refers to the immediate and potential effect of change in
the exchange rate on the net present value (NPV) of expected future cash flows generated by the affiliates. The
favourable factors in a country like stability, low rates of taxation, easy availability of funds, and favourable
balance of payment may change over time because of variations in the economic condition of a country. The
local currency may also be devalued or depreciated as a result of changes in the economic forces. The inflationary
forces, supply of funds, and price controls may also be affected as a result of change in exchange rates. In fact,
the economic exposure encompasses all facets of a companys operations including the effects of exchange
rate changes on customers, suppliers, and competitors. The economic exposure is more subjective, difficult to
measure, and broader in nature than the translation and the transaction exposures. In fact, the translation and
the transaction losses are one-time events, whereas the economic loss is a continuous one. For example,
assume that the Danish subsidiary of an Indian company is likely to earn 100 million Kroner each year. The
annual depreciation charges are estimated at 10 million Kroner. The exchange rate between the countries is
likely to change from ` 9.60 per Danish Kroner to ` 8.00 per Kroner in the next year. The change in the
exchange rate will have the following effect on the cash flows of the parent company:
Profit after taxes
100 million Kroner
Depreciation
10 million Kroner
Cash flow from operations
110 million Kroner
Old rate (` 9.60 per Danish Kroner)

(110 million Kroner x ` 9.60)
` 1056 million
New rate (` 5.00 per Danish Kroner)

(110 million Kroner x ` 8.00)
` 880 million
Exchange loss
` 176 million
Thus, the Indian company loses ` 176 million in cash flows over the next one year. If the anticipated business
activity would be same for the next five years, the next cash flows would decrease by ` 880 million.
The actual impact of economic exposure on the value of the company depends on the distribution of sales
between the domestic and export markets, elasticity of demand for the product in each market, and the cost
structure of the affiliate.
The major differences among the exposures are given below:
Differences among Translation, Transaction and Economic Exposures
Bases
EconomicExposure
Duration
Life of the project
Duration of the contract
At a point of time (conversion)
Gains/
Losses
Actual, total value difficult

to compute
Actual, total value relatively

less difficult to calculate
Paper exercise only easy to

work out
Contract
General in nature
Specific in nature
Specific in nature
Measurement
in actual spot
rates
Value depends on variation Value depends on changes in Value depends on accounting

actual spot rates
guidelines
Lesson 12
Hedging
Difficult because difficult

to predict
Relatively easy
Easy
Value
Market value of assets
Contract value of assets and Book value of assets and liabilities

liabilities
Extent of
exposure
Guided by the product

and factor markets
Determined by the nature
Depends on the accounting rules
Management
of exposure
All departments
Treasury department
Treasury department
Thus, the translation exposure is historic in nature. It is basically static. It does not consider the likely change in
an exchange rate. Moreover, no cash flow is involved in this exposure. The transaction and economic exposures,
on the other hand, consider the impact of an exchange rate change in future.
It may be noted that the firms are exposed to exchange rate changes at every stage in the process of capital
budgeting, from developing new products to entering into contracts to sell these products in foreign market. For
example, a weakening of the Re. will increase the competition among firms that depend upon the export markets,
while hurting those firms that need import as inputs in their production process.
The transaction exposure can result in exchange rate related losses and gains that are already realized and
have an impact on the reported income. However, the translation exposure results in exchange rate losses and
gains that are reflected in the firms accounting record and are not realized and hence have no impact on the
taxable income. Thus, if the financial market are efficient and the managerial goal is consistent with the wealth
maximization, then the firm should not have to waste efforts and real resources hedging against the book value
losses caused by translation exposure. However, if the financial market is not efficient, then the firm should find
it economical and go for hedge against expected translation exposure. But it is useful for a firm to manage its
transaction and economic exposures because they affect the value of the firm directly.
GENERAL PROTECTION MEASURES FOR FOREIGN EXCHANGE RISK EXPOSURE

MANAGEMENT
The general protection measures are those measures which are implemented on an ongoing basis as a part of
a firms normal operations. The assumption here is that in a multinational setting, the subsidiaries are whollyowned. If there are shareholders in the host countries of the subsidiaries, these measures could at times conflict
with their interests.
(a) Invoicing Policies: if a firm has subsidiaries abroad, there may be transaction among them or between a
subsidiary and the parent firm. Or, the parent and the subsidiaries may have transactions in foreign currencies with
third parties. The foreign exchange effect on intra-firm payments on a consolidated basis does not depend upon
the currency denomination of the invoice. For, a payable in the books of an importing subsidiary is off-set by an
exactly equal amount of a receivable in the same currency in the books of the exporting subsidiary. It is immaterial
from the parents point of view whether the invoice is in the currency of the exporting subsidiary of that of the
importing subsidiary. Even if the invoice is in a third currency, The foreign exchange risk will be shared by the
exporting and importing subsidiaries concerned. When the consolidated position of the firm is not affected, regard
should be had of external factors such as tax structure and exchange controls in the countries of the firm and its
subsidiaries, and invoicing decisions should be based on the what is advantageous to the firm as a whole. The
objective should be to obtain maximum credits upon exchange losses or to minimise tax liabilities on exchange
gains. Invoices to third parties abroad should be denominated in the relatively stronger currency. On the other
hand, while importing goods etc. from third parties a firm should try to negotiate payments in the weaker currency.
Respective bargaining strenghs and the need for good customer relations have a bearing on the invoicing decision.
In India, exchange control does not place restrictions on the choice of a currency for invoicing international
transactions, It could be indian rupee, SDR, ECU or any freely convertible currency, or further for certain specified
410 PP-FT&FM
purposes, currencies of the A.C.U. parties undertaking such transactions may also keep in view the availability
of forward cover in the currency chosen.
(b) Transfer Pricing: It is a mechanism by which profits are transferred through an adjustment of prices on intrafirm transactions. It can be applied to transactions between the parent firm and its subsidiaries or between
strong currency and weak currency subsidiaries. Subject to the demands of competition, a parent may charge
higher prices to its weak currency subsidiary, thereby increasing its own profit and reducing that of the subsidiary.
The taxable income of the subsidiary comes down. Recovering higher level of operating charges from the
subsidiaries also serves the same purpose. It is likely that audit profession, exchange controls and customs
duties of the host country may supervene to negate this strategy. So, the mechanism may be applied moderately
gradually over a long period, without upsetting the environment in which the subsidiaries operate.
(c) Leading and Lagging and extension of Trade Credit: Leading implies speeding up collections on receivables
if the foreign currency in which they are invoiced is expected to appreciate. Lagging implies delaying payments
of payables invoiced in a foreign currency that is expected to depreciate. At the level of an individual transaction
this is a specific protection measure; but at the corporate level this requires forecasting of currency movements,
centralisation of information on transactions, and evolving guidelines for subsidiaries. Hence, it has been located
here as a general protection measure.
Leading and lagging is primarily an intra-firm measure, because in third party trade there is a clear conflict of
interest between buyer and seller. It involve both costs and benefits. There are three elements in this calculation:
(i) cash cost/benefit represented by the interest rate differential between the lead and lag countries; (ii) an
expected cash gain/loss to be realised on the altered transactional exposure in the said countries, and (iii) an
expected translation gain/loss on the altered translation exposure. The corporate policy should take them into
account and also consider effective tax rates in the two countries as also the currency of intra-firm invoicing.
Duration of a trade credit should be decided keeping in view much the same factors discussed above.
Problem: An Indian importer has to settle an import bill for $1,30,000. The exporter has given the Indian exporter
two options :
(i) Pay immediately without any interest charges.
(ii) Pay after three months with interest @ 5% per annum.
The importers bank charges 15% per annum on overdrafts. The exchange rates in the market are as follows :
Spot rate (` /$)
3-Month forward rate (` /$)
48.35/48.36
:
48.81/48.83
The importer seeks your advice. Give your advice.

Solution:
Option I: Pay immediately without any interest charges
Bill value converted to Indian rupees ($ 1,30,000 x ` 48.36)
= ` 62,86,800
Interest on the borrowing from bank (o/d) @ 15% p.a.

For three months ` 62,86,800 x 15/100 x 3/12 =
` 2,35,755
Total : ` 65,22,555
Option II: Pay after 3 months with interest @ 5% p.a.

Bill value
$ 1,30,000
Interest @ 5% p.a. for 3 months= $ 1,30,000 x 0.05 x 0.25
$ 1,625
$ 1,31,625
Lesson 12
Forward ` /$ rate ($ 1,31,625 x ` 48.83) =
` 64,27,249
Difference in outflows in Option I and Option II

= ` 65,22,555 ` 64,27,249 = ` 95,306.
Advice: it is advisable to settle bill payable after three months since rupee outflow is less by ` 95,306.
(d) Netting: All transactions-gross receipts and payments among the parent firm and subsidiaries should be
adjusted and only net amounts should be transferred. This technique is called netting. This again involves
centralisation of data at the corporate level, selection of the time period at which netting is to be done, and
choice of the currency in which netting is to be done. The currency could be the home currency of the firm.
Netting reduces costs of remittance of funds, and increases control of intra-firm settlements. It also produces
savings in the form of lower float (funds in the pipe-line) and lower exchange costs.
(e) Matching: It is a process whereby cash inflows in a foreign currency are matched with cash outflows in the
same currency with regard, to as far as possible, amount and maturation. Hedging of exchange risk could be
done for the unmatched portion. When there are cash inflows in one foreign currency and cash outflows in
another foreign currency, the two could still be matched, provided they are positively correlated i.e. expected to
move in tendem. There is the risk of exchange rates going off the expectations.
EXCHANGE RATE FORECASTING

Participants in the international markets face problems, in making decisions which are based on future exchange
rates. For example, future exchange rates may be required by the companies to hedge against potential losses,
arranging short-and long-term funds, performing investment analysis, and to assess earnings of a foreign
subsidiary. The quality of decision, in such cases, depends on the accuracy of exchange rate projections.
The percentage change between the current and the forecasted exchange rates may be calculated to find out
appreciation or depreciation in the currency. A positive percentage change represents currency appreciation
whereas a negative percentage change a shows depreciation.
The exchange rates may be fixed or floating. Different methods are used to forecast fixed and floating exchange
rates.
The floating exchange rates, are determined by the market forces of demand and supply. These are not influenced
by the government intervention. Fixed exchange rates, on the other hand, are decided by the regulating agencies.
The floating exchange rates may be forecast with the help of various methods. Fundamental and technical
analyses are commonly used for this purpose. Fundamental analysis studies the relationship between macro
economic variables (such as inflation rates, national income growth, and changes in money supply) and exchange
rates to forecast the latter. Technical analysis uses past prices and volume movements to project future currency
exchange rates. The technical analysis may produce useful results if the past trend is repeated. The companies
normally use technical analysis for short-term forecasts. But, they use fundamental analysis for long-term
projections. The primary methods of technical analysis are charting and mechanical rules. The reliability of the
forecasts may be found out on the basis of forecasting error which is calculated by root square error. The root
square error is computed with the help of the following formula:
RSE
(FV RV)2
RV
Where RSE is the root square error as a percentage of realized value; FV is the forecasted value and RV is the
realized value.
Fixed exchange rate forecasts are based on the study of government decision-making structure. Attempt is
made to determine the pressure to devalue the currency of the nation and the ability of the government to
sustain the disequlibrium.
412 PP-FT&FM
Forecasting fixed exchange rates requires an assessment of balance-of-payments disequilibrium on the basis
of key economic variables such as inflation, money supply, international reserves, gap between official and
market rates, and the balance of foreign trade. The change in the exchange rate required to restore the balance
of payment equilibrium is estimated with the help of forward exchange rates, free market rates and the purchasing
power parity principle. The capacity of the country to resist or postpone the use of corrective measures is
evaluated on the basis of the ability to borrow hard currencies and the availability of international reserves.
Attempt is also made to project the policies which may be followed by the Government to correct the position of
the nation.
Thus, exchange rates are forecasted to make various decisions by the companies which require foreign exchange.
These forecasts are made separately for the fixed and floating exchange rates with the help of different methods.
Percentage change between forecasted and current exchange rates may be calculated to find out appreciation
or depreciation in the currency.
RISK IN FOREIGN EXCHANGE BUSINESS

While the forex market may offer more excitement to the investor, the risks are also higher in comparison to
trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging
losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders
to understand, because in the forex market - due to the large amount of money involved and the number of
players - traders will react quickly to information released into the market, leading to sharp moves in the price of
the currency pair.
Though currencies dont tend to move as sharply as equities on a percentage basis (where a companys stock
can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the
spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you
control $100,000 in capital. If you put $100,000 into a currency and the currencys price moves 1% against you,
the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing
a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stocks value
on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks
involved in the forex market before diving in.
PEGGING OF CURRENCY
Pegging of currency refers to a method of stabilizing a countrys currency by fixing its exchange rate to that of
another country
Different countries follow different methods for pegging of their currencies. The foreign exchange value is established
according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency
and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of
domestic currency vis-a-vis other foreign currencies. Thus, in that situation, performance of the domestic economy is
not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange rate.
The other extreme is allowing the exchange value of the national currency to float independently according to market
forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate
arrangements for determination of exchange values. These arrangements are being listed below:
(a) Domestic currency pegged to one foreign currency
Under this arrangement, the exchange rate of one currency is pegged to a dominant foreign currency, usually
the U.S. dollar. For example the Argentine Peso was till recently pegged to the US dollar in the ratio of 1:1.
(b) A currency pegged to a basket of currencies
The currency of a country may be pegged to a basket of currencies. The basket is generally formed by the
Lesson 12
currencies of major trading parties to make the pegged currency more stable than if a single currency peg is
used. Trade, services and major capital flows may be used as currency weights while calculating the basket.
The Indian Rupee is linked to a basket of currencies.
(c) Flexibility limited in terms of a single currency
In this system, the value of the currency is maintained within certain margins of the peg. Some Middle Eastern
countries follow this system and maintain their currency within a limit of the peg against the U.S. dollar.
(d) Pegged to some indicators
Under this arrangement, the currencies adjust more or less automatically to changes in the selected indicators.
A common indicator is the real effective exchange rate (REER) that reflects inflation adjusted changes in the
currency against major trading parties.
This category also includes cases where the exchange rate is adjusted according to a pre-announced schedule.
(e) Managed Float
Central Bank of a country decides the exchange rate in this system. The rates are revised from time to time
depending on forex reserves, developments in parallel exchange markets, the real effective exchange rate etc.
(f) Independent float
In this system market forces determine the exchange rate. Most of the developed countries follow this system of
exchange rate.
SOME CASE STUDIES

Question No 1: Following are the quotes given by Banker at Mumbai.
Direct / Indirect
Quote the Opposite Rate
1) 1$ = ` 43.18
2) 1 = ` 78.68
3) 1INR = Euro 0.0184
4) 100 Indo Rupiah = ` 0.53
Identify the quote as Direct or Indirect quote. Also compute the Direct for Indirect Quote and Vice Versa.
Solution:
Direct/Indirect
Opposite rate
1$ = ` 43.18
Direct
1 INR = $ 0.0232 [1/43.18]
1 = ` 78.68
Direct
1 INR = 0.0127 [1/78.68]
1INR = Euro 0.0184
Indirect
1 Euro = ` 54.35 [1/0.0184]
100 Indo Rupiah = ` 0.53
Direct
1 INR = Indo Rupiah 188.69 [100/0.53]
Question No. 2
Direct Quote
a) INR/$43.72 43.94
b) INR/Euro 54.44 54.67
c) INR/100 0.3996-0.3999
Bid Rate
Offer Rate Spread
Spread %
414 PP-FT&FM
Find out Bid Rate and offer Rate. Also find out the spread. Express the spread in %
Solution:
Direct Quote
Bid
Offer
Spread
Spread as %
INR/$ 43.72 43.94
43.72
43.94
0.22
0.22/43.94 x 100 = 0.50%
INR/Euro 54.44 54.67
54.44
54.67
0.23
0.23/54.67 x 100 = 0.42%
INR/100 0.3996-0.3999
0.3996
0.3999
0.0003
0.0003/0.3999x100=0.075%
Question No. 3
Mr. X took a long position in dollar futures [bought futures] on 01.07.12 when the futures were trading at ` 42.35.
He closed his position on 05.07.12 by making a future sell at ` 42.40. He bought 5 dollar futures contract. The
size of each contract is $1,25,000. The closing futures price during the period when his position was open is
given below.
Date
Closing futures price
01.07.12
42.36
02.07.12
42.45
03.07.12
42.25
04.07.12
42.30
05.07.12
42.40
Show how Mr. X will take book profit or loss from futures market?
Solution
It seen that, the futures exchange daily closes the open buy position by selling futures at the days closing price
and reopens by buying on next days opening price. The daily profit or loss is then credited to margin account.
Date
Buy price
Sell price Profit or loss per $
Amount credited or (debited) to

margin a/c
01.07.12
42.35
42.36
0.01
$6,25,000 x 0.01 = 6,250
02.07.12
42.36
42.45
0.09
$6,25,000 x 0.09 = 56,250
03.07.12
42.45
42.25
(0.20)
$6,25,000 x 0.20 = (1,25,000)
04.07.12
42.25
42.30
0.05
$6,25,000 x 0.05 = 31,250
05.07.12
42.30
42.40
0.10
$6,25,000 x 0.10 = 62,500
Net credit
0.05
31250
Question No. 4
On 1.1.2013, UBS, a French firm, purchased a machinery from a US firm for $ 1,00,000 on 3 months credit. On
the same day, the French firm entered into a 3 months forward contract with its bank for purchasing $ 1,00,000.
Later on the machinery was found sub-standard. After negotiation, it was decided that UBS will pay only $70,000.
On 31.3.2013, UBS book the delivery of $ 70,000 from the bank and paid the same to the US firm. Calculate the
net amount in Euro that UBS has to pay to its bank, using the following data:
Lesson 12
1.1.2013
Spot 1 Euro = $1.25/1,26
3 months forward swap margins 0.10 / 0.08 c
31.3.2013
Spot 1 Euro = $1.26/1.27
Solution
1.1.2013 Spot 1 Euro = $ 1.25/1.26
3 months forward rate 1 Euro = $ 1.2490/1.2592
31.3.2013 Spot 1 Euro = $ 1.26/1.27
31, 3.2013:
UBS has to purchase 1, 00,000$ for 1,00,000/1.2490 i.e. 80,064 Euro It will pay 70,000$ to US firm. It will sell
remaining 30,000$ to bank @ 1.27$ per Euro (spot rate on 31.3.13).
Amount payable for 1, 00,000$
80,064 Euro
Amount Receivable for 30,000$
23,622 Euro
Net payable to bank
56,442 Euro
Question No. 5: A US Co. exports a Radiotherapy machine to the Health Department of Government of
Switzerland. The price is 1,00,000 CHF with terms of 30 days. The present spot rate is 1.72 CHF per dollar. The
30 days forward rate is 1.71. The US Co. enters into forward contract. How many dollars the US Co. receives
after 30 days? Is the CHF at premium or at a discount?
Solution
The applicable rate: 1$ = 1.71 CHF
To receive after 30 days = 1,00,000/1.71 i.e. 58,479.53$
Today 1$ = 1.72 CHF
Forward 1$ = 1.71 CHF
(It means purchasing power of dollar, in terms of CHF, is decreasing. It means dollar is at discount), So, CHF is
at premium.
Question No. 6
Sacrifice Ltd. is planning to import a multi-purpose machine from Japan at a cost of 3,400 lakhs Yen. The
company can avail loans at 18% interest per annum with quarterly rests with which it can import the machine.
However there is an offer from Tokyo branch of an India based bank extending credit of 180 days at 2% per
annum against opening of an irrevocable letter of credit.
Other information:
Present exchange rate ` 100=340 yen
180 days forward rate ` 100=345 yen
Commission charges for letter of credit at 2% per 12 months. Advise whether the offer from the foreign branch
should be accepted?
416 PP-FT&FM
Solution
Assumptions
Credit from Tokyo Branch is available for 180 days. Considering this fact, we assume
(a) Alert Ltd. requires credit for 180 days i.e. under both the alternatives, all the payments (Principal,
Commission & Interest) will be made after 180 days.
(b) 180 Days = 6 months = Two Quarters.
Evaluation of Two alternatives
(A) To pay 3,400 Lakhs Yen, Alert Ltd. may borrow ` 1,000 Lakhs in Indian Market. From this amount, it
may purchase 3,400 Lakhs Yen and pay for machine. (Now there is no foreign exchange risk). It may
repay the loan (raised in Indian market) with interest after 180 days. Total payment (including interest) =
` 1,000 Lakhs (1.045) (1.045) = ` 1,092.025 Lakhs
(B) Alert may borrow 3,400 Lakhs Yen from Tokyo Branch and pay for machine. It has to pay 34 Lakhs Yen
as interest. (Rate of interest is 2% p.a.; For 180 days it is 1%. 1% of 3,400 Lakhs = 34 Lakhs). Alert has
to pay 3,434 Lakhs Yen after 180 days. At that time 1 Yen can be purchased, on the basis of forward, for
Re. 0.289855. (345 Yens = ` 100).
(Hence 1 Yen = 100 / 345 i.e. 0.289855). To purchase 3,434 Lakhs Yen, Alert has to pay 3,434 Lakhs x .289855
i.e. ` 995.362 Lakhs).
Under this alternative, there is one more cost i.e. cost of getting Letter of credit (LC).
Bank charges for issuing LC will be 1% (Commission is 2% per 12 months. For 180 days, it is 1%). The LC will
be for 3,400 Lakhs Yen. Today 3,400 Lakhs Yen are equal to ` 1,000 Lakhs. Hence Commission = ` 1,000
Lakhs x 1 % i.e. ` 10 Lakhs. We assume that commission will be paid after 180 days and for this delay Bank will
charge interest @ 18% p.a. with quarterly rests. Commission and interest on commission = ` 10 lakhs (1.045)
(1.045) = ` 10.92 1akhs.
Total payment under Alternative I (After 180 days) = ` 1,092.025 Lakhs
Total payment under Alternative II (After 180 days) = (` 995.362 Lakhs + ` 10.92 Lakhs) = ` 1,006.282 Lakhs
Recommendation
Alternative II (Tokyo Branch Credit) may be preferred
Question No. 7
A customer with whom the Bank had entered into 2 months forward purchase contract for Euro 5,000 @ ` 54.50
comes to bank after 1 months and requests for cancellation of the contract. On this date, the prevailing rates are:
Spot 1 Euro : ` 54.60 / 54.70
One month forward 1 Euro : ` 54.90 / 55.04
What is the loss or gain to customer on cancellation?
Solution
On the day the customer comes to the bank for cancellation, the bank will enter into a forward contract (same
maturity date as that of the original) under which bank will sell 5,000 Euro @ ` 55.04.
On maturity, bank will sell 5,000 Euro to customer (@ ` 55.04) for ` 2,75,200 (under the new contract) and
Lesson 12
purchase 5,000 Euro from the customer (@ ` 54.50) for ` 2,72,500 ( under the original contract ). Loss to the
customer ` 2,700. (This loss will be recovered from the customer)
Question No 8: An Indian exporting firm, Bimal Jalan & Co. would cover itself against a likely depreciation of
Pound sterling. The following data is given :
Receivables of Bimal Jalan & Co. : 5,00,000. Spot rate ` 56/
3 months interest rate: India: 12% p.a. UK : 5% p.a. What the exporter should do?
Solution :
The firm may borrow 5,00,000/1.0125 i.e. 4,93,827.16.
This amount shall be repaid after three months with interest @ 5% p.a. using the export proceeds.
Convert borrowings in Rupees. 4,93,827.16 x 56 i.e. ` 2,76,54,321,
Invest this amount for three months.
Investment proceeds = 2,76,54,321x1.03
= ` 2,84,83,950.63
Question No. 9
The rate of inflation in USA is likely to be 3% p.a. and in India it is likely to be 6.50%. The current spot rate of US
$ in India is 53.40. Find the expected rate of US $ in India after 1 year and 3 years from now using purchasing
power parity theory.
Solution
Spot rate: 1 $ = ` 53.40
1 year forward rate: 1$(1.03) = ` 53.40 (1.0650)
1 $ = ` 55.21456
3 year forward rate: 1$(1.03)3 = ` 53.40 (1.0650) 3
1 $ = ` 59.03076
Question No. 10
On April 1, 3 months interest rate in UK Pound and USD are 7.50% and 3.50% p.a. respectively. The UK Pound/
USD spot rate is .7570. What would be the forward rate of USD for delivery 30th June?
Solution
Three months interest rate (UK): 7.50/4 = 1.875% = 0.01875
Three months interest rate (US): 3.50/4 = 0.875% = 0.00875
Spot rate: 1$ = 0.7570
3 months forward rate : 1$(1.00875) = 0.7570(1.01875)
1 $ = 0.7645
418 PP-FT&FM
LESSON ROUND-UP
Forex management may be defined as the science of management of generation, use and storage of
foreign currencies in the process of exchange of one currency into other called foreign exchange.
Exchange rate is the price of one countrys money in terms of other countrys money.
Factors affecting Foreign Exchange Rates can be grouped into Fundamental Factors, Political and
Psychological Factors, Technical Factors such as Capital Movement, Relative Inflation Rates. Exchange
rate policy and intervention-Interest rates and Speculation.
A spot exchange rate is a rate at which currencies are being traded for delivery on the same day.
A direct quote indicates the number of units of the domestic currency required to buy one unit of
foreign currency.
An indirect quote indicates the number of units of foreign currency that can be exchange for one unit
of the domestic currency.
Ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be
purchased from the dealer.
Bid price is the rate at which the dealer is ready to buy the foreign currency in exchange for the
domestic currency
The ask-bid spread depends upon the breadth and depth of the market for that currency and the
volatility of the currency.
% Spread =
Ask Pr ice Bid Pr ice

100
Ask Pr ice
The exchange rate between two currencies calculated on the basis of the rate of these two currencies
in terms of a third currency is known as a cross rate.
The forward rate is a price quotation to deliver the currency in future. The exchange rate is determined
at the time of concluding the contract, but payment and delivery are not required till maturity.
Transfer Pricing is a mechanism by which profits are transferred through an adjustment of prices on
intra-firm transactions.
Leading implies speeding up collections on receivables if the foreign currency in which they are invoiced
is expected to appreciate.
Lagging implies delaying payments of payables invoiced in a foreign currency that is expected to
depreciate.
Netting implies that all transactions-gross receipts and payments among the parent firm and subsidiaries
should be adjusted and only net amounts should be transferred.
Matching is a process whereby cash inflows in a foreign currency are matched with cash outflows in
the same currency with regard, to as far as possible, amount and maturation
A transaction exposure occurs when a value of a future transaction, through known with certainty, is
denominated in some currency other than the domestic currency.
Translation Exposure is also called the accounting exposure. It refers to and deals with the probability
that the firm may suffer a decrease in assets value due to devaluation of a foreign currency even if no
foreign exchange transaction has occurred during the year.
Lesson 12
The economic exposure refers to the probability that the change in foreign exchange rate will affect
the value of the firm.
Capital account convertibility implies the right to transact in financial and other assets with foreign
countries without restrictions.
SELF-TEST QUESTIONS
1 What is the importance of Foreign Exchange for a country?
2. What do you understand by spot rates and forward rates?
3. What factors determine exchange rates?
4. How can forex risks be managed?
420 PP-FT&FM
Practical Questions and Case Studies 421
PRACTICAL QUESTIONS AND CASE STUDIES

CAPITAL BUDGETING
Question No. 1
Following data in respect of two machines namely A and B are detailed below Depreciation has been charged
on straight line basis and estimated life of both machines is five years.
(In `)
Item
Machine A
Machine B
Cost
56,125
56,125
1st Year
3,375
11,375
2nd Year
5,375
9,375
3rd Year
7,375
7,375
4th Year
9,375
5,375
5th Year
11,375
3,375
36,875
36,875
Net income after depreciation and taxes:
Find out
(a) Average rate of return on A and B machines
(b) Which machine is better from the point of view of pay-back period and why?
(c) Calculate average rate of return when salvage value of machine A turns out to be ` 3,000 and when B
machine has zero salvage value.
Answer to Question No. 1
(a) Average Rate of Return (ARR)
ARR =
Average net income after taxes

Average investment
` 36,875
Average income of machine A =
= ` 7,375
5
` 36,875
Average income of machine B =
= ` 7,375
5
Average investment =
1
(` 56,125) = ` 28,062.50
2
(Average investment of Machine A and Machine B is the same as the cost is same)
ARR for Machine A =
7,375
100
28,062.50
26.28%
422 PP-FT&FM
ARR for Machine B =
7,375
100 26.28%
28,062.50
(b) From the Point of View of Pay-back Period

From this point of view, Machine B is better as the initial inflow is much higher compared to Machine A
and hence Machine B provides large liquidity of funds.
(c) Average Rate of Return when Salvage Value of Machine A is ` 3,000
Average Investment
= ` 3,000 + 1/2 (` 56,125 ` 3,000)

= ` 3,000 + ` 26,563 (approximately)
= ` 29,563 (approximately)
ARR
Average income
Average investment
=
7,375
100
29,563
= 24.95%
ARR of Machine A
= 24.95%
As Machine B does not have any salvage value, the ARR for Machine B will remain the same, i.e. 26.28% (as
calculated in (a) above).
Question No. 2
A Company is contemplating to purchase a machine. Two machines A and B are available, each costing `
5,00,000. In comparing the profitability of the machines, a discounted rate of 10% is to be used. Earnings after
taxation are expected as follows:
CASH FLOW
Year
Machine A(`)
Machine B(`)
1,50,000
50,000
II
2,00,000
1,50,000
III
2,50,000
2,00,000
IV
1,50,000
3,00,000
1,00,000
2,00,000
Indicate which of the machines would be profitable using the following methods of ranking investments proposals:
(i) Pay back method
(ii) Net present value method
(iii) Post pay back profitability
(iv) Average rate of return.
This discount factor at 10% is:
1st year
.9091

2nd year
.8264
3rd year
.7513
4th year
.6830
5th year
.6209

(I) PAY BACK METHOD:
Pay back period for Machine A
Cash Flow (`)
Year
Total
Cumulative Cash flow
1,50,000
1,50,000
II
2,00,000
3,50,000
III
2,50,000
5,50,000
Investment
5,00,000
1,50,000
12 = 2 years 7.2 months
2 year +
2,50,000
Total pay back period :

Pay back period for Machine B
Cash Flow (`)

Year
Total
Cumulative Cash flow
50,000
II
1,50,000
2,00,000
III
2,00,000
4,00,000
IV
3,00,000
5,00,000
Investment
5,00,000
50,000
1,00,000
12 = 3 years 4 months
3 year +
3,00,000
Total pay back period :

Rankings:
Machine A
Machine B
II
(II) NET PRESENT METHOD:

Calculation of Present Values of Cash Flows
Year
Cash Flow (`)

Machine A
Machine B
1,50,000
50,000
II
2,00,000
1,50,000
Discount
Factor @10%
Present Value (`)

Machine A
Machine B
0.9091
1,36,365
45,455
0.8264
1,65,280
1,23,960
424 PP-FT&FM
III
2,50,000
2,00,000
0.7513
1,87,825
1,50,260
IV
1,50,000
3,00,000
0.6830
1,02,450
2,04,900
1,00,000
2,00,000
0.6209
62,090
1,24,180
Total Present Value
6,54,010
6,48,755
Initial Investment
5,00,000
5,00,000
Net Present Value
1,54,010
1,48,755
Machine A
Machine B
II
Ranking
(iii) Post Pay Back Profitability:

Machine A
Machine B
Total Actual Cash Flows
8,50,000
9,00,000
Less: Initial Investment
5,00,000
5,00,000
3,50,000
4,00,000
II
Machine A
Machine B
Total cash flows
8,50,000
9,00,000
(Less Depn. For 5 years)
5,00,000
5,00,000
Net earning after tax and depn.
3,50,000
4,00,000
70,000
80,000
5,00,000
5,00,000
70,000
100
5,00,000
80,000
100
5,00,000
= 14%
= 16%
II
(Recovered during pay-back)

Post Pay back Profitability
Ranking
(iv) Return on Investment Method:
Return on Investment* =
Average Annual Cash Flow

10
Initial Investment
Life of Machine (yrs)

Average earning per year
Initial cost
ARR
Ranking

Question No. 3
Following are the details of three project A, B and C
A
70,000
70,000
12 years
14 years
Cost (`)
50,000
Life
10 years
Estimated scrap (`)
5,000
10,000
7,000
Annual Profit Less Taxation (`)
5,000
6,000
5,500
Select the best one using

(i) Pay back period
(ii) Surplus life over pay back period
(iii) Surplus cash flow, as the decision criterion.
* Note: It may be calculated by using other methods also.
(a) Under pay-back method, the project which has the shortest pay-back period is selected. The pay-back
period is the length of time required for recovering the initial investment out of the annual cash flow. In
our question, the following are the pay-back periods of projects A, B and C.
Project A
50,000/5,000
= 10 years
Project B
70,000/6,000
= 11.66 years
Project C
70,000/5,500
= 12.73 years
(b) From the above, one can simply say that, on the basis of surplus life over pay-back period, Project C is
the best because, C has the longest surplus life of 1.27 years. (14 12.73). However, to be more
scientific, the scrap value should be taken into account in this case, because if the full life is alowed to
be run the scrap value will be realised. One way to do this would be to deduct scrap value from initial
cost and calculate the time period required to cover this cost. The difference between the life of the
project and the time required to cover this cost may then be taken to represent the surplus life. On this
basis, the surplus life of our projects are:
Project A:
10 years
(45,000/5,000) years
= 1 year
Project B:
12 years
(60,000/6,000) years
= 2 years
Project C:
14 years
(63,000/5,500) years
= 2.55 years
So, Project C is the best one.

(c) In our question, time value of money has been ignored. As such, the calculation of surplus cash flow,
thus becomes easier. The scrap value may be deducted from the initial cost to derive the actual cost. On
this basis, the surplus cash flows from each project after the life of each project is over, are:
A
Total cash flow: (Life x Annual Cash Flow)
50,000
72,000
77,000
Less: Initial cost: (Cost Estimated Scrap Value)
45,000
60,000
63,000
5,000
12,000
14,000
Surplus
426 PP-FT&FM
However, in order to select the best project we must see the highest rate of cash flow:
For Project A, the rate of surplus cash flow is 1.1 per cent per annum.
For Project B, the rate of surplus cash flow is 1.7 per cent per annum.
For Project B, the rate of surplus cash flow is 1.6 per cent per annum.
On the above basis, Project B yields the highest rate of surplus cash flow per annum and is the best.
Alternative Solution
Calculation of Depreciation
A
Cost (`)
Less: Scrap (`)
50,000
70,000
70,000
5,000
10,000
7,000
45,000
60,000
63,000
12
14
Life (years)
10
Depreciation p.a. (`)
4,500
5,000
4,500
Projects
A (`)
B (`)
C (`)
Profits less Taxation
5,000
6,000
5,500
Depreciation
4,500
5,000
4,500
CFAT but before Depriciation
9,500
11,000
10,000
Pay Back Period
50,000
9,500
70,000
11000
,
70,000
10,000
Pay Back Period:
= 5.3 years
= 6.4 years
= 7 years
II
III
Life
10 years
12 years
14 years
Profitable Period (Life Pay Back Period)
4.7 years
5.8 Years
7 years
III
II
` 44,650
` 63,800
` 70,000
5,000
10,000
7,000
49,650
73,800
77,000
III
II
Rank
Rank
Cash Flows over the profitable period
Profitable period * CFATBD
Estimated Scrap
Surplus Cash Flow
Rank

Question No. 4
The particulars relating to two alternative Capital Projects are furnished below:
PROJECT X
4 years
PROJECT Y
6 years
15
15
1st Year
2nd Year
10
3rd Year
4th Year
5th Year
6th Year
Life of Project
Estimated Cash Outflow (` in lakhs)
Estimated Cash Inflow (` in lakhs)
Compute internal rate of return of Project X and Y and state which project you could recommend. You may use
the present value tables given below:
PRESENT VALUE OF Re. 1
After
20%
25%
30%
35%
40%
45%
50%
1st
0.833
0.800
0.769
0.741
0.714
0.690
0.677
2nd
0.694
0.640
0.592
0.549
0.510
0.476
0.444
3rd
0.579
0.512
0.455
0.406
0.364
0.328
0.296
4th
0.482
0.410
0.350
0.301
0.260
0.226
0.198
5th
0.402
0.328
0.269
0.223
0.186
0.156
0.132
6th
0.335
0.262
0.207
0.165
0.133
0.108
0.088

OUT FLOW: ` 15,00,000
Project X
Years
Cash Inflow
Discount
Factor @ 25%
Present
Value (`)
Discount Factor
@30%
Present
Value (`)
1st Year
8,00,000
.800
6,40,000
.769
6,15,200
2nd Year
10,00,000
.640
6,40,000
.592
5,92,000
3rd Year
7,00,000
.512
3,58,400
.455
3,18,500
4th Year
3,00,000
.410
1,23,000
.350
1,05,000
Inflow
Discount Factor
@ 35%
1st Year
8,00,000
.741
5,92,800
.714
5,71,200
2nd Year
10,00,000
.549
5,49,000
.510
5,10,000
Discount Factor
@ 40%
428 PP-FT&FM
3rd Year
7,00,000
.406
1,84,200
.364
2,54,800
4th Year
3,00,000
.301
96,300
.260
78,000
15,16,300
14,14,000
PV required 15,00,000
PV at 35%
15,16,300
PV at 40%
14,14,000
Difference in Rate = 5%
Difference in inflow at 35% and 40% = 1,02,300
IRR = 35% +
16,300
5 35.8%
102
, ,300
Project Y
OUT FLOW: ` 15,00,000
Years
Cash Inflow
Discount
Factor @ 30%
Present
Value (`)
Discount Factor
@ 40%
Present
Value (`)
7,00,000
.741
5,18,700
.714
4,99,900
8,00,000
.549
4,39,200
.51
4,08,000
8,00,000
.406
3,24,800
.364
2,91,200
6,00,000
.301
1,80,600
.26
1,56,000
5,00,000
.223
1,11,500
.186
93,000
4,00,000
.165
66,000
.133
53,000
Total
16,40,800
Discount Factor
@ 45%
7,00,000
.69
4,83,000
8,00,000
.476
3,80,800
8,00,000
.328
2,62,400
6,00,000
.226
1,35,600
5,00,000
.156
78,000
4,00,000
.106
43,200
13,83,000
PV required: `15,00,000
PV at 40%: `15,01,200
PV at 45%: ` 13,83,000
Difference in Rate = 5%
Difference in inflow at 40% and 45% = 1,18,200
IRR = 40% +
1200
,
5
118
, ,200
= 40 + .05 = 40.05%
15,01,200

The profitability statement of project X shows that at 35 per cent, trial cash inflows are marginally greater and
therefore 35 per cent is the rate of return which equates the present value of inflows with outflows. After employing
the interpolation techniques the true rate in case of project X comes to be 35.8%. The profitability of project Y
shows that the rate of return is 40%. Using the rate of return method project Y yields a rate of return of 40.05
per cent while project X yields 35.8%. On this basis Project Y is recommended.
Question No. 5
A company is faced with the Question of choosing between two mutually exclusive projects. Project A requires
a cash outlay of ` 1,00,000 and cash running expenses of ` 35,000 per year. On the other hand, Project B will
cost ` 1,50,000 and require cash running expenses of ` 20,000 per year. Both the projects have a eight-year life.
Project A has a ` 4,000 salvage value and Project B has a ` 14,000 salvage value. The companys tax rate is
50% and rate of return is 10%. Assume depreciation on straight line basis. Which project should be accepted.
Present value of Re. 1 at the end of each year at 10% for 8 years is equal to ` 5.335 and present value of Re. 1
at the end of 8th year at 10% is equal to Re. 0.467.
Project A
Project B
1,00,000
1,50,000
50,000
50,000
Cash running expenses before taxes
35,000
20,000
+15,000
Tax saving (@ 50%) on expenses
17,500
10,000
7,500
7,500
Net savings depreciation
12,000
17,000
+ 5,000
6,000
8,500
2,500
1
Cash Outlay
Tax savings on depreciation
Differential Differential
cash flow
net cash
(B-A) flow (B-A)
Net savings
Salvage (at the end of 8 years)
2,500
10,000
4,000
14,000
10,000
10,000
Thus, if Project B is chosen it would require an additional outlay of ` 50,000 but would save in terms of cash
inflows ` 10,000 each year for eight years. This project should be accepted if it has a positive net present value
at a 10% discount rate.
`
PV of ` 10,000 each for eight years @ 10% (10,000 x 5.335)
PV of ` 10,000 at the end of eight years @ 10% (10,000 x .467)
53,350
4,670
58,020
Less: Cash outlay
50,000
Net present value
8,020
As Project B will offer whatever Project A offers and also helps in generating an additional net present value of
` 8,020 it should be preferred to Project A.
Question No. 6
The Klein & Co. is contemplating either of two mutually exclusive projects. The data with respect to each are
430 PP-FT&FM
given below. The initial investment for both is equal to their depreciable value. Both will be depreciated straight
line over a five-year life.
Project A
Project B
(` )
(` )
1,00,000
1,40,000
Initial Investment
Year
Profits after taxes

1
10,000
25,000
15,000
25,000
20,000
25,000
25,000
25,000
35,000
25,000
(i) Calculate the net present value and benefit-cost ratio for each project.
(ii) Evaluate the acceptability of each project on the basis of above mentioned two techniques.
(iii) Select the best project, using NPV and benefit cost ratios and comment on the resulting rankings.
(iv) Assume that the Klein Co. has an 11% cost of capital.
(v) The following data relates to discounting factor:
Year
Discounting factor at 11%
.901
.812
.731
.659
.593
and discounting factor for present value of an annuity discounted at 11% for five years is 3.696.
(i) The NPV for project A can be calculated as follows:
Year
Cash inflow after tax but adding

back depreciation (`)
Present value interest

factor at 11%
Present value (`)
30,000
.901
27,030
35,000
.812
28,420
40,000
.731
29,240
45,000
.659
29,655
55,000
.593
2,515
Total
1,46,600
For Project A, question provides data regarding profits after taxes. To obtain cash inflow, therefore, we have to
add depreciation amount. Total project investment is ` 1,00,000. Life of the project is 5 years and it is depreciated
at straight line method. Therefore, depreciation amount would be ` 20,000 each year which should be added to

PAT to obtain CI (Cash Inflow).
Similarly, for project B, the depreciation amount would be ` 28,000 per year, which should be added to PAT for
obtaining Cash Inflow.
PV for inflow
(3.696) x (53,000)
` 1,95,888
NPV of Project B
1,95,888 1,40,000
` 55,888
NPV of Project A
1,46,960 1,40,000
` 46,960
Benefit Cost Ratio

The benefit-cost ratio (B/C) can easily be determined by dividing the present value of inflow by the initial investment
in each case.
Project A
B/C
146
, ,960
= 1.47
100
, ,000
Project B
B/C
195
, ,888
= 1.40
140
, ,000
(ii) On the basis of both NPV and B/C ratios, both projects are acceptable because their NPVs are greater than
zero and their B/Cs are greater than one respectively.
(iii) On the basis of NPV, project B is preferable to project A. On the basis of B/C ratios, project A is preferable to
project B. If the firm is operating under capital rationing the B/C ratio approach would be best (i.e. project A
preferred), while if the firm has unlimited funds, the NPV approach is best (i.e. project B preferred).
Question No. 7
M/s Lalvani & Co. has ` 2,00,000 to invest. The following proposal are under consideration. The cost of capital
for the company is estimated to be 15 per cent.
Project
Initial Outlay `
Annual Cash Flow `
Life of Project (Years)
1,00,000
25,000
10
70,000
20,000
30,000
6,000
20
50,000
15,000
10
50,000
12,000
20
Rank the above projects on the basis of

(i) Pay-back method
(ii) NPV method
(iii) Profitability index method
Present value of annuity of Re. 1 received in steady steam discount at the rate of 15%
8 years
4.6586
10 years
5.1790
20 years
6.3345
432 PP-FT&FM
The ranking of various project under the various methods are shown below:
(i) Pay-Back Method:
Pay back period =
Initial Investment
Annual cash flows
The project with the lowest pay-back period is to be ranked first.

Project
Initial Investment `
Annual Cash Flow `
Pay-back period(in years)
Ranking
1,00,000
25,000
70,000
20,000
3.5
30,000
6,000
50,000
15,000
3.33
50,000
12,000
4.17
(ii) Net Present Value Method: The project with the highest N.P.V. is to be ranked first.
Project
Initial investment Annual Cash

(`)
Flow (`)
Life in
years
PV Factor
at 15%
PV`
NPV (`)
Ranking
1,00,000
25,000
10
5.1790
1,29,475
29,475
70,000
20,000
4.6586
93,172
23,172
30,000
6,000
20
6.3345
38,007
8,007
50,000
15,000
10
5.1790
77,685
27,685
50,000
12,000
20
6.3345
76,014
26,014
(iii) Profitability Index Method: The project which shows the highest profitability index is to be ranked first.
Profitability Index =
Total Present Value of Cash flows

Initial Investment
Project
Initial
investment (`)
Annual Cash
Flow (`)
Life in
years
PV Factor
at 15%
PV(`)
Profitability
Index
Ranking
1,00,000
25,000
10
5.1790
1,29,475
1.29
70,000
20,000
4.6586
93,172
1.33
30,000
6,000
20
6.3345
38,007
1.27
50,000
15,000
10
5.1790
77,685
1.55
50,000
12,000
20
6.3345
76,014
1.52
Question No. 8
Mohan & Co. is considering the purchase of a machine. Two machines X and Y each costing ` 50,000 are
available. Earnings after taxation are expected to be as under:

Year
Machine X(`)
Machine Y(`)
Discount factorat 10%
1st
15,000
5,000
.9091
2nd
20,000
15,000
.8264
3rd
25,000
20,000
.7513
4th
15,000
30,000
.6830
5th
10,000
20,000
.6209
Estimate the two alternatives according to

(i) Payback method;
(ii) Return on investment method;
(iii) Net present value method a discount rate of 10% is to be used.
(i) Payback method:
Year
Earning
Machine X(`)
Earning
Machine Y(`)
Cumulative Earning
Machine X (`)
Cumulative Earning
Machine Y (`)
1st
15,000
5,000
15,000
5,000
2nd
20,000
15,000
35,000
20,000
3rd
25,000
20,000
60,000
40,000
4th
15,000
30,000
75,000
70,000
5th
10,000
20,000
85,000
90,000
Pay back period for Machine X
Pay back period for Machine Y
15,000
12 year
25,000
2 years +
2 years 7 months 6 days.
3 years +
3 years 4 months
10,000
12 year
30,000
(ii) Return on Investment Method:

PARTICULARS
MACHINE X
MACHINE Y
Total of Cash flows
` 85,000
` 90,000
Average Annual Cash flows
` 85,000/5
` 90,000/5
= ` 17,000
= ` 18,000
Annual Depreciation (` 50,000/5)
` 10,000
` 10,000
Annual Net Savings
` 17,000 10,000
` 18,000 10,000
= ` 7,000
= ` 8,000
` 50,000/2
` 50,000/2
= ` 25,000
= ` 25,000
Average Investment
434 PP-FT&FM
Return on Investment
Annual Net Savings

100
Average Investment
7,000 100 8,000 100

7,000 100 8,000 100
25,000
25,000 25,000
25,000
28%
32%
Note: In this case, Net cash flows after depreciation have been calculated for arriving at the ROI. The question
can be solved with gross cash flows also.
(iii) Net present value method
Calculation of Present Value of Cash Flows
Year Discount factor at 10%
Machine X
Machine Y
Cash flow
P.V.
Cash flow
P.V.
.9091
15,000
13,636
5,000
4,545
.8264
20,000
16,528
15,000
12,396
.7513
25,000
18,782
20,000
15,026
.6832
15,000
10,245
30,000
20,490
.6209
10,000
6,209
20,000
12,418
85,000
65,400
90,000
64,875
Net Present Value
= Present value Initial Investment
Net Present Value of Machine X = ` 65,400 ` 50,000

= ` 15,400
Net Present Value of Machine Y = ` 64,875 ` 50,000
= ` 14,875
It is evident from the above calculations that machine X would be preferred under the pay-back method and Net
Present Value Method while machine Y would be preferred under the return on investment method. But NPV
method is more scientific and therefore investment in Machine X will be more profitable while taking the time
value of cash inflows into consideration.
Question No. 9
Calculation the payback period, accounting rate of return, net present value and internal rate of return for the
following investment:
Year
Cashflow (`)
(30,000)
4,000
10,000
20,000
11,000

The discount rate for discounted cashflow (DCF) calculation is 12 per cent. Accounting profits are the same
as cashflow except that the initial expenditure should be depreciated over 4 years; there is no resale value at
year 4.
Calculation of Pay Back Period
Year
(`)
Cashflow
Inflow (`)
(30,000)
4,000
4,000
10,000
14,000
20,000
34,000
11,000
45,000
Pay back period = 2 years + (16/20 x 12) = 2.8 years (app.)

Accounting Rate of Return
Annual depreciation
= 30,000/4 = ` 7,500
Accounting profits/(losses) =
In `
(`)
Year 1
4,000 7,500
= (3,500)
Year 2
10,000 7,500
= 2,500
Year 3
20,000 7,500
= 12,500
Year 4
11,000 7,500
= 3,500
15,000
`15,000
Average profits =
= ` 3,750
4
`3,750 100
ARR =
= 12.5%
`30,000
Net Present value
Year
Cashflow(`)
DF@12%
PV (`)
(30,000)
1.0
(30,000)
4,000
0.8929
3,572
10,000
0.7972
7,972
20,000
0.7118
14,236
11,000
0.6355
6,991
NPV
2,771
Cumulative Cash
436 PP-FT&FM
Internal Role of return
Discount at 16% and use linear interpolation:
Year
Cashflow (`)
DF@16%
PV (`)
(30,000)
1.0
(30,000)
4,000
0.8621
3,448
10,000
0.7432
7,432
20,000
0.6407
12,814
11,000
0.5523
6,075
NPV = ` (231)
2,771
4% 15.7%
IRR = 12% +
2771 231
Question No. 10
The management of a company has two alternative projects under consideration. Project A requires a capital
outlay of ` 1,20,000 but Project B needs ` 1,80,000. Both are estimated to provide a cash flow for five years: A
` 40,000 per year and B ` 58,000 per year. The cost of capital is 10%. Show which of the two projects is
preferable from the viewpoint of (i) Net Present Value; and (ii) Internal rate of Return.
(i) Determination of NPV
Years
CFAT Project in `
15
40,000
58,000
P.V. Factor
Total P.V. in `
A
3.791
` 1,51,640
2,19,878
Less: Cash Outlay
1,20,000
1,80,000
Net Present Value
31,640
39,878
In the above case, Project B is preferable as its NPV is more than that of A.
(ii) Determination of IRR
Payback Period =
=
180
, ,000
58,000
120
, ,000
40,000
= 3 years (Project A)
= 3.1034 (Project B)
Annuity Table indicates that closest factor to 3.0 against five years are 3.058 (19%) and 2.991 (20%).
By interpolation, we get
IRRA = r1
= 19
(PVCFAT PVC ) 1
PV
(122
, ,320 120
, ,000)
1
2680
= 19 + 0.86

= 19.86%
In case of Project B, Annuity Table indicates that closest factor to 3.0134 against five years are 3.127 (18%) and
3.058 (19%). By interpolation, we get
IRRB = 18
= 18
(181366
, ,
180
, ,000)
1
4,002
(1366)
,
1
(4,002)
= 18 + 0.34 = 18.34%
So project A is preferable as its IRR is greater that of B.
Question No. 11
Andhra Pradesh Udyog is considering a new automatic blender. The new blender would last for 10 years and
would be depreciated to zero over the 10 year period. The old blender would also last for 10 more years and
would be depreciated to zero over the same 10 year period. The old blender has a book value of ` 20,000 but
could be sold for ` 30,000 (the original cost was ` 40,000). The new blender would cost ` 1,00,000. It would
reduce labour expense by ` 12,000 a year. The company is subject to a 50% tax rate on regular income and a
30% tax rate on capital gains. Their cost of capital is 8%. There is no investment tax credit in effect.
You are required to
(a) Identify all the relevant cash flows for this replacement decision.
(b) Compute the present value, net present value and profitability index.
(c) Find out whether this is an attractive project?
(a) Tax on the sale of the old machine:
Original cost
` 40,000
Sale Price
` 30,000
Book value
` 20,000
Profit
` 10,000
Tax
50% of ` 10,000 = 5,0000
After tax cash receipts from sale of old machine:

Sale Price
` 30,000
Taxes on sale
5,000
After-tax cash receipts
` 25,000
Net cash flow to replace old machine with new:

Cost of new machine
` 100,000
After-tax receipt from sale of old machine
` 25,000
Net cash flow to replace old machine with new
` 75,000
Depreciation on new machine
= 1,00,000/10 =
` 10,000
Depreciation on old machine
` 2,000
20,000/10 =
438 PP-FT&FM
Book Value in `
Cash flow in `
12,000
12,000
Annual labour savings

Increased depreciation (` 10,000 ` 2,000)
8,000
Increased earnings before tax
4,000
Increased tax
2,000
2,000
Increased earnings after tax
2,000
Increased after-tax cash flow
10,000
(b) Calculation of present value at 8% discount rate are tabulated below:

Year
Cash flow
Present value factor
Present value
1-10
` 10,000
6.710
` 67,100
Present value
` 67,100
Net present value
` 67,100 ` 75,000
= () ` 7,900
Profitability Index
` 67,100/` 75,000
= .895
(c) Since the net present value is negative and profitability index is less than one, the project is not an attractive
project.
Question No. 12
A most profitable company in the country is faced with the prospect of having to replace a large stamping
machine. Two machines currently being marketed will do the job satisfactorily. The Zenith Stamping machine
costs ` 100,000 and will require cash running expenses of ` 40,000 per year. The Godrej Stamping machine
costs ` 150,000 but running expenses are only expected to be ` 30,000 per year. Both machines have a tenyear useful life with no salvage value and would be depreciated on a straightline basis.
(a) If the company pays a 50% tax rate and has 10% after-tax required rate or return, which machine should
it purchase?
(b) Would your answer be different if the required rate of return were 8%?
Godrej
Zenith
Differential
` 1,50,000
` 1,00,000
`50,000
Operating expenses
30,000
40,000
10,000
Depreciation
15,000
10,000
5,000
Initial outlay
Expenses savings-depreciation
5,000
Tax on the above
2,500
Cash flow
7,500
(Expenses savings of ` 10,000 - tax)

Present value of Re. 1 received each year for 10 year
5.6502
7,500 x 5.65
42,376

Since the present value of the incremental cash flow benefits ` 42,376 is less than the differential cash outlay of
` 50,000, the additional cost of the Godrej machine cannot be justified. Thus, the Zenith machine should be
purchased.
(b) Present value of Cash flow at 8% for 10 year = ` 7,500 x 6.7101 = ` 50,336
Since the present value of incremental benefits, ` 50,336 now exceeds ` 50,000 the Godrej machine should
be purchases.
Question No. 13
Saroj & co. is considering purchase of a machine that will enable production to increase by 2.5% (from 40,000
units to 50,000 units). The machine costs Re. 1 lakh and has a useful life of 10 years with a salvage value of 5%.
The company is eligible for investment allowance of 25%. There will be increased requirement of working
capital to the extent of ` 20,000. The following additional information is also furnished to you :
Variable cost (per unit)
`5
Fixed cost (per annum)
` 1,00,000
The variable costs will remain the same but the fixed costs will increase by the amount of depreciation on the
new machine. The current selling price is ` 10 per unit, which may have to be brought down by 50 paise in order
to sell the entire production of 50,000 units.
The company adopts straight line method of depreciation, tax rate is 50% and the minimum required rate of
return is 15%. P.V. factors at 15%.
(i) Present value of an annuity of Re. 1 at the end of 9 years
= 4.772
(ii) Present value of Re. 1 receivable at the end of the 10 years
= 0.247
Discuss if it would be advisable for the company to purchase the machine.

1. Cash Outflows (Period):
`
Cost of new machine
1,00,000
Working capital increase
20,000
Tax saving on account of investment allowance* i.e. (25% of ` 1 lakhs x 50%)
(12,500)
Net cash outlay
1,07,500
*This could also be considered at year 1 end.

2. Cash inflows (year to year 9):
Revenues:
Existing
Proposed
4,00,000
40,000 units @ ` 10
50,000 units @ ` 9.50
4,75,000
Variable cost
40,000 units @ ` 5
2,00,000
440 PP-FT&FM
50,000 units @ ` 5
_______
2,50,000
Contribution margin
2,00,000
2,50,000
Fixed cost
1,00,000
**1,09,500
Surplus
1,00,000
1,15,500
Excess marginal contribution
15,500
Less: Tax @ 50%
7,750
Incremental Cash Flow from year 1 to 9 after tax (including depreciation)` 7,750 + ` 9,500
= ` 17,250
3. Cash Inflow (10th year):
`
Annual incremental cash flow
17,250
Working capital recovered
20,000
5% salvage value of machine
5,000
42,250
4. Present value of Cash Flows:

Year
Cash flow
(` )
P.V. at 15%
Total P.V
(` )
1-9
17,250
4,772
82,317.00
10
42,250
0.247
10,435.75
Total
92,752.75
P.V. of outlays
1,07,500.75
Net Present Value
(14,747.25)
The machine yields negative P.V. of (`14,747.25) and hence should not be procured. Therefore, it would not be
advisable for the company to purchase the machine.
**Note: Depreciation =
Cost - Salvage Value

Useful life
Rs. 1,00,000 - Rs. 5,000

= Rs. 9,500 p.a.
10
Fixed cost = ` 1,00,000 + ` 9,500 = ` 1,09,500.

Question No. 14
Rama manufacturing company must choose between constructing a large or small factory to produce a new line
of products. The large plant would be needed if the future brings a high demand for new products. But the large
plant would have a net cash inflows below the ` 20,00,000 outlay, if demand for the product is medium or
low. The present value of cash inflows are ` 28,00,000 with high demand, ` 18,00,000 with medium demand
and ` 12,00,000 with low demand. The smaller plant produces a lower return if demand is high but has positive
net present values at medium demand for the products. It would cost ` 4,00,000 as a cash outlay and would

return a present value inflow of ` 6,40,000 with high demand, ` 5,40,000 with medium demand and `
3,60,000 with low demand. What is the net present value (NPV) of each alternative if there is 40% chance of
high demand and 20% chance of low demand.
Capital outlay for large project ` 20,00,000
Probabilities of demand for products
Present value of cash inflow

(` )
Expected Return
(` )
3=1x2
High demand (.40)
28,00,000
11,20,000
Medium demand (.40)
18,00,000
7,20,000
Low demand (.20)
12,00,000
2,40,000
Total Expected Return
20,80,000
Less: Capital outlay
20,00,000
NPV
80,000
Capital outlay for small project ` 4,00,000

Probabilities of demand for products
Present value of cash inflow

(` )
Expected Return
(` )
3=1x2
High demand (.40)
6,40,000
2,56,000
Medium demand (.40)
5,40,000
2,16,000
Low demand (.20)
3,60,000
72,000
Total Expected Return
5,44,000
Less: Capital outlay
2,00,000
NPV
1,44,000
From the above it is clear that the small factory is a better investment on NPV basis.
Question No. 15
A product is currently being manufactured on a machine that has a book value of ` 30,000. The machine was
originally purchased for ` 60,000 ten years ago. The per unit costs of the product are: Direct labour ` 8.00;
direct materials ` 10.00; variable overheads ` 5.00; fixed overheads ` 5.00; and total is ` 28.00. In the past year
6,000 units were produced and sold for ` 50.00 per unit. It is expected that the old machine can be used
indefinitely in the future.
An equipment manufacturer has offered to accept the old machine at ` 20,000, a trade-in for a new version. The
purchase price of the new machine is ` 1,00,000. The projected per unit costs associated with the new machine
are: direct labour ` 4.00; direct materials ` 7.00; variable overheads ` 4.00; fixed overheads ` 7.00; and total is
` 22.00.
The management also expects that, if the new machine is purchased, the new working capital requirement of
the company would be less by ` 10,000. The fixed overheads costs are allocations from other departments plus
the depreciation of the equipment. The new machine has an expected life of ten years with no salvage value; the
straight line method of depreciation is employed by the company. It is also expected that the future demand of
442 PP-FT&FM
the product would remain at 6,000 units per year. Should the new equipment be acquired? Corporate tax is @
50%.
Notes:
(i) Present value of annuity of Re. 1.00 at 10% rate of discount for 9 years is 5.759.
(ii) Present value of Re. 1.00 at 10% rate of discount, received at the end of 10th year is 0.386.
Determination of Cash Outflows t = 0
`
Cost of new machine
1,00,000
(i)
Sale value of old machine
(ii)
Tax saving due to direct loss on the sale of old machine

@ 50% on ` 10,000 (i.e. 30,000 20,000)
(iii)
Release of working capital
Less :
20,000
5,000
10,000
Net cash outflows
35,000
65,000
Calculation of Cash Inflows:
`
I.
II.
Cost saving after tax:

Cost saving: 6,000 x 8*
48,000
Less: Tax @ 50%
24,000
24,000
Tax saving on additional depreciation

Depreciation on new machine
10,000
Less: Depreciation on old machine
3,000
Additional Depreciation
7,000
Tax saving @ 50% on ` 7,000
3,500
Cash inflows after tax i.e. CFAT (t = 1 to 10)
27,500
Determination of Net Present Value:

Year
CFAT (A)
PV factor at 10% (B)
110
` 27,500
x 6.145 = (5.759 + 0.386)
Less: Present value of cash outlay

Since NPV > 0 therefore, the new equipment should be acquired.
*Variable cost (i.e. cost saving per unit):
Total P.V. (A x B) (`)

1,68,987.50
65,000.00
1,03,987.50

`
Old machine
23
Less: New machine
() 15
8
Question No. 16
Apollo Ltd. manufactures a special chemical for sale at ` 30 per kg. The variable cost of manufacture is ` 15 per
kg. Fixed cost excluding depreciation is ` 2,50,000. Apollo 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 replaced, the company can achieve maximum
capacity in the next 5 years gradually increasing the production by 10% a year.
The finance manager estimates that for each 10% increase in capacity, the additional increase in fixed cost will
be ` 50,000. The existing machines with a current book value of ` 10,00,000 and remaining useful life of 5 years
can be disposed of for ` 5,00,000. The vice-president (finance) is willing to replace the existing machines
provided the NPV on replacement is ` 4,53,000 at 15% cost of capital.
(a) You are required to compute the total value of machines necessary for replacement. For computations,
you may assume the following:
(i) All the assets are in the same block. Depreciation will be on straight line basis and the same is
allowed for tax purposes.
(ii) There will be no salvage value for the new machines. The entire cost of the assets will be depreciated
over a five year period.
(iii) Tax rate is 46%.
(iv) Cash inflows will accrue at the end of the year.
(v) Replacement outflow will be at the beginning of the year (year 0).
(b) On the basis of data given above, the managing director feels that the replacement, if carried out, would
at least yield a post-tax return of 15% in three years provided the capacity build up is 60%, 80% and
100% respectively. Do you agree? Give reasons.
Year 1
Year 2
Year 3
Year 4
Year 5
Present value factor

at 15%
0.87
0.76
0.66
0.57
0.50
Present value annuity

factor at 15%
0.87
1.63
2.29
2.86
3.36

(a) Determination of total replacement value of machines
Incremental cash outflows:
Cost of replacement of new machines
Less: Disposal value of existing machines
Cash outflows required
=`X
= ` 5,00,000
= (X ` 5,00,000)
444 PP-FT&FM
Determination of cash flows after tax (CFAT) and Net Present Value (NPV) (excluding depreciation)
Years
1
Increase Production
and sales (kg) ...(I)
10,000
20,000
30,000
40,000
50,000
Contribution per
unit (Sales Price
Variable Cost) i.e.
` 30 ` 15) ...(II)
15
15
15
15
15
1,50,000
3,00,000
4,50,000
6,00,000
7,50,000
50,000
1,00,000
1,50,000
2,00,000
2,50,000
1,00,000
2,00,000
3,00,000
4,00,000
5,00,000
Less: Taxes @ 46%

(VI)
46,000
92,000
1,38,000
1,84,000
2,30,000
Earnings after
taxes ...(V VI)
54,000
1,08,000
1,62,000
2,16,000
2,70,000
0.87
0.76
0.66
0.57
0.50
46,980
82,080
1,06,920
1,23,120
1,35,000
Incremental
Contribution
(I x II) ...(III)
Incremental fixed
cost ...(IV)
Incremental
profits (III IV) ...(V)
PV Factor
Total Present Value (`)
Total Present Value for 5 years (T = 1 5) ` 4,94,100 ..(A)

Base for Incremental Depreciation
`
Current book value of existing machine
10,00,000
Add: Cost of new machines
Less: Sale proceeds of existing machine
5,00,000
Depreciation base of new machine
X + 5,00,000
Less: Depreciation base of existing machine

Base for Incremental Depreciation
10,00,000
X 5,00,000
Calculation of Present Value of tax savings on Incremental Depreciation for years 15

Incremental Depreciation per year
= X 5,00,000 / 5
= 0.20 X 1,00,000
Tax Rate
= 0.46
Present Value Factor of annuity for 5 years = 3.36

Present Value of tax savings on Incremental Depreciation for years 1 5 = Incremental Depreciation per year

Tax rate ` PV of annuity for 5 years
= 0.20X 1,00,000) x 0.46 x 3.36
= 0.30912X ` 1,54,560
Total Present Value
...(B)
= (A) + (B)
= ` 4,94,100 + 0.30912X ` 1,54,560
= ` 3,39,540 + 0.30912X
Net present value = Present value of cash flows after tax Present value of outflows
` 4,53,000
= ` 3,39,540 + 0.30912X (X ` 5,00,000)
` 4,53,000
= ` 3,39,540 + 0.30912X X + ` 5,00,000
0.69088X
= ` 3,39,540 + ` 5,00,000 ` 4,53,000

X=
3,86,540
= ` 5,59,489
0.69088
Total value of machines required for replacement is ` 5,59,489

(b) Financial evaluation whether replacement would yield post-tax return of 15% in 3 years
1
10%
30%
50%
` 10,000
` 30,000
` 50,000
` 15
` 15
` 15
` 1,50,000
` 4,50,000
` 7,50,000
` 50,000
` 1,50,000
` 2,50,000
` 1,00,000
` 3,00,000
` 5,00,000
` 11,898
` 11,898
` 11,898
Earnings before taxes
` 88,102
` 2,88,102
` 4,88,102
Less: Taxes (0.46)
` 40,527
` 1,32,527
` 2,24,527
` 47,575
` 1,55,575
` 2,63,575
` 59,473
` 1,67,473
` 2,75,473
0.87
0.76
0.66
` 51,742
` 1,27,279
` 1,81,812
Increased Capacity (%)

Increased sales
Contribution (Sales V.C.)
i.e. (` 30 ` 15)
Incremental Contribution
Less: Incremental fixed cost
Less: Incremental Depreciation
(Rs. 5,00,000 + 5,59,489 10,00,000) Rs. 59,489
5 years
5
Cash flow after tax

(Earnings after tax +
Deprecation)
Present Value Factor at 15%
Present Value
446 PP-FT&FM
Total Present Value
= ` 3,60,833
Less: Incremental Cash Outflows
=`
Net Present Value
59,489
` 3,01,344
Hence, the assessment of the managing director is correct as the Net Present Value is positive.
Question No. 17
The management of Rohit Ltd. is considering the replacement of machine which has current written down value
of `25,00,000 and a present sale value of `8,00,000. The machine is still usable for 5 years, but will have no
scrap value at the end of 5 years.
A new machine having a useful life of 5 years and scrap value of ` 1,00,00,000 at the end of this is available for
` 10,00,000. The installation of the new machine, it is estimated, would result in saving of ` 20,00,000 per
annum in operating cost at the present level of production. The capacity of new machine is more than that of old,
and since sales are no Question, utilisation of additional capacity would bring in an additional contribution of `
25,00,000 per annum (after meeting incremental costs of production and sale). This machine would be depreciated
@ 25 per cent on written down basis.
The company has other assets in the block. Current income tax is 35 per cent. Considering the companys
estimated cost of capital, it will not pay to purchase the new machine unless the net savings are 20% or more,
on the added investment. Should the company replace the existing machine?
(`)
Existing Machine
Current Written Down Value of Machine
25,00,000
Present Sale Value of Machine
8,00,000
Life of Machine
5 years
Scrap Value after 5 years
New Machine
Scap Value
10,00,000
Cost Price
1,00,00,000
Life of Machine
5 years
Calculation of Cash Flows for 5 years
(`)
1
Saving in Operating Cost
20,00,000
20,00,000
20,00,000
20,00,000
20,00,000
Contribution
25,00,000
25,00,000
25,00,000
25,00,000
25,00,000
EBIT
45,00,000
45,00,000
45,00,000
45,00,000
45,00,000
Incremental Depreciation
16,75,000
12,56,250
9,42,187
70,664
5,29,980
EBIT
28,25,000
32,43,750
35,57,813
37,93,359
39,700
98,750
11,35,313
12,45,234
13,27,676
13,89,507
Less Tax (@ 35%)

PAT
18,36,250
21,08,438
23,12,579
24,65,683
25,80,513
NPV
15,30,147
14,64,099
13,38,289
11,89,199
1,03,78,108
Total PV
65,58,842.3
As the Net Present cash inflow in negative, it is not advisable to purchase the machine.
Old Machine Cost
` 25,00,000
New Machine Cost
` 1,00,00,000 ` 8,00,000
Sale Value of Machine
` 92,00,000
Calculation of Incremental Depreciation
(`)
Year
Old machine
New machine
Incremental Depreciation
625000
2300000
1675000
468750
1725000
1256250
351563
1293750
942187
263672
970313
706641
197754
727734
529980
Question No. 18
Strong Enterprises Ltd. is a manufacturer of high quality running shoes. Ms. Dazling, President, is considering
computerising the companys ordering, inventory and billing procedures. She estimates that the annual savings
from computerisation include a reduction of ten clerical employees with annual salaries of `15,000 each, `8,000
from reduced production delays caused by raw materials inventory Questions, `12,000 from lost sales due to
inventory stockouts and `3,000 associated with timely billing procedures. The purchase price of the system is
`2,00,000 and installation costs are `50,000. These outlays will be capitalised (depreciated) on a straight-line
basis to a zero book salvage value which is also its market value at the end of five years. Operation of the new
system requires two computer specialists with annual salaries of `40,000 per person. Also annual maintenance
and operating cash expenses of `12,000 are estimated to be required. The companys tax rate is 40% and its
required rate of return (cost of capital) for this project is 12%.
You are required to
(a) find the projects initial net cash outlay.
(b) find the projects after tax profit and cash flows over its 5-year life.
(c) evaluate the project using Net Present Value (NPV) method.
(d) evaluate the project using Profitability Index (PI) method.
(e) calculate the projects payback period.
(f) find the projects cash flows and NPV [parts (a) through [(c)] assuming that system can be sold for
`25,000 at the end of five years even though the book salvage value will be zero.
(g) find the projects cash flows and NPV [parts (a) through (c)] assuming that the book salvage value of
depreciation purposes is `20,000 even though the machine is worthless in terms of its resale value.
448 PP-FT&FM
NOTE:
(i) Present value of annuity of Re. 1 at 12% rate of discount for 5 years in 3.605.
(ii) Present value of Re. 1 at 12% rate of discount, received at the end of 5 years is 0.567.
(a) Projects Initial cash outlay
`
Cost
2,00,000
Installation Expenses
50,000
Total Net Cash Outlay
2,50,000
(b) Projects after tax profit and cash inflows over its 5-year life
Savings
Reduction in clericals salaries
1,50,000
Reduction in production delays
8,000
Reduction in lost sales
12,000
Gains due to timely production
3,000
1,73,000
Less: Expenses
Depreciation
50,000
Addl. employees cost
80,000
Maintenance cost
12,000
1,42,000
Profit before Tax
31,000
Less: Tax (40%)
12,400
Profit after Tax
18,600
Cash inflow
= PAT + Depreciation
= ` 18,600 + ` 50,000 = ` 68,600
The cash flow is the same for the years 1 to 5.

(c) Evaluation of the Profit by using NPV Method
Years
Cash inflow
after tax (`)
PV of Annuity of Re. 1 at
12% for five years
(1 to 5)
68,600
3.605
2,47,303
Less: total Initial Cash Outlay
2,50,000
NPV
Since NPV is negative, the project is unviable.
(d) Evaluation of the Project by using PI Method
Profitability Index (PI)
= PV of cash inflows/Initial outlay
Total present value (`)
( ` 2,697)

= 2,47,303/2,50,000 = 0.989
Since PI is less than 1.0, the project is unviable.
(e) Calculation of the Projects Payback Period
Year
Net cash inflow (`)
Cumulative cash inflow (`)
68,600
68,600
68,600
137,200
68,600
205,800
68,600
274,400
68,600
343,000
Payback period = 3 yeas + (` 2,50,000 ` 2,05,800)

68,600
Therefore, the payback period is 3.64 years.
(f) Calculation of cash flows and NPV assuming when the system can be sold for ` 25,000 at the end of
5 years.
In case the project has a salvage of ` 25,000 at the end of five years, present value of the after tax salvage
amount is required to be added to the current NPV.
Post tax salvage value in year 5 = ` 15,000.
Present value of ` 15,000 discounted at 12% is (` 15000 0.567) = ` 8,505 Previous NPV of the projects is `
2697. [see above] New NPV is ` 8,505 ` 2,697 = ` 5,808, Since NPV > 0, the project is viable.
(g) Projects cash flow and NPV assuming that book salvage value for depreciation purposes is ` 20,000.
Depreciation = ` 2,50,000 ` 20,000/5 = ` 46,000 per year
Cash flow for the years 1 to 5 are ` 67,000*.
In year 5, the firm get an additional tax credit on ` 20,000 book value, which is ` 8,000, the NPV of this additional
tax credit and new cash flow is ` 3,929**. Since NPV is negative the project is not viable.
`
Working*
Saving [see (b) above]
1,73,000
Less : Expenses
Depreciation
` 46,000
Addl. employees cost
` 80,000
Maintenance cost
` 12,000
1,38,000
Profit before tax
35,000
Tax (40%)
14,000
Profit after tax
21,000
450 PP-FT&FM
Cash inflow = PAT + Depreciation = ` 21,000 + ` 46,000 = ` 67,000.
Working**
Years
Cash inflow (`)
PV factor at 12%
Total present value (`)
(1 to 5)
67,000
3.805 (Annuity)
2,41,535
8,000
0.567
4,536
Add. Tax Credit in 5th year

Total PV of cash inflow
2,46,071
Less: Total initial cash outlay
2,50,000
NPV
( ` 3,929)
Question No. 19
P. Ltd. has a machine having an additional life of 5 years, which costs `10,00,000 and has a book value of
`4,00,000. A new machine costing `20,00,000 is available. Though its capacity is the same as that of the old
machine, it will mean a saving in variable costs to the extent of `7,00,000 per annum. The life of the machine will
be 5 years at the end of which it will have a scrap value of `2,00,000. The rate of income-tax is 46% and P Ltd.s
policy is not to make an investment if the yield is less than 12% per annum. The old machine, if sold today, will
realise `1,00,000; it will have no salvage value if sold at the end of 5th year. Advise P. Ltd. whether or not the old
machine should be replaced. (Present value of Re. 1 receivable annually for 5 years at 12% = 3.605, present
value of Re. 1 receivable at the end of 5 years at 12% per annum = 0.567). Capital gain is tax free. Ignore
income-tax savings on depreciation as well as on loss due to sale of existing machine.
Net Cash Outlay on New Machine
`
Purchase Price
Less: Realisation from sale of old machine
Net Initial Investment
20,00,000
1,00,000
19,00,000
Cash Inflows
Annual saving in variable cost as a
Result of purchase of New Machine
7,00,000
Tax = 46%
Annual Saving in variable cost after tax = ` 7,00,000 (1 0.46) =
3,78,000
Present value for cash inflows annually

for 5 years @12% per annum = 3,78,000 x 3.605 =
13,62,690
PV of Salvage value (2,00,000 x 0.567)

at the end of 5 years @ 12% per annum
1,13,400
Total PV of Cash Inflows
14,76,090
Less: Initial Investment
19,00,000
Net Present Value
4,23,910

Since NPV of new machine is negative, it is not profitable for the company to go for new machine. Therefore, the
company should continue with the old machine.
Question No. 20
Norton Engineering company is considering the replacement of existing machine by a new one. The written
down value of the existing machine is ` 1,50,000 and its cash salvage value is ` 40,000. The removal of this
machine could cost ` 10,000 by way of labour charges etc. The purchase price of the new machine is ` 40 lakhs
and its expected life is 10 years. The company follows straight line depreciation without considering scrap
value. The other expenses associated with the new machine are carriage inward and installation charges `
30,000, cost of training workers to handle the new machine ` 10,000, additional working capital ` 20,000 (which
is assumed to be received back by sale of scraps in last year) and the fees paid to a consultant for his advice to
buy a new machine ` 20,000. The annual savings (before tax) from the new machine would amount to `
4,00,000. The income tax rate is 40%. The companys required rate of return is 12%. Should the company
replace the existing machine?
Note: Present value of Re. 1 at 12% discount rate are as follows:
Year
10
P.V.
.893
.797
.712
.636
.567
.507
.452
.404
.361
.322

Present Value of Cash Outflow:
`
Purchase Price of a new machine
40,00,000
Carriage inward for installation
30,000
Cost of Training to workers
10,000
Fees Paid to consultant
20,000
Total Investment on new machine
40,60,000
Add: Working capital
20,000
40,80,000
Less: Cash inflow at the start cash salvage value of old machine
Less: Removal charges
Less: Tax benefit on the loss of old machine (40%)
40,000
10,000
30,000
48,000
78,000
Total cash outflow
40,02,000
Annual Cash Inflow (New Machine):

Annual saving before tax
4,00,000
Less: Tax at 40%
1,60,000
Annual Saving after tax
2,40,000
Add: Depreciation (` 40,60,000 10)
4,06,000
Annual Cash inflow
6,46,000
452 PP-FT&FM
Statement Showing NPV of Cash Flows
Cash
inflows
PV Factor
12%
(` )
Annual Cash inflow for 10 years
Working capital received back after 10 years
Present
value
(` )
6,46,000
5.650
36,49,900
20,000
0.322
6,440
Total Present Value of Cash-inflow in 10 years
36,56,340
Present value of cash outflows in 1st year
40,02,000
NPV =
(3,45,660)
Recommendation: Since NPV is negative by ` 3,45,660, the company is advised not to buy the new machine.
`
@
Written down value of the old machine
1,50,000
Salvage Value
40,000
Less: Removal Charges
10,000
Loss on Salvaging the machine
30,000
1,20,000
Tax benefit due to loss on old machine (40%)
48,000
Note: Tax benefit has been presumed to have been realised at zero year. In practical life, tax benefit will be
realised at the year-end over and if this presumption is taken then ` 48,000 will have to be discounted by the
factor 0.893.
Question No. 21
A firm has an investment proposal, requiring an outlay of ` 40,000. The investment proposal is expected to have
2 years economic life with no salvage value. In year-1, there is a 0.4 probability that cash flow after tax (CFAT)
will be ` 25,000 and 0.6 probability that CFAT will be ` 30,000. The probabilities assigned to CFAT for the year2 are as follows:
If CFAT = ` 25,000
If CFAT = ` 30,000
Amount
Amount
Probability
(`)
Probability
(`)
12,000
0.2
20,000
0.4
16,000
0.3
25,000
0.5
22,000
0.5
30,000
0.1
The firm uses a 10% discount rate for this type of investment.
You are required to
(i) Present the above information in the form of a decision tree.
(ii) Find out the NPV under (a) the worst outcome; and (b) under the best outcome.
(iii) Find out the profitability or otherwise of the above investment proposal.

(i) Decision Tree
Probability Year 1
Probability Year 2
Path No.
Joint profitability
Year 1 & Year 2
0.4
` 25000
0.2
12000
0.08
0.3
16000
0.12
0.5
22000
0.20
0.4
20000
0.24
0.5
25000
0.30
0.1
30000
0.06
Cash Outlay
` 40,000
0.6
` 30000
1.00
The Decision Tree given above shows that there are six possible outcomes each represented by a path.
(ii) The Net Present Value (NPV) of each path at 10% discount rate is given below:
(Cash inflow
year 1 x Discount
factor year 1)(a)
(Cash inflow year

2 x Discount factor
year 2)(b)
Total
Cash
inflow
(c) =
(a)+(b)
Cash
Outflow
(d)
Net
present
value(e)
=(c)(d)
1.
(25,000 x 0.909) = 22,725
(12,000 x 0.826) = 9,912
32,637
40,000
7,363
2.
(25,000 x 0.909) = 22,725
(16,000 x 0.826) = 13,216
35,941
40,000
4,059
3.
( 25,000 x 0.909) = 22,725
(22,000 x 0.826) = 18,172
40,897
40,000
897
4.
(30,000 x 0.909) = 22,270
(20,000 x 0.826) = 16,520
43,790
40,000
3,790
5.
(30,000 x 0.909) = 22,270
(25,000 x 0.826) = 20,650
47,920
40,000
7,920
6.
(30,000 x 0.909) = 22,270
(30,000 x 0.826) = 24,780
52,050
40,000
12,050
Path
(a) If the worst outcome is realized, the Net Present Value which the project will yield in ` 7,363 (negative).
(b) The best outcome will be path 6 when Net Present Value is highest i.e. ` 12,050 (Positive).
(iii) Statement showing the Expected Net Present Value
Path
NPV @ 10% (a) `
Joint Probability (b) `
Expected PV(a) x (b) `
7,363
0.08
589.04
4,059
0.12
487.08
897
0.20
179.40
3,790
0.24
909.60
454 PP-FT&FM
5
7,920
0.30
2,376.00
12,050
0.06
723.00
1.00
3,111.88
Yes, the project will be accepted since the Expected Net Present Value is positive.
Question No. 22
A product is currently manufactured on a machine that is not fully depreciated for tax purposes and has book
value of ` 80,000. It was purchased for ` 2,40,000 twenty years ago. The costs of the product are as follows:
Unit Cost
(` )
Direct labour
28.00
Indirect labour
14.00
Other variable overhead
10.50
Fixed overhead
17.50
70.00
In the past year 10,000 units were produced. It is expected that with suitable repairs the old machine can be
used indefinitely in future. The repairs are expected to average ` 75,000 per year.
An equipment manufacturer has offered to accept the old machine as trade-in for a new equipment. The new
machine would cost ` 5,20,000 before allowing for ` 1,00,000 for the old equipment. The project costs associated
with the new machine are follows:
Unit Cost
(` )
Direct labour
14.00
Indirect labour
21.00
Other variable overhead
7.00
Fixed overhead
22.75
64.75
The fixed overhead costs are allocations for other departments plus the depreciation of the equipment.
The old machine can be sold now for ` 60,000 in the open market. The new machine has an expected life of 10
years and salvage value of ` 20,000 at that time. The current corporate income tax rate is assumed to be 50%.
For tax purpose cost of the new machine and the book value of the old machine may be depreciated in 10 years.
The minimum required rate is 10%. It is expected that the future demand of the product will stay at 10,000 units
per year. The present value of an annuity of Re. 1 for 9 years @ 10% discount factor is = 5.759. The present
value of Re. 1 received at the end of 10th year @ 10% discount factor is = 0.386.
Should the new equipment be purchased? (Assume no capital gain taxes).

Net Cash outlay on New Machine
`
Purchase Price
5,20,000
Less: Trade in value
1,00,000
4,20,000
Depreciation:
New Machine
Old Machine
Differential Depreciation per annum
50,000
8,000
42,000
Annual Cash Savings from New Machine

Variable Cost of product on new machine (A)
4,20,000
(10,000 units x ` 42)

Variable cost of product on old machine (B)
(10,000 units x ` 52.50) + Annual Repair
5,25,000
75,000
6,00,000
Differential savings (` 6,00,000 ` 4,20,000)

per annum
1,80,000
Taxable Saving (` 1,80,000 ` 42,000)
1,38,000
Less: Tax @ 50%
69,000
Income after tax
69,000
Add: Depreciation (Difference)
42,000
Cash flow per annum for 9 years
1,11,000
Cash flow for 10th year ` 1,11,000 + ` 20,000 salvage value
1,31,000
Present value of 1,11,000 annuity for 9 years

(` 1,11,000 x 5.759)
6,39,249
Present value of ` 1,31,000 at the end of 10th year

(` 1,31,000 x 0.386)
50,566
Present value of Total cash Inflow
6,89,815
Less: Cash outlay
4,20,000
Net Present Value
2,69,815
Recommendation: Since NPV is positive, new equipment should be purchased.
456 PP-FT&FM
COST OF CAPITAL
Question No. 23
In considering the most desirable capital structure for a company, the following estimates of the cost of debt and
equity capital (after tax) have been made at various levels of debt-equity mix:
Debt as percentage of
total capital employed
Cost of debt (%)
Cost of equity (%)
7.0
15.0
10
7.0
15.0
20
7.0
15.5
30
7.5
16.0
40
8.0
17.0
50
8.5
19.0
60
9.5
20.0
You are required to determine the optimal debt-equity mix for the company by calculating composite cost of
capital.
Composite Cost of Capital
Debt as % of
total capital
Cost of
debt %
Cost of
equity %
Composite
Cost of capital %
7.0
15.0
(7 x 0) + (15 x 1)
= 15.0
10
7.0
15.0
(7 x 0.10) + (15 x 0.9)
= 14.20
20
7.0
15.5
(7 x 0.20) + (15.5 x 0.80)
= 13.80
30
7.5
16.0
(7.5 x 0.30) + (16 x 0.70)
= 13.45
40
8.0
17.0
(8 x 0.40) + (17 x 0.60)
= 13.40
50
8.5
19.0
(8.5 x 0.50) + (19 x 0.50)
= 13.75
60
9.5
20.0
(9.5 x 0.60) + (20 x 0.40)
= 13.70
The optimal debt-equity mix for the company on the basis of composite cost of capital = 40 % debt
= 60 % Equity
When the composite cost of capital will be least i.e. 13.40.
Question No. 24
M/s Robert Cement Corporation has a financial structure of 30% debt and 70% equity. The company is considering
various investment proposals costing less than ` 30 lakhs.
The corporation 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
9%
13%
Above ` 5 lakhs and upto ` 20 lakhs
10%
14%
Above ` 20 lakhs and upto ` 40 lakhs
11%
15%
Above ` 40 lakhs and upto ` 1 crore
12%
15.5%
Upto ` 5 lakhs
Assuming the tax rate of 50% you are required to calculate:

(i) Cost of capital of two projects A and B whose funds requirements are ` 8 lakhs and ` 21 lakhs respectively,
and
(ii) If a project is expected to give after tax return of 11% determine under what conditions it would be
acceptable.
(i) Calculation of Weighted Average Cost of Capital
Project
Financing
Prop. of
capital
structure
Cost
before
tax (%)
Cost after
tax of
Capital
Weighted
cost
Upto ` 5 lakhs
Debt
0.30
9.00
4.50
1.35
Equity
Equity
0.70
13.00
13.00
9.10
Above ` 5 lakhs and

upto ` 20 lakhs
Debt
0.30
10.00
5.00
1.50
Equity
Equity
0.70
14.00
14.00
9.80
Above ` 20 lakhs and

upto ` 40 lakhs
Debt
0.30
11.00
5.50
1.65
Equity
Equity
0.70
15.00
15.00
10.50
Above ` 40 lakhs and

upto ` 1 Crore
Debt
0.30
12.00
6.00
1.80
Equity
Equity
0.70
15.50
15.50
10.85
10.45
11.30
12.15
12.65
(i) Project A costs ` 8 lakhs. In the above table one can see that Project A lies in the range of ` 5 lakhs and
` 20 lakhs. So the weighted average cost of capital for this amount to the company will be 11.30 per
cent. Similarly, for the project B which requires ` 21 lakhs and lies in the range of ` 20 lakhs and ` 40
lakhs the weighted average cost of capital will be 12.15 per cent.
(ii) A company may accept a project which is expected to give after tax return of 11% if project cost is below
` 5 lakhs. The project which requires above ` 5 lakhs may not be accepted by the company because the
expected rate of return on the project is low as against its cost of capital and thus acceptance of project
will adversely affect the value of share of the company.
458 PP-FT&FM
Question No. 25
Following are the details regarding capital structure of a company.
Book value
Market value
(`)
(%)
Debentures
80,000
76,000
Preference Capital
20,000
22,000
1,20,000
2,40,000
13
40,000
2,60,000
3,38,000
(`)
Equity Capital
Retained Earnings
Specific cost
You are required to calculate the weighted average cost of capital using (i) book value as weights (ii) market
value as weights. Can you imagine a situation where weighted average cost of capital would be the same using
either of the weights?
(i) Calculation of the weighted average cost of capital using book value weights:
Source of Capital
Amount of Book value (W) (`) SpecificCost (X)(%)
Totalcost (XW) (`)
Debentures
80,000
4,000
Preference Capital
20,000
1,600
1,20,000
13
15,600
40,000
3,600
Equity Capital
Retained Earning
2,60,000
Weighted average cost of capital (Ko)
24,800
XW
W
Total Costs
100
Total Capital
Rs. 24,800
100 9.54%
Rs. 2,60,000
Approximately
(ii) Calculation of the weighted average cost of capital using market value as weights:
Source of Capital
Marketvalue (W)(Rs)
SpecificCost (X)(%)
Totalcost (WX)(`)
Debentures
76,000
3,800
Preference Capital
22,000
1,760
1,80,000
13
23,400
60,000
5,400
Equity Capital
Retained Earning
3,38,000
Rs. 34,360
Ko
100
Rs. 3,38,000
= 10.17%
34,360

In our question the market value of equity share and retained earnings is ` 2,40,000 as against their book value
` 1,60,000. In relative term we can say that every equity funds of rupees 2 at book value have market value of
` 3/- (` 2,40,000/` 1,60,000). On basis of this criteria, we may calculate the value of retained earning and that of
equity shares as under.
Value of retained earnings = ` 40,000
, ,000
Value of Equity Share = ` 120
3
`Rs60,000
. 60,000
2
3
`Rs
.180
, ,000
18,0,000
2
The weighted average cost of capital computed on the basis of market value weight is higher than the weighted
average cost of capital computed on the basis of book value weights as in our Question. Because market value
of equity capital is higher than its book value.
The weighted average cost of capital would be the same under book value weights and market value weights
provided there is no difference in value of securities under both the cases.
Question No. 26
The Novex company has the following capital structure on 31st March, 2013
`
Ordinary shares (4,00,000 shares)
80,00,000
10% Preference shares
20,00,000
14% Debentures
60,00,000
1,60,00,000
The share of the company sells for ` 20. It is expected that company will pay next year a dividend of ` 2 per
share which will grow at 7 per cent forever. Assume a 40 per cent tax rate.
You are required to:
(a) Compute a weighted average cost of capital based on existing capital structure.
(b) Compute the new weighted average cost of capital if the company raises an additional ` 40 lakh debt by
issuing 15 per cent debenture. This would result in increasing the expected dividend to ` 3 and leave
the growth rate unchanged, but the price of share will fall to ` 15 per share.
(c) Compute the cost of capital if in (b) above growth rate increases to 10 per cent.
(a) Weighted Average Cost of Capital Existing Capital Structure
Amount
cost
After-tax
(%)
Weights
cost (%)
Weighted
Ordinary Shares
80,00,000
0.17
* 0.500
0.0850
10% Preference Shares
20,00,000
0.10
0.125
0.0125
14% Debentures
60,00,000
0.084
0.375
0.0315
Total
Weighted Average Cost of Capital (WACC)
1,60,00,000
0.1290
or 12.9%
460 PP-FT&FM
(K e )
*Cost of Ordinary Share
D1
g
P0
Rs. 2
0.07
Rs. 20
= 0.10 + 0.07 = 0.17

(b) Weighted Average Cost of CapitalNew Capital Structure
Amount
(` )
After-tax
cost
Weights
(%)
Weighted
cost (%)
Ordinary shares
80,00,000
0.27
0.40
0.108
20,00,000
0.10
0.10
0.010
14% Debentures
60,00,000
0.084
0.30
0.025
15% Debentures
40,00,000
0.09
0.20
0.018
Scripts
Total
**
2,00,00,000
0.161

**Cost of ordinary share
(K e )
or 16.1%
D1
g
P0
Rs. 3
0.07
Rs.15
= 0.20 + 0.07 = 0.27

(c) Weighted Average Cost of CapitalChanged Growth Rate
Scripts
Amount
(` )
After-tax
cost
Weights
(%)
Weighted
cost (%)
Ordinary shares
80,00,000
0.30
*** 0.40
0.120
20,00,000
0.10
0.10
0.010
14% Debentures
60,00,000
0.084
0.30
0.025
15% Debentures
40,00,000
0.09
0.20
0.018
Total
2,00,00,000

***Cost of ordinary share
(K e )
D1
g
P0
Rs. 3
0.10
Rs.15
= 0.20 + 0.10 = 0.30

Note: The book value weights have been used to calculate WACC in the above cases.
0.173
or 17.3%

MANAGEMENT OF WORKING CAPITAL
Question No. 27
From the given information for Ajanta manufacturing company, prepare an estimate of the requirement of working
capital.
Production
90,000 units
Selling Price per unit
` 5/-
Raw Materials
60% of selling price
Direct Wages
Overheads
Materials in hand
2 months requirements
Production time
1 month
Finished goods in stores
3 months
Credit for material
2 months
Credit allowed to customers
3 months
Average cash balance
` 30,000/-
Wages and overheads are paid at the beginning of the month following. In production all the required materials
are charged in the initial stage and wages and overheads accrue evenly.
Calculation of Working Capital Requirement
Amount in `
Amount in `
Current assets (level of production 90,000 units)

Current Assets:
Materials (90,000 x ` 3 x 2/12)
45,000
Work in Progress:
Materials (90,000 x ` 3 x 1/12)
22,500
Labour (90,000 x ` 0.50 x 1/12 x 1/2)
1,875
Overheads (90,000 x Re. 1 x 1/12 x 1/2)
3,750
28,125
Finished goods (90,000 x 90% x ` 5 x 3/12)
1,01,250
Debtors (90,000 x ` 5 x 3/12)
1,12,500
Cash
30,000
Total Current Assets (A)
3,16,875
Less: Current Liabilities

Creditors (90,000 x ` 3 x 2/12)
45,000
Outstanding wages (90,000 x Re. 0.50 x 1/12)
3,750
Outstanding Overheads (90,000 x Re. 1 x 1/12)
7,500
Total Current Liabilities (B)

Estimated Working Capital Requirements (AB)
56,250
2,60,625
462 PP-FT&FM
Question No. 28
The Management of Apollo Ltd. Has called for a statement showing the working capital needed to finance a level
of activity of 6,00,000 units of output for the year. The cost structure for the companys product, for the above
mentioned level is given as under:
Cost per unit (`)
Raw materials
20
Direct labour
Overheads
15
Total cost
40
Profit
10
Selling price
50
Past trends indicate that raw materials are in stock on an average for two months.
Work in progress will approximate to half a months production. Finished goods remain in warehouse on an
average for a month. Supplier of a materials extend a months credit.
Two months credit is normally allowed to debtors. A minimum cash balance of ` 60,000 is expected to be
maintained. The production pattern is assumed to be even during the year. Prepare the statement of working
capital determination.
Statement showing Cost & Profit
Per unit (`)
Amount for 6,00,000

Units of output (`)
20.00
1,20,00,000
5.00
30,00,000
Overheads
15.00
90,00,000
Total cost
40.00
2,40,00,000
Profit
10.00
60,00,000
Sales
50.00
3,00,00,000
Raw materials
Direct labour
Calculation of working capital requirement
`
2
, ,00,000
Raw materials (stock for two months) = 120
12
Work in progress 1/2 months production i.e. 1/2 month total cost
1
= 2,40,00,000
24
Finished goods remain in warehouse for one month
1
2,40,00,000
Total inventory one months total cost =
12
20,00,000
10,00,000
20,00,000

50,00,000
Debtor balances 2 months sales =
2
3,00,00,000
12
50,00,000
Cash balance (minimum as given in the question)
60,000
Total current assets

Less: Creditors =
1,00,60,000
1
120
, ,00,000
12
10,00,000
Working capital required
90,60,000
Question No. 29
M/s Kataria & Co. have approached their banker for their working capital requirement who have agreed to
sanction the same by retaining the margins as under:
Raw material
15%
Stock in Progress
30%
Finished goods
20%
Debtors
10%
From the following projections for 201314 you are required to work out:
(a) the working capital required by the company; and
(b) the working capital limits likely to be approved by bankers.
Estimates for 201314
Annual Sales
16,80,000
Cost of production
14,40,000
Raw material Purchases

Monthly Expenditure
8,15,000
45,000
Anticipated opening stock of raw materials
1,80,000
Anticipated closing stock of raw materials
1,55,000
Inventory Norms:
Raw material
Work in Progress
Finished goods
2 months
15 days
1 months
The firm enjoy a credit of 15 days on its purchases and allows 1 month credit on its supplies. On sales orders,
the company has received an advance of ` 25,000. State your assumption if any.
464 PP-FT&FM
Calculation of Monthly consumption of raw materials, monthly sales and
monthly cost of production
Raw materials
Opening Stock + Purchases (` 8,15,000 + ` 1,80,000)
` 9,95,000
Less closing stock
` 1,55,000
Annual Consumption
` 8,40,000
Rs. 8,40,000
Monthly Consumption =
12
` 70,000
` 1,40,000
` 1,20,000
Monthly Sales
Annual Sales Rs.16,80,000
12
12
Monthly Cost of Production
Cost of Production per year Rs.14,40,000
12
12
Calculation of Working capital required by Kataria & Co.

`
1. Raw materials 2 months consumption
1,40,000
2. Work in Progress 15 days Cost of Production
60,000
3. Finished Goods 1 month Cost of Production
1,20,000
4. Sundry debtor 1 month sales
1,40,000
5. Expenses for 1 month
45,000
5,05,000
8,15,000 1

Less : (i) Creditors 15 days purchases
2
12
= 33,959
(ii) Advance received on sales order
= 25,000
Working capital required by the company
58,959
4,46,041
Working capital limits set by bankers

1. Raw materials 2 months consumption
1,40,000
Less: 15% margin
21,000
2. Work in progress 15 days cost of production
60,000
Less: 30% margin
18,000
3. Finished goods 1 month cost of production

Less: 20% margin
4. Sundry Debtors 1 month sales
Less: 10% margin
5. For expenses
Total limit likely to be approved by bank
1,19,000
42,000
1,20,000
24,000
96,000
1,40,000
14,000
1,26,000
Nil
3,83,000

Question No. 30
A company is floated to manufacture a new chemical called moin. Currently moin is imported in India at a
landed cost of ` 8,500 per tonne. The following data have been collected regarding the project:
(i) Investment:
Land
= ` 1 lakh
Building
= ` 8 lakhs
Plant and machinery
= ` 12 lakhs
(ii) Cost of production:

Imported raw material
= ` 6,50,000
Indigenous raw material
= ` 6,26,000
Salaries and wages
= ` 1,35,000
Repairs and maintenance:

Depreciation:
5% on plant cost; and 2% on building cost

7% on plant; and 2-1/2% on building
Steam requirement
= ` 50,000
= ` 7,000 tonnes at ` 16 per tone
Power
Packing drums
= ` 60,000
= ` 30 each per 500 kgs.
(iii) Working capital requirements:

Imported raw material stock
6 months
Local raw material stock
3 months
Packing material stock
3 months
Finished product stock
1 month
Credit to customers
1 month
Credit from suppliers
1 month
Cash expenses
1 month
(iv) Expected production 250 M/T per annum.

(a) Calculate the total capital needed for the project.
(b) Assuming that the entire production can be sold at the imported price, calculate the percentage
yield on the investment and profit on sales.
(c) Also calculate the rate of cash generation per annum before taxation.
466 PP-FT&FM
Working:
Forecast Operating Statement
Raw materials imported
6,50,000
Raw materials local
6,26,000
Packing material 500 drums @ ` 30/- each
15,000
Salaries and wages
1,35,000
Repair and Maintenance: Plant
60,000
Building
16,000
50,000
Steam requirement
1,12,000
Power
60,000
Depreciation: Plant
84,000
Building
20,000
Total Cost
18,28,000
Production 250 M/T

Cost per tonne (` 18,28,000 250)
7,312
Selling price
8,500
Profit
1,188
Total profit per annum
2,97,000
Investment
` in lakh
Fixed Assets
1.00
Land
8.00
Building
12.00
Total
21.00
Answer to Question No. 30(i)

Working Capital
Stores: Raw Material:
Imported (` 6,50,000 x 6/12)
3,25,000
Local (` 6,26,000 x 3/12)
1,56,000
Packing (` 15,000 x 3/12)
3,750
Finished products (` 18,28,000 x 1/12)
1,52,333
Debtors (` 21,25,000 x 1/12)
1,77,083
Cash expenses (` 4,33,000 x 1/12)
36,083
8,50,749
Less: Suppliers credit (` 6,41,000 x 1/12)

Say ` 7,97,000
53,417
7,97,332

Answer to Question No. 30(ii)
It has been assumed that no credit is available in respect of imported raw material.
(a) Total Capital requirement
`/lakh
Investment
21.00
Working Capital
7.97
28.97
(b) Percentage yield on total investment =

Profit on sales:
2,97,000 100
Rs. 10.25%
Rs. 28,97,000
Rs. 1188
,
100 13.97%
Rs. 8,500
Answer to Question No. 30(iii)

Cash generation per annum:Profit + Depreciation
` 2.97 lakhs + ` 1.04 lakhs
= ` 4.01 lakhs
Question No. 31
PQR company is currently selling 2,00,000 units of its product @ ` 50 each. At the current level of production the
cost per unit is ` 45, variable cost per unit is ` 40. The company is currently extending one month credit. The
company is thinking of extending credit period to two months in the expectation that sales will increase by 20 per
cent. If the required rate of return on firms investment is 25 per cent, is the new credit policy desirable for the
company?
Calculation of total cost at new Sales Level
`
Cost at present level of sales (2,00,000 x ` 45)
90,00,000
Cost of increased sales (2,00,000 x 20%) x 40
16,00,000
Cost of Sales of 2,40,000 units

Average cost per unit of sales at the new level of Sales is =
1,06,00,000
106
, ,00,000
2,40,000
44.16
Calculation of Profitability and required rate of return

Profitability on additional sales [40,000 x (` 50 ` 40)]
4,00,000
Present average investment in receivables = ` 90,00,000/12
7,50,000
Average investment in receivable after change in credit policy

(` 1,06,00,000/6)
17,66,666
Additional investment in receivables (` 17,66,666 ` 7,50,000)
10,16,666
Required rate of return on additional investment (` 10,16,666 x .25)
2,54,166
468 PP-FT&FM
From above it is clear the new credit policy is acceptable to the company because profit on account of additional
sales is expected to increase by ` 4,00,000 as against the required rate of return of ` 2,54,166 on the additional
investment in receivable.
Assumptions :
(1) All sales are on credit sales.

(2) Fixed cost do not change.
Question No. 32
Compute maximum bank borrowings permissible under Method I, Method II and Method III of Tandon Committee
norms from the following figures and comment on each method:
` (lakhs)
Current Liabilities:
Current Assets:
Creditors for purchases
400
Other current liabiltiies
200
Bank borrowings inclu

bills discounted
discounted with bankers
` (lakhs)
Raw Materials
600
Work-in-process
Finished goods
Receivables including billswith bankers
800
80
360
800
200
____
1,400
Other current assets
40
1,480
Assume core current assets are ` 380 lakhs.

Maximum bank borrowings permissible under different methods of
Tandon Committee norms
Method I
(` in lakhs)
1480
Less: Current liabilities other than bank borrowings
600
Working capital gap
880
Less: Borrowers contribution of 25% of above from Long term sources
220
Maximum bank borrowings permissible
660
Excess borrowings (` 800 lakhs ` 660 lakhs)
140
Method II
1480
370
600
510
290

Method III
1480
Less: Core current assets (100% Contribution)
380
Real current assets
1100
275
825
600
225
575
Comments
Method I:
According to Method I prescribed by Tandon Committee the maximum permissible limit of bank
borrowings for the Company are ` 660 lakhs whereas actual bank borrowings are of ` 800
lakhs. Thus, there is excess amount of bank borrowing to the tune of ` 140 lakhs which may be
converted into term loan to be paid out gradually.
Method II:
According Method II, the Company has to get ` 290 lakhs converted into term loan to be phased
out gradually.
Method III:
As per Method III, excess borrowings of the Company from bank are ` 575 lakhs. Under this
method, the borrower has to finance core current assets also from the long-term sources. Till
the time the borrower is able to arrange for long-term funds, bank may convert the excess
amount of borrowings into term loan to be phased out in future.
Question No. 33
X Public Limited Company has obtained the following data concerning the average working capital cycle for
other components in the same industry.
Day
Raw material stock turnover
Credit received
20
(40)
Work in progress turnover
15
Finished goods stock turnover
40
Debtors collection period
60
95
Using the following information, you are required to calculate the current working capital cycle for X Public
Limited Co. and briefly comment on it.
470 PP-FT&FM
` (000)
Sales
3,000
Cost of sales
2,100
Purchases
600
Average raw material stock
80
Average work-in-progress
85
Average finished goods stock
180
Average creditors
90
Average debtors
350

Working capital cycle for X Public Ltd. Co. can be calculated in the following manner
Raw material stock
Less: Creditors
Work in progress
Finished goods stock
Debtors
Average raw material stock

365
Purchases
80
365 49 days approx.
600
Average creditors
Purchases
90
365 (55)days
60
Average work in Progress

365
Cost of goods sold
85
365 15 days
2100
Average finished goods stock

365
Cost of goods sold
180
365 31 days
2100
Average debtors
365
Sales
350
365 43 days
3000
Working capital cycle is 83 days = 49 55 + 15 + 31 + 43

Comments
Overall, the working capital cycle is below the industry average, indicating a lower investment in current assets.
However, the following point should be noted about the individual elements of working capital:
(a) The stock of raw material is considerably higher than the average. The stock control procedures should
be reviewed since these could possibly be reduced.

(b) The value of creditors is also above average. This indicates that X Ltd. Company is delaying the payment
of creditors beyond the credit period. Although this is an additional source of finance, it may result in a
higher cost of raw materials.
(c) The finished goods stock is below average. This may be due to high demand for the firms goods or to
efficient stock control. A low finished goods stock can be however, reduce sales since it can cause
delivery delays.
(d) Debts are collected more quickly than average. The Company may employ good credit control procedures
or may offer cash discount for early payment. This can, however, be done at the expense of profitability.
Question No. 34
Calculate the amount of working capital requirements for Jolly & Co. Ltd. from the following information :
` (per unit)
Raw materials
160
Direct labour
60
Over heads
120
Total cost
340
Profit
Selling price
60
400
Raw materials are held in stock on an average for one month. Materials are in process on an average for halfa-month. Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two months. Time leg in payment of
wages is 1-1/2 weeks. Time leg in payment of overhead expenses is one month. One fourth of the finished
goods is sold against cash.
Cash in hand and at bank is expected to be ` 50,000 ; and expected level of production amounts to 1,04,000
units.
You may assume that production is carried on evenly throughout the year, wages is equivalent to a month.
Total value method
Working:
1. Raw material inventory: Total cost of materials for the whole year (Fifty two weeks) is ` 1,66,40,000.
The monthly (four weeks ) consumption would be ` 12,80,000. Raw material requirement is for one
month, hence raw materials in stock would be ` 12,80,000.
2. Debtors: The average credit sales (per week) is ` 6,00,000. Therefore, a sum of ` 48,00,000 is the
amount of sundry debtors.
3. Creditors: Suppliers allow a one month credit period. Hence the average amount of creditors is `
12,80,000. Besides wages and overhead payable are:
Wages (1-1/2 weeks) = ` 1,80,000
Overheads (4 weeks) = ` 9,60,000
4. Work-in-process:
472 PP-FT&FM
`
(i) Raw materials in WIP
6,40,000
(ii) Labour cost (it is given in the question that labour and overheads accrue
evenly throughout the year or month. Thus on the first day of month it would
be zero, and on the last day of the month the WIP includes one months labour cost
on an average it is equivalent to 1 week labour cost).
1,20,000
(iii) Overhead (for 1 weeks as explained above)
2,40,000
Total WIP
10,00,000
5. Finished goods inventory:

One month cost of raw material
12,80,000
Labour
4,80,000
Overhead
9,60,000
27,20,000
Working capital requirements :

Current Assets (A):
Raw materials inventory
12,80,000
Debtors
48,00,000
Work-in-process
10,00,000
27,20,000
Cash
50,000
98,50,000
Current liabilities (B):

Creditors
12,80,000
Wages payable
1,80,000
Overheads payable
9,60,000
24,20,000
74,30,000
Alternate Cash Cost Method

Working capital requirements:
Current Assets
Raw materials inventory
12,80,000
*Debtors
40,80,000
Work-in-progress
10,00,000
27,20,000
Cash
50,000
Total
91,30,000

Current Liabilities:
Creditors
12,80,000
Wages payable
1,80,000
Overhead payable
9,60,000
Estimated Working Capital requirement (Balancing figure)
67,10,000
Total
91,30,000
*Debtors: The average credit sales (per week) is ` 5,10,000 (1,500 units x `340).
Question No. 35
In order to increase sales from the normal level of ` 2.4 lakhs per annum, the marketing manager submits a
proposal for liberalising credit policy as under :
Normal sales
` 2.4 lakhs
Normal credit period
30 days
Proposed increase in credit period

beyond normal 30 days
Relevant increase
over normal sales
(` )
15 days
12,000
30 days
18,000
45 days
21,000
60 days
24,000
The P.V. ratios of the company is 33-1/3%

The company expects a pre-tax return of 20% on investment. Evaluate the above four alternatives and advise
the management. (Assume 360 days a year)
Evaluation of Alternative
(` in lakhs)
Existing
Credit Policy
1
Proposed Credit Policy
(i) Credit period days
30
45
60
75
90
(ii) Credit period year
1/12
1/8
1/6
1/4.8
1/4
(iii) Sales
2.4
2.52
2.58
2.61
2.64
0.8
0.84
0.86
0.87
0.88
(iv) Contribution
(Sales x P/V ratio)
(v) Increase in contribution
474 PP-FT&FM
overexisting (a)
0.04
0.06
0.07
0.08
0.2
0.315
0.43
0.54375
0.66
(vii) Required pre tax return

on investment
0.04
0.063
0.086
0.10875
0.132
(viii) Increase in return on

investment over
existing (b)
0.023
0.046
0.06875
0.092
0.017
0.014
0.00125
(0.012)
(vi) Debtors balances

(Sales x Credit period)
(ix) Excess (a b)
It will be seen from the above calculation that there is maximum return when the credit period is for 45 days.
There is an excess of contribution over increase in return on investment. Therefore management is advised to
extend the credit period to 45 days.
Note: Investment in debtors could be calculated on variable cost basis also.
Question No. 36
Taxes Manufacturing Company Ltd., is to start production on 1st January, 2012. The prime cost of a unit is
expected to be ` 40 out of which ` 16 is for materials and ` 24 for labour. In addition variable expenses per unit
are expected to be ` 8, and fixed expenses per month ` 30,000. Payment for materials is to be made in the
month following the purchase. One-third of sales will be for cash and the rest on credit for settlement in the
following month. Expenses are payable in the month in which they are incurred.
The selling price is fixed at ` 80 per units manufactured and sold are expected to be as under :
January
900
April
2,100
February
1,200
May
2,100
March
1,800
June
2,400
Draw up a statement showing requirements of working capital from month to month, ignoring the question of
stocks.
Statement showing requirements of Working Capital (Jan. to June 2012)
January
February
March
April
May
June
21,600
28,800
43,200
50,400
50,400
57,600
14,400
19,200
28,800
33,600
33,600
30,000
30,000
30,000
30,000
30,000
30,000
Variable
7,200
9,600
14,400
16,800
16,800
19,200
Total (i)
58,800
82,800
1,06,800
1,26,000
1,30,800
1,40,000
Requirements:
Wages
Materials
Expenses:
Fixed
Receipts:

Cash sales
24,000
32,000
48,000
56,000
56,000
64,000
48,000
64,000
96,000
1,12,000
1,12,000
24,000
80,000
1,12,000
1,52,000
1,68,000
1,76,000
34,800
2,800
5,200
26,000
37,200
35,600
34,800
37,600
32,400
6,400
30,800
66,400
Sundry Debtors
(Credit Sales)
Total (ii)
Cash required:
[(i)(ii)]
Surplus (ii)(i)
Cumulative requirement
Cumulative Surplus
Question No. 37
Estalla Garment Co. Ltd. is a famous manufacturer and exporter of garments to the European countries. The
finance manager of the company is preparing its working capital forecast for the next year. After carefully screening
all the documents, he collected the following information:
Production during the previous year was 15,00,000 units. The same level of activity is intended to be maintained
during the current year.
The expected ratios of cost to selling price are:
Raw materials
40%
Direct wages
20%
Overheads
20%
The raw materials ordinarily remain in stores for 3 months before production. Every unit of production remains
in the process for 2 months and is assumed to be consisting of 100% raw material, wages and overheads.
Finished goods remain in warehouse for 3 months. Credit allowed by the creditors is 4 months from the date of
the delivery of raw material and credit given to debtors is 3 months from the date of dispatch.
The estimated balance of cash to be held: ` 2,00,000
1
Lag in payment of wages:
month
2
1
Lag in payment of expenses: 8 month
2
Selling price is ` 10 per unit. Both production and sales are in a regular cycle. You are required to make a
provision of 10% for contingency (except cash). Relevant assumptions may be made.
You have recently joined the company as an assistant finance manager. The job of preparing the forecast
statement has been given to you. You are required to prepare the forecast statement. The finance manager is
particularly interested in applying the quantitative techniques for forecasting the working capital needs of the
company. You are also required to explain the approach in the brief note to be prepared by you.
476 PP-FT&FM
Forecast statement of Working Capital Requirement of Estalla Garment Co. Ltd.
A. Current Assets
`
80
3
(i) Debtors 1,50,00,000

100
12
30,00,000
80
3
(ii) Finished goods 1,50,00,000

100 12
30,00,000
80
2
(iii) Work-in-progress 1,50,00,000

100 12
20,00,000
40
3
(iv) Raw materials 1,50,00,000

100 12
15,00,000
Total Current Assets (A)
________
95,00,000
B. Current Liabilities
`
40
4
(i) Creditors 1,50,00,000

100
12
20,00,000
20
1
(ii) Wages 1,50,00,000

100
24
1,25,000
20
1
(iii) Expenses 1,50,00,000

100 24
1,25,000
Total Current Liabilities (B)
________
22,50,000
`
Excess of current assets over current liabilities (A B)
72,50,000
Add: Provision of 10% contingency
7,25,000
79,75,000
Add: Balance of Cash available

Forecast of Working Capital Requirement
Working Notes:
Total sales of the company for the current year:
Total sales
Number of units sold x Price per unit
Total sales
15,00,000 x ` 10
` 1,50,00,000
2,00,000
81,75,000

Assumptions:
(i) All sales are made on credit basis.
(ii) The working capital blocked in debtors, finished goods and work-in-progress is taken at cost i.e. 80% of
selling price.
NOTE
Dated: 2.1.2013
From: Assistant Finance Manager
To: Finance Manager
Sir,
This has reference to your direction to prepare a brief note on application of quantitative techniques for forecasting
the working capital. In this connection, I hereby submit as under:
Apart from the estimation of working capital, as per operating cycle method, the following quantitative techniques
are also used for estimating the working capital needs of the company:
(i) Regression analysis method: The regression analysis method is very useful statistical technique of
forecasting working capital requirements. In the sphere of working capital management, it helps in
making projections after establishing the average relationship in the past years between sales and the
working capital and its various components. The analysis can be carried out through the graphic portrayals
(scatter diagram) or through mathematical formulae. The relationship between sales and working capital
may be simple and direct indicating complete linearity between the two or may be complex in differing
degrees involving simple linear regression and multiple regression situations. This method is suitable
for simple as well as complex situations.
(ii) Percent-of-sales method: It is a traditional and simple method of determining the level of working
capital and its components. In this method, working capital is determined on the basis of past experience.
If over the years, the relationship between sales and working capital is found to be stable, then this
relationship may be taken as base for determining the working capital for future. This method is simple,
easy to understand and useful in forecasting of working capital. However, this method is criticised on
the assumption of linear relationship, between sales and working capital. Therefore, this method is not
universally applicable.
Submitted please.
XYZ
(Assistant Finance Manager)
Question No. 38
A dealer having annual sales of ` 50 lakh extends 30 days credit period to its debtors. The variable cost is
estimated at 80% on sales and fixed costs are ` 6,00,000. The dealer intends to change the credit policy for
which the following information is given:
Credit Policy
Period (Days)
Average Collection
(` in lakhs)
Annual Sales
45
56
60
60
75
62
478 PP-FT&FM
Rate of return (pre-tax) required on investment is 20%.
You are required to assess the most profitable policy with the help of incremental approach. Calculations may be
restricted to two decimal places.
Evaluation of Proposed Credit Policies
Amount in lakhs (`)
Credit Policy
Present
Period (days)
30
45
60
75
Annual Sales
50
56
60
62
Variable Cost (80% on sales)
40
44.8
48
49.6
Fixed Cost
Total Cost
46
50.8
54
55.6
4.00
5.20
6.00
6.40
1.20
2.00
2.40..(A)
Profit (Annual Sales-Total Cost)

Incremental Profit (A)
Average Investment in Debtors
46 x 30/365
3.78
50.8 x 45/365
6.26
54 x 60/365
8.88
55.6 x 75/365
Incremental Investment in Debtors as compared
to present level
11.42
2.48
5.10
7.64
20% of incremental investment (B)
0.50
1.02
1.53
Excess return i.e. (A B)
0.70
0.98
0.87
Required Return:
Policy B having Average Collection Period 60 days yields the maximum profit and thus is most profitable.
Question No. 39
On 1st January, 2013, the Board of directors of Dowell Co. Ltd. wishes to know the amount of working capital
that will be required to meet the programme of activity; they have planned for the year. The following information
is available:
(i) Issued and paid-up capital ` 2,00,000.
(ii) 5% Debentures (secured on assets) ` 50,000.
(iii) Fixed assets valued at ` 1,25,000 on 31.12.2013.
(iv) Production during the previous year was 60,000 units. It is planned that this level of activity should be
maintained during the present year.

(v) The expected ratios of cost to selling price are raw materials 60%, direct wages 10% and overheads
20%.
(vi) Raw materials are expected to remain in stores for an average of two months before these are issued
for production.
(vii) Each unit of production is expected to be in process for one month.
(viii) Finished goods will stay in warehouse for approximately three months.
(ix) Creditors allow credit for 2 months from the date of delivery of raw materials.
(x) Credit allowed to debtors is 3 months from the date of dispatch.
(xi) Selling price per unit is ` 5.
(xii) There is a regular production and sales cycle.
Prepare:
(a) working capital requirement forecast; and
(b) an estimated profit and loss account and balance sheet at the end of the year.
(a) Forecast of Working Capital Requirements of Dowell Co. Ltd.
Holding Periods
2 months
30,000
1 month
18,750
Finished goods
3 months
67,500
Debtors
3 months
75,000
1,91,250
Less: Current Liabilities Creditors
2 months
Current Assets:
Raw Material
Work-in-progress
Net Working Capital (CA CL)
30,000
1,61,250
Dowell Company Limited

Estimated Profit and Loss Account
for the year ending 31st December, 2013
(b)(i)
`
Sales 60,000 units @ `5
`
3,00,000
Less: Cost of Sales:

Raw material @ 60%
1,80,000
Direct Wages @ 10%
30,000
Overheads @ 20%
60,000
Gross profit
Less: Debenture Interest @ 5% on 50,000
Net Profit
2,70,000
30,000
2,500
27,500
480 PP-FT&FM
Dowell Company Limited
(ii)
Estimated Balance Sheet

for the end of 31st December, 2013
Liabilities
Share Capital
2,00,000
Reserve & Surplus
8,750
Assets
Fixed Assets
1,25,000
Current Assets:
(balance figure)
Raw material
30,000
Profit & Loss A/c
Work-in-progress
18,750
67,500
(Profit for the year)
27,500
Finished goods
5% Debentures
50,000
Debtors (equivalent
Creditors
30,000
to 3 months sales)
75,000
3,16,250
3,16,250
Working Notes:
(i) Computation of Cost and Sales:
Per unit
Total
60,000 units
5.00
3,00,000
Raw material
3.00
1,80,000
Direct Wages
0.50
30,000
Overheads
1.00
60,000
4.50
2,70,000
Selling price
Cost of Sales:
(ii) Stock of Raw material:
1,80,000 2
= ` 30,000
2 months consumption
12
(iii) Work in progress (1 months production):
1,80,000
Raw Material Rs.

12
` 15,000
30,000 1

Direct Wages*
2
12
` 1,250
60,000 1

Overheads*
2
12
` 2,500
*Presumed to accrue evently during the period
` 18,750

(iv) Finished goods (3 months production)
` 2,70,000 3
= ` 67,500
12
(v) Debtors (3 months cost of sales)
` 3,00,000 3
= ` 75,000
12
(vi) Creditors (2 months consumption of raw materials)
` 1,80,000 2
= ` 30,000
12
Question No. 40
Prepare working capital forecast and projected profit and loss account and balance sheet from the following
information:
`
Issued equity share capital
50,00,000
Preference share capital
15,00,000
Fixed assets
30,66,667
Production during the previous year was 10,00,000 units which is expected to be maintained during the current
year. The expected ratios of cost to selling price are?
Raw material
40%
Direct wages
20%
Overheads
20%
Raw material ordinarily remains in stock for 3 months before production. Every unit of production remains in
process for 2 months. Finished goods remain in stock for 3 months. Creditors allow 3 months for payment and
debtors are allowed 4 months credit. Estimated minimum cash to be held will be half a month. The selling price
will be ` 8 per unit. The production is in continuous process and sales are in regular cycle.
Total Production
10,00,000 units
Sale Rate
` 8/unit
Cost per unit of:

Raw Material
` 8 x 40% = ` 3.20
Wages
` 8 x 20% = ` 1.60
Overheads
` 8 x 20% = ` 1.60
482 PP-FT&FM
Current Assets
(` )
Cash
2,00,000
Raw Material 10,00,000 x ` 3.20 x 3m/12
8,00,000
Work-in-Progress 10,0,000 x [` 3.20 + ` 0.80 + ` 0.80] x 2/12
8,00,000
Finished Goods 10,00,000 x ` 6.40 x 3/12
16,00,000
Debtors 10,00,000 x ` 8 x 4/12
26,66,667
Total :
60,66,667
Current Liabilities
Creditors 10,00,000 x ` 3.20 x 3/12
8,00,000
Wages 10,00,000 x ` 1.60 x 1/24
66,667
Overheads 10,00,000 x ` 1.60 / 1/24
66,667
9,33,334
51,33,333

It is assume that there is a lag of 1/2 months in payment of basis and overhead
Profit Statement
(` )
Sales
80,00,000
Less:
Raw Material
32,00,000
Wages
16,00,000
Wages
16,00,000
Profit
64,00,000
16,00,000
Balance Sheet as on
Liabilities
Assets
Capital
50,00,000
Fixed
Prof. Share Capital
15,00,000
Raw Material
8,00,000
Work-in-Progress
8,00,000
Profit: Previous Years

(Balance figure)
Current Year
Creditors
Wages Payable
Overheads Payable
1,00,000
16,00,000
8,00,000
30,66,667
Finished Goods
16,00,000
Debtors
26,66,667
Cash
2,00,000
66,667
66,667
91,33,334
________
91,33,334

Question No. 41
During a 5 year period, the relevant results for the aggregate market are that the rf (risk-free rate) is 8 percent
and the rm (return on market) is 14 percent. For that period, the results of four portfolio managers are as follows:
Portfolio
Manager
Average
Return (%)
Beta
13
0.80
14
1.05
17
1.25
13
0.90
Using CAPM model you are required to (a) Calculate the expected rate of return for each portfolio manager and
compare the actual returns with the expected returns. (b) Based upon your calculations, select the manager
with the best performance.
(a) Use the CAMP equation :
The expected rates of return are as follows :
Portfolio
Manager
Average
Return (%)
Expected Return (%)
Actual
Return
(%)
Difference
between
Actual and
Expected
Returns (%)
13
rA = 8% + 0.80 (14% 8%) = 12.8
13
+ 0.2
14
rB = 8% + 1.05 (14% 8%) = 14.3
14
0.3
17
rC = 8% + 1.25 (14% 8%) = 15.5
17
+ 1.5
13
rD = 8% + 0.90 (14% 8%) = 13.4
13
0.4
(b) Portfolio Managers A and C did better than expected, since A exceeded the expected return by 1.56 percent
(0.2% 12.8%) and C bettered the expected return by 9.68 percent (1.5% 15.5%). C therefore showed the
best performance.
Note: Average return is the actual return.
Question No. 42
From the following information, calculate the expected rate of return of a portfolio:
Risk Free rate of interest
12%
Expected return of market portfolio
18%
Standard deviation of an asset
2.8%
Market standard deviation
2.3%
Co-relation co-efficient of portfolio with market
0.8%
484 PP-FT&FM
Calculation of Expected Rate of Return of a Portfolio
Expected Rate of Return of a portfolio can be worked by using following formula:
R e R f j (Rm R f )
Where Re
...(1)
stands for expected rate of return of a portfolio
Rf
= Risk free rate of interest or return
rm
Expected return of market portfolio
0.80 0.028
=
Beta co-efficient of Security j.
0.023
Since in the question, information on ? is not given, it is essential to find it. The formula to calculate ? is
rsm s
m
(2)
Where rsm
Stands for correlation co-efficient of portfolio with market
Standard deviation of an asset
Market standard deviation
By substituting the available information in above formula, (2) we may get
0.80 0.028
0.023
= 0.97
Now we may get expected rate of return by substituting available information in equation (1)
Re
= 12 + 0.97 (18 12)

= 17.82 per cent
Question No. 43
The following information is available in respect of Security-X and Security-Y:
Security
Expected Rate of Return
1.8
22.00%
1.6
20.40%
Rate of return of market portfolio is 15.3%.

If risk-free rate of return is 7%, are these securities correctly priced? What would be the risk-free rate of return,
if they are correctly period?
If the two Securities X and Y are correctly priced, then the returns required, based on their levels of systematic
risk and calculated from the CAPM, will be the same as their expected returns given. So, the required return can
be ascertained with the help of CAPM equation as follows:
Security X
IRF + (RM IRF) b

=
7% + (15.3% 7%) 1.8
7% + (8.3% x 1.8)
7% + 14.94%
21.94%
This is less than the expected return of Security X i.e. 22%. Therefore, Security A is not correctly priced.
Security Y
0.80 0.028
0.023
IRF + (RM IRF)
7% + (15.3% 7%) 1.6
7% + (8.3% x 1.6)
7% + 13.28%
20.28%
Return of 20.28% is less than the expected return of 20.40%. Therefore, Security Y is not correctly priced.
In case, both securities are correctly priced, then they must offer same Reward to Risk Ratio. The risk free rate
would have to be such that:
(22% IRF) 1.8
(20.4% IRF) 1.6
(.22% IRF) x 1.6
(.204 IRF) x 1.8
.352 1.6 IRF
.3672 1.8 IRF
.2 IRF
0.152
IRF
7.6%
So, both securities would have correctly priced if the risk free rate is 7.6%.
LEASING
Question No. 44
XYZ Ltd. Is considering to acquire an additional computer to supplement its time-share computer services to its
clients. It has two options
(i) To purchase the computer for ` 22,00,000.
(ii) To lease the computer for 3 years from a leasing company for ` 5,00,000 as annual lease rent plus 10%
of gross time-share service revenue. The agreement also requires an additional payment of ` 6,00,000
at the end of the third year. Lease rent are payable at the year end, and the computer reverts to the
lessor after the contract period.
The company estimates that the computer under review now will be worth ` 10 lakhs at the end of the third year.
Forecast revenues are
Year
22,50,000
25,00,000
27,50,000
Annual operating costs (excluding depreciation/lease rent of computer) are estimated at ` 9,00,000 with an
additional ` 1,00,000 for start-up and training costs at the beginning of the first year. These costs are to be borne
by the lessee. XYZ Ltd. Will borrow at 16% interest to finance the acquisition of the computer; repayments are to
be made according to the following schedule:
486 PP-FT&FM
Year-end
Principal (`)
Interest (`)
Total (`)
5,00,000
3,52,000
8,52,000
8,50,000
2,72,000
11,22,000
8,50,000
1,36,000
9,86,000
The company uses the straight line method to depreciate its assets and pays 50% tax on its income.
The management of XYZ Ltd. Approaches you, as a company secretary, for advice. Which alternative would you
recommend and why?
Note: Present value factor at 8% and 16% rate of discount:
Year
8%
16%
0.926
0.862
0.857
0.743
0.794
0.641

Present Value of Cash Outflows under Leasing Alternative
Year
Payment under lease contract (`)

Lease
10% of
Lump-sum
Rent
gross
payment
Total
revenue
payment
Tax Shield Net

PV
@ 50% on cash
factor
lease
outflows at 8%
Total PV
(` )
(` )
(` )
(` )
(` )
(` )
(` )
1.
5,00,000
2,25,000
7,25,000
3,62,500
3,62,500
0.926
3,35,675
2.
5,00,000
2,50,000
7,50,000
3,75,000
3,75,000
0.857
3,21,375
3.
5,00,000
2,75,000
6,00,000
13,75,000
6,87,500
6,87,500
0.794
5,45,875
12,02,925
PV
factor
at 8%
Total PV
Present Value of Cash Outflows under Buying/Borrowing Alternative

Year
end
Instalment Payment
Tax advantage on
Net cash
outflows
Depreciation
Principal
Interest
@16%
Total
Interest Payment
(` )
(` )
(` )
(` )
(` )
(` )
1.
5,00,000
3,52,000
8,52,000
1,76,000
2,00,000
4,76,000
0.926
4,40,776
2.
8,50,000
2,72,000
11,22,000
1,36,000
2,00,000
7,86,000
0.857
6,73,602
3.
8,50,000
1,36,000
9,86,000
68,000
2,00,000
7,18,000
0.794
5,70,092
Salvage
value
Total
(` )
(10,00,000) 0.794
(7,94,000)
8,90,470
Recommendation: Since the Present value of cash outflows under borrowing/buying alternative ` 8,90,470 is

less than Present value of cash outflow under lease alternative i.e. ` 12,02,925. Therefore, the Company is
advised to buy the computer.
*Depreciation for 3 years = (` 22,00,000 ` 10,00,000) = ` 12,00,000. Effective rate of interest or discount =
16% (1 .50) = 8%.
NOTE: Since the annual operating costs and training costs are same under both the alternatives, so it is not
included in the calculations of cash outflows.
Question No. 45
The Controller of Mahindra Electronic Corporation of India has been analysing the firms policy regarding
computers, which are now being leased on a yearly basis on rental amounting to ` 2,00,000 per year. The
computer can be bought for ` 10,00,000. The purchase would be financed by 16% loan repayable in 4 equal
annual instalments.
On account of rapid technological progress in the computer industry, it is suggested that a 4 year economic life
should be used, instead of 10 years physical life. It is estimated that the computer could be sold for ` 4,00,000
at the end of 4 years.
The company uses the straight line method of depreciation. Corporate tax rate is 50%.
You are required to:
(a) Comment on whether the equipment should be bought or leased?
(b) Analyse the financial viability from the point of view of the lessor, assuming 14% cost of capital.
(c) Determine the minimum lease rent at which the lessor would break-even.
(d) Determine the lease rent which will yield on IRR of 16% to the lessor.
(a) Present value of cash outflows under Leasing alternative
Year
Lease Rent after Taxes (`)
PV factor at 8%
Total Present Value (`)
14
1,00,000
3.312
3,31,200
Cash outflows under Buying alternative

Year end
Loan at the
beginning of
the year in `
Loan
Instalment
in `
Interest
on Loan
in `
Principal
Principal
Repayment
outstanding
of the year in ` at the end in `
10,00,000
3,57,398
1,60,000
1,97,398
8,02,602
8,02,602
3,57,398
1,28,416
2,28,982
5,73,620
5,73,620
3,57,398
91,779
2,65,619
3,08,001
3,08,001
3,57,398
49,397
3,08,001
*(` 10,00,000 / 2.798) Present value factor of annuity of Re. 1 at 16% for 4 years.
Present value of cash outflows under Buying alternative
Year
Loan
Instalment
Tax advantage
Payment of
DepreInterest
ciation
Net Cash
on
PV factor Total PV
Outflows
at 8%
3,57,398
80,000
75,000
2,02,398
0.926
1,87,421
3,57,398
64,208
75,000
2,18,190
0.857
1,86,989
3,57,398
45,890
75,000
2,36,508
0.794
1,87,787
488 PP-FT&FM
4
3,57,398
24,699
75,000
2,57,699
0.735
1,89,409
Salvage value
(4,00,000)
0.735
(2,94,000)
4,57,606
Recommendation: It may be noted from the above workings that leasing option is financially superior as against
buying alternative because present value of cash outflow under leasing option is lower.
(b) (i) Viability from the lessers point of view. at 14% cost of capital
Determination of CFAT
Lease rent received
2,00,000
Less: Depreciation
1,50,000
Earning before tax
50,000
Less: Taxes (50%)
25,000
Earning after tax
25,000
Add: Depreciation
1,50,000
CFAT
1,75,000
(ii) Determination of NPV

Year
CFAT (`)
PV Factor at 14%
Total PV (`)
1-4
1,75,000
2.914
5,09,950
4,00,000
0.592
2,36,800
7,46,750
Less: Cost of computer
10,00,000
(2,53,250)
Recommendation: The proposal is not financially viable to the lessor.

(c) Lease rent at which lessor would break even:
`
Cost of computers
10,00,000
Less: PV of salvage price of computer
2,36,800
Net cost to be covered
7,63,200
CFAT (Desired) (7,63,200 2.914*)
2,61,908
Less: Depreciation
1,50,000
Earning after taxes
1,11,908
Add: Taxes @ 50%
1,11,908
Earning before tax
2,23,816
Add: Depreciation
1,50,000
Lease rent at which lessor would break-even
3,73,816
* Annuity factor at 14% for four years.

(d) Lease rent to yield 16% IRR
4
` 10,00,000
t 1 (1 0.16 )
Rs. 4,00,000
(1 0.16 )
Where X = CFAT
` 10,00,000
Rs. 4,00,000
(1.16 )
t 1 (1 0.16 )
Substituting (i) PV factor of annuity of Re. 1 at 16% for 4 years is 2.798 and
(ii) PV factor of Re. 1 at 16% in 4 years is 0.552.
` 10,00,000 ` 4,00,000 x .552 = 2.798X
` 10,00,000 ` 2,20,800 = 2.798X
`
779200
X
2.798
X = ` 2,78,485
`
CFAT desired
2,78,485
Less: Depreciation
1,50,000
Earning after taxes
1,28,485
Add: Taxes @ 50%
1,28,485
Earning before taxes
2,56,970
Add: Depreciation
1,50,000
Lease Rent Desired
4,06,970
Question No. 46
ABC Ltd. is considering to acquire an additional sophisticated computer to supplement its time-share computer
services to its clients. It has two options:
(i) To purchase the computer for ` 44,00,000.
(ii) To lease the computer for 3 years from a leasing company for ` 10,00,000 as annual lease rent plus
10% of gross time share service revenue. The agreement also requires an additional payment of `
12,00,000 at the end of the third year. Lease rents are payable at the year end, and the computer
reverts back to the lessor after the contract period.
The company estimates that the computer under review now will be worth ` 20 lakhs at the end of the third year.
Year
45,00,000
50,00,000
55,00,000
Annual operating costs (excluding depreciation/lease rent of computer) are estimated at ` 18,00,000 with an
490 PP-FT&FM
additional cost of ` 2,00,000 for start-up and training at the beginning of the first year. These costs are to be
borne by the lessee. ABC Ltd. will borrow 16% interest to finance the acquisition of the computer and the
repayments are to be made according to the following schedule:
Year-end
Principal (`)
Interest (`)
Total (`)
10,00,000
7,04,000
17,04,000
17,00,000
5,44,000
22,44,000
17,00,000
2,72,000
19,72,000
The company uses the straight line method to depreciate its assets and pays 50% tax on its income.
The management of ABC Ltd. approaches you, as a Company Secretary-cum-Finance Manager, for advice.
Which alternative would you recommend and why?
Note: Present value factor at 8% and 16% rate of discount:
Year
8%
16%
0.926
0.862
0.857
0.743
0.794
0.641

Present Value of Cash Outflows under Leasing Alternative
Year
Payment under lease contract (`)

Lease
10% of
Lump-sum
Rent
gross
payment
Total
revenue
payment
Tax Shield Net

PV
@ 50% on cash
factor
lease
outflows at 8%
Total PV
(` )
(` )
(` )
(` )
(` )
(` )
10,00,000
4,50,000
14,50,000
7,25,000
7,25,000
0.926
6,71,350
10,00,000
5,00,000
15,00,000
7,50,000
7,50,000
0.857
6,42,750
10,00,000
5,50,000
12,00,000
27,50,000
13,75,000
13,75,000 0.794
10,91,750
(` )
PV
24,05,850
Present Value of Cash Outflows under Buying/Borrowing Alternative

Year
end
Instalment Payment
Tax advantage on
Principal Interest
@16%
Total
Interest payment
(` )
(` )
(` )
(` )
(` )
Net cash
outflows
Depreciation
PV
factor
at 8%
(` )
Total PV
(` )
10,00,000 7,04,000
17,04,000 3,52,000
4,00,000 9,52,000
0.926
8,81,552
17,00,000 5,44,000
22,44,000 2,72,000
4,00,000 15,72,000
0.857
13,47,204
17,00,000 2,72,000
19,72,000 1,36,000
4,00,000 14,36,000
0.794
11,40,184
PV
17,80,940
Salvage Value
(20,00,000)
0.794
(15,88,000)

Recommendations: Since the Present value of cash outflows under borrowing/buying alternative ` 17,80,940 is
less than Present value of cash outflow under lease alternative i.e. ` 24,05,580. Therefore, the Company is
advised to buy the computer.
Depreciation for 3 years
= (` 44,00,000 ` 20,00,000)
= ` 24,00,000 / 3 = ` 8,00,000.
Effective rate of interest or discount = 16% (1 .50) = 8%.

Note: Since the annual operating costs and training costs are same under both the alternatives, these are not
considered in the calculation of cash outflows.
FINANCIAL DECISIONS
Question No. 47
Sales and earnings before interest and taxes for the XYZ Company during 2012, were ` 17,50,000 and `
4,50,000, respectively. During 2012, interest expense was ` 4,000 and preferred dividends were ` 10,000.
These fixed charges are expected to continue during 2013. An expansion is planned, which will require ` 1,75,000
and is expected to increase EBIT by ` 1,00,000 to ` 5,50,000.
The firm is considering the following financing alternatives:
(a) Issue 5,000 shares of common stock to net the firm ` 35 per share. The firm currently has 40,000 shares
of common stock outstanding.
(b) Issue ` 1,75,000 of fifteen-year bonds at 8%. Sinking fund payments on these bonds will commence in
2012.
(c) Issue ` 1,75,000 of 8.5% preferred stock.
Assume a 50% income tax rate.
(i) Calculate the EPS for 2013 at the expected earnings before interest and taxes level of ` 5,50,000 of
each financing alternative.
(ii) Calculate the equivalency level of earnings before interest and taxes between the debt and common
stock alternatives.
(iii) Calculate the equivalency level of earnings before interest and taxes between the preferred stock
and common stock alternatives.
(i) Determination of EPS at EBIT of ` 5,50,000
Financial Plans
(a) Equity
shares
(b) Bonds
(c) Preference
shares
(` )
(` )
(` )
5,50,000
5,50,000
5,50,000
4,000
18,000
4,000
Taxable income
5,46,000
5,32,000
5,46,000
Less: Taxes 50%
2,73,000
2,66,000
2,73,00
Income after taxes
2,73,000
2,66,000
2,73,000
EBIT
Less: interest
492 PP-FT&FM
Less: Dividend on preference shares
Earnings available for equityholders
EPS
10,000
10,000
24,875
2,63,000
2,56,000
2,48,125
45,000
40,000
40,000
` 5.84
` 6.40
` 6.20
(ii) Equivalency level of earnings between equity and debt plan
(X I1)(1 t) P1 (X I1 I2 )(I t)P1
N1
N2
where
I = Interest, t = tax rate

P = Dividend to Preference Share holders.
or
(X Rs. 4,000)0.5 Rs. 10,000 (X Rs. 4,000 Rs. 14,000)0.5 Rs. 10,000
45,000
40,000
or
0.5X Rs. 2,000 Rs. 10,000

0.5X Rs. 9,000 Rs. 10,000
45,000
45,000
or
0.5X Rs. 12,000 0.5X Rs. 19,000
45,000
40,000
Multiplying each side of the equation by 3,60,000

8(0.5X ` 12,000)
9(0.5X ` 19,000)
4X ` 96,000
4.5X ` 1,71,000
75,000
0.5X
` 1,50,000
X (EBIT)
Verification table
Equity plan
(` )
Debt plan
(` )
1,50,000
1,50,000
4,000
18,000
Taxable earnings
1,46,000
1,32,000
Less: Taxes 50%
73,000
66,000
73,000
66,000
Less: Preference dividends
10,000
10,000
Earnings for equity holders
63,000
56,000
45,000
40,000
` 1.40
` 1.40
EBIT
Less: Interest
EPS

(iii) Equivalency level between the preferred stock and common stock alternatives
(X I1)(1 t) P1 P2 (X I1)(I t) P1
N1
N2
or
(X Rs. 4,000)0.5 Rs. 24,875 (X Rs. 4,000)(0.5) Rs. 10,000
40,000
45,000
or
0.5X Rs. 2,000 Rs. 24,875 0.5X Rs. 2,000 Rs. 10,000
40,000
45,000
Multiplying both sides of the equation by 3,60,000

9(0.5X ` 26,875)
8(0.5X ` 12,000)
4.5X ` 2,41,875
4X ` 96,000
0.5X
` 1,45,875
` 2,91,750
Question No. 48
The balance sheet of XYZ Company is given as under:
Liabilities
Equity Capital
(` 10 per share)
10% long term debt
Assets
Net fixed assets
90,000
Current Assets
`
2,25,000
75,000
1,20,000
Retained earning
30,000
Current liabilities
60,000
3,00,000
_______
3,00,000
The Companys total assets turnover ratio is 3.00, its fixed operating cost is `1,50,000 and its variable operating
cost ratio is 50%. The income tax rate is 50%.
You are required to
(a) Calculate different type of leverages for the company.
(b) Determine the likely level of EBIT if EPS is (i) Re. 1 (ii) ` 2 (iii) Re. 0
Income Statement of XYZ Company
Sales Turnover ratio
Sales
Total Assets
or
Let sales of the Company be X, then 3
3,00,000
Less: Variable Cost (50% of sales)
` 4,50,000
Less: Fixed Assets
` 1,50,000
Earning before Interest and Taxes (EBIT)

Less: Interest (10% of ` 1,20,000)
` 9,00,000
` 6,00,000
` 3,00,000
` 12,000
494 PP-FT&FM
Earning before Taxes (EBT)
` 2,88,000
Less: Taxes (50% of Income)
` 1,44,000
Earning after Taxes (EAT)
` 1,44,000
Leverages
(a)(i) operating leverages
Contribution
EBIT
Rs. 9,00,000 Rs. 4,50,000

Rs. 3,00,000
(a)(ii) financial leverage
(a)(iii) combined leverage
` 4,50,000
150
.
` 3,00,000
EBIT
EBT
` 3,00,000
104
.
`2,88,000
= operating leverage x financial leverage
Combined leverage = 1.50 x 1.04
Contribution EBIT
EBIT
EBT
= 1.56
EPS
where
stands for interest
stands for taxes
stands for number of shares
(EBIT I)(1 t)
N
(b)(i) If EPS = Re. 1

Re. 1
(EBIT `12,000)(1 .50)

9,000
` 9,000
= (EBIT ` 12,000) (.50)
` 9,000
= .5 EBIT ` 6,000
.5EBIT
= ` 9,000 + ` 6,000
.5EBIT
= ` 15,000
EBIT
= ` 15,000 x 2 = ` 30,000
(b)(ii) If EPS = ` 2
`2
` 18,000
(EBIT `12,000)(1 .5)

9,000
= .5 EBIT ` 6,000

.5EBIT
= ` 18,000 + ` 6,000
.5EBIT
= ` 24,000
EBIT
= ` 48,000
(b)(iii) If EPS = Re. 0

Re. 0
(EBIT `12,000)(1 .5)

9,000
.5EBIT 6,000
=0
.5EBIT
= ` 6,000
EBIT
= ` 12,000
Question No. 49
X & Co. needs ` 10,00,000 for construction of a new plant for which it has three financing plans. The company
wants to maximise EPS. Currently, the equity share is selling for ` 30 per share. The EBIT resulting from the
plant operations are expected to run about ` 1,80,000 per year. The companys marginal tax rate is 50%. Money
can be borrowed at the rates indicated as under:
Upto ` 1,00,000 at 10%
Over ` 1,00,000 and upto ` 5,00,000 at 14%
Over ` 5,00,000 at 18%
If fund is excess of ` 5,00,000 are borrowed, the company anticipates a drop in the price of equity to ` 25 per
share. The three financing plans are as follows:
Plan-A Use ` 1,00,000 debt
Plan-B Use ` 3,00,000 debt
Plan-C Use ` 6,00,000 debt
You are required to determine the EPS for these three plans and indicate the financial plan which will result in
the highest EPS.
Calculation of EPS under different plans
Plan - A
Plan - B
Plan - C
1,80,000
1,80,000
1,80,000
10,000
38,000
84,000
1,70,000
1,42,000
96,000
Taxes (50%)
85,000
71,000
48,000
EAT
85,000
71,000
48,000
No. of shares
30,000
23,333
16,000
2.83
3.04
3.00
EBIT (`)
Interest (`)
EBT (`)
EPS (`)
From the above it is clear that plan B gives highest earning per share i.e. ` 3.04 for the Company.
496 PP-FT&FM
Question No. 50
Sales and earnings before interest and taxes for the XYZ Ltd., during current year were ` 35,00,000 and `
9,00,000, respectively. During the year interest expense was ` 8,000, and preference dividends were ` 10,000.
These fixed charges are expected to continue for the next year.
An expansion is planned, which will require ` 3,50,000 and is expected to increase EBIT by ` 2,00,000 to `
11,00,000.
The firm is considering the following financing alternatives:
(a) Issue 10,000 shares of common stock to net the firm ` 35 per share. The firm currently has 80,000
shares of common stock outstanding.
(b) Issue ` 3,50,000 of fifteen-year bonds at 15%. Sinking fund payments on these bonds will commence
after 15 years.
(c) Issue ` 3,50,000 of 14% preference share.
Assume a 50% income tax rate:
(i) Calculate the EPS at the expected earnings before interest and taxes level of ` 11,00,000 for each
financing alternative.
(ii) Calculate the equivalency level of earnings before interest and taxes between the debt and common
stock alternatives.
(iii) Calculate the equivalency level of earnings before interest and taxes between the preference share and
common stock alternatives.
(i) Determination of EPS at EBIT Level of ` 11,00,000
Financing Plan
(a)
Equity
Shares
(b)
Bond
Shares
(c)
Preference
11,00,000
11,00,000
11,00,000
8,000
60,500
8,000
10,92,000
10,39,500
10,92,000
Less: Taxes 50%
5,46,000
5,19,750
5,46,000
Income after taxes
5,46,000
5,19,750
5,46,000
10,000
10,000
59,000
5,36,000
5,09,750
4,87,000
90,000
80,000
80,000
5.96
6.37
6.09
EBIT
Less: Interest
Taxable Income
Less: Dividend on Preference Shares

Earning available for equity holders
Number of Equity shares
EPS (`)

(ii) Equivalency Level of Earnings between Equity and Debt Plan
( X I1 ) (1 t ) P1 ( X I1 I 2 ) (1 t ) P1
N1
N2
OR
( X Rs. 8,000 ) 0.5 Rs.10,000 ( X Rs. 8,000 Rs. 52,500 ) 0.5 Rs.10,000
90,000
80,000
0.5 X Rs. 4,000 Rs.10,000 0.5 X Rs. 30,250 Rs.10,000
90,000
80,000
The above equation can be simplified as under:
8 (0.5X ` 14,000) = 9 (0.5X ` 40,250)
4X ` 1,12,000 = 4.5X ` 3,62,250
4X 4.5X ` 3,62,250 + ` 1,12,000
0.5X = 2,50,250
X = ` 5,00,500
Verification Table
Equity Plan
(` )
Debt Plan
(` )
5,00,500
5,00,500
8,000
60,500
4,92,500
4,40,000
Less: Taxes (50%)
2,46,250
2,20,000
EAT
2,46,250
2,20,000
10,000
10,000
2,36,250
2,10,000
90,000
80,000
2.625
2.625
EBIT
Less: Interest
Less: Pref. Dividend

Earnings for Equityholders
No. of Equity shares
EPS (`)
(iii) Equivalency level between the Preferred stock and common stock alternatives
( X I1 ) (1 t ) P1 P2 ( X I1 ) (1 t ) P1
N1
N2
OR
( X Rs. 8,000 ) 0.5 Rs.10,000 Rs. 49,000 ( X Rs. 8,000 ) 0.5 Rs.10,000
80,000
90,000
=
0.5 X Rs. 4,000 Rs. 59,000 0.5 X Rs. 4,000 Rs.10,000
80,000
90,000
498 PP-FT&FM
OR
0.5 X Rs. 63,000 0.5 X Rs.14,000
80,000
90,000
By simplifying the above, we get:
9 (0.5X ` 63,000) = 8 (0.5X ` 14,000)
4.5X ` 5,67,000 = 4X ` 1,12,000
4.5X 4X = ` 5,67,000 ` 1,12,000

0.5X = ` 4,55,000
Rs`. 4,55,000
X=
= ` 9,10,000
.5
Question No. 51
Two companies P Ltd. and Q Ltd. belong to the equivalent risk group. The two companies are identical in every
respect except that Q Ltd. is levered, while P Ltd. is unlevered. The outstanding amount of debt of the levered
company is `6,00,000 in 10% debentures. The other information for the two companies are as follows:
Net operating income (EBIT) (`)
P Ltd.
Q Ltd.
1,50,000
1,50,000
60,000
1,50,000
90,000
0.15
0.20
10,00,000
4,50,000
6,00,000
10,00,000
10,50,000
15.0%
14.3%
1.33
Interest (`)
Earnings to equity-holders (`)
Equity capitalization rate, ke
Market value of equity (`)
Market value of debt (`)
Total value of firm (`)
Overall capitalization rate, ko = EBIT/V
Debt-equity ratio
An investor owns 5% equity shares of Q Ltd. 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?
Investors current position (in Company Q)
Dividend income (5% of ` 90,000)
` 4,500
Market value of Investment (5% of ` 4,50,000)
` 22,500
He sells his holdings in company Q for ` 22,500 and creates a personal leverage by borrowing ` 30,000 (5% of `
6,00,000). The total amount with him is ` 52,500. He purchases 5% equity holdings of the Company P for `50,000
as the total value of the firm is ` 10,00,000. Further, his position with respect to income would be as follows:
Company P
Company Q
` 7,500
` 4,500
Less: Interest (10% of ` 30,000)
3,000
Net Income
4,500
4,500
Dividends (5% of profit)

The investor, thus, can save an amount of ` 2,500 through the use of leverage and still continue to earn the
same earnings of ` 4,500 as before.
There are limits to the arbitrage process and it will come to an end when the market values of both the companies
are same.
Question No. 52
XYZ Corporation has plans for expansion which calls for 50% increase in assets. The alternatives before the
corporation are issue 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, 2012
Liabilities
`
(in lakhs)
12% debentures
25
Assets
Total assets
`
(in lakhs)
200
Ordinary shares
10 lakhs shares of
` 10 each
100
General reserve
75
200
200
Profit & loss account for the year ending 31st December, 2012
`
(in lakhs)
Sales
750
Less: Total cost excluding interest
675
EBIT
75
Less: Interest on debentures
EBT
72
Less: Taxes
36
EAT
36
Earning per share (EPS) ` 36,00,000 10,00,000

P/E ratio
Market price
3.60
5 times
18.00
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%.
With the above information determine the following:
(i) If the EBIT is 10% of sales, calculate EPS at sales levels of ` 4 crores, `8 crores and ` 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.
500 PP-FT&FM
(iii) Using P/E ratios calculate the market value per share at each sales level for both debt and equity
financing.
(i)
` 100 lakhs:
Sales Level
Sales
` 4 crores
` 8 crores
` 10 crores
` in lakh
Equity
Debt 14%
Equity
Debt 14%
Equity
Debt 14%
40
40
80
80
100
100
17 (3+14)
17 (3+14)
17 (3+14)
37
23
77
63
97
83
Less: Tax @ 50%
18.5
11.5
38.5
31.5
48.5
41.5
EAT
18.5
11.5
38.5
31.5
48.5
41.5
18
10
18
10
18
10
1.03
1.15
2.14
3.15
2.00
4.15
EBIT at 10%
Less: Interest
EBT
*No. of equity shares in lakhs

EPS (`)
*Existing Shares
10,00,000
Rs.10,00,000 10
12.5
New issue =
(if equity financing is resorted)
(since shares are sold at a premium of 25%)
(ii) Let A be the EBIT level at which EPS would be the same:
( A I1 ) .5 ( A I1 I 2 ) .5
EBIT
18
10
Where I1, is interest when additional funds are raised through equity and I2 is incremental interest charges if
financing is through debt.
i.e.
( A 3) .5 ( A 3 14) .5
18
10
5 A 1 .5 .5 A 8 .5
18
10
By cross multiplication, we may get

10 (.5A 1.5)
18 (.5A 8.5)
5A 15
9A 153
4A
138
4A
138
138/4
34.5

So solving for A, we get the EBIT as ` 34.5 lakhs.
Question No. 53
Triplex Company Limited is considering an expansion programme which is expected to cost ` 10,00,000. The
company can finance it either through debt or through equity. Its current financing pattern is given as below:
`
Equity Capital (50,000 shares @ ` 10 each)
5,00,000
Reserves and Surplus
2,00,000
Debt (10%)
Total
3,00,000
10,00,000
The latest income statement reveals the following information:
`
Sales
64,00,000
Less: Total costs
59,00,000
EBIT
5,00,000
Less: Interest
30,000
EBT
4,70,000
Less: Income-tax @ 50%
2,35,000
EAT
2,35,000
The expansion programme is expected to generate additional sales of
` 16,00,000 with a return of 15% on sale, before interest and taxes. If the expansion is financed through debt,
the rate of new debt will be 12% and the price earning ratio will be 4 times. If the expansion programme is
financed through equity shares i.e. the new shares can be sold at a price of ` 40 and the price to earning ratio
will be 5 times. Which form of financing should the company choose if the objective of financial management in
the company is maximisation of shareholders wealth.
Statement Showing the Comparative Analysis of Alternative Financial Plan
Financial Plans
I
II
Debt Issue
Equity Issue
(` )
(` )
(` 5,00,000 + 15% of 16,00,000)
7,40,000
7,40,000
Less: Interest
1,50,000
30,000
Earnings Before Taxes (EBT)
5,90,000
7,10,000
Less: Taxes @ 50%
2,95,000
3,55,000
Earnings After Taxes
2,95,000
3,55,000
Earnings Before Interest and Taxes (EBIT)
502 PP-FT&FM
No. of shares
EPS (EAT/No. of shares)
Price-Earning Ratio
Market value of share
(EPS P/E ratio)
50,000
75,000
5.90
4.73
4 times
5 times
5.90 x 4
4.73 x 5
= ` 23.60
= ` 23.65
Decision: Though there is a marginal difference in the market value of shares under alternative financial plans but in
view of higher EPS (` 5.90) and debt equity ratio with in acceptable norm, i.e., 2.1; Financial Plan I may be accepted.
DIVIDEND DECISIONS
Question No. 54
From the given details regarding three companies, you are required to (i) calculate the value of an equity share
of each of these companies when dividend pay-out ratio is (a) 20% (b) 50% (c) 0% and (d) 100% (ii) Comment
on the results drawn.
A Ltd.
B Ltd.
C Ltd.
R = 15%
R = 10%
R = 8%
Ke = 10%
Ke = 10%
Ke = 10%
E = ` 10
E = ` 10
E = ` 10

According to J. Walter, the price of a equity share in a company with no debt or taxes may determined by the
following equations.
D
P
r
(E D)
Ke
Ke
Where P
Price per share
Cash dividend per share
Earnings per share
Operating return on assets or internal rate of return
Ke
Cost of equity capital or capitalisation rate.
Using the above mentioned formula, the price or value of an equity share can be calculated as under:
A Ltd.
B Ltd.
C Ltd.
(i) When dividend

pay out ratio
is 20%
15%(10 2)
10%
10%
(.15)(8)
.10
.10
= ` 140
10%(10 2)
10%
10%
2 8
.10
= ` 100
8%(10 2)
10%
10%
.08 8
.10
.10
= ` 84

(ii) When dividend
pay out ratio is 50%
.15(10 5)
.10
.10
= ` 125
.10(10 5)
.10
.10
= ` 100
.08(10 5)
.10
.10
= ` 90
(iii) When dividend

pay out ratio is 0%
.15(10 0)
.10
.10
= ` 150
.10(10 0)
.10
.10
= ` 100
.08(10 0)
.10
.10
= ` 80
(iv) When dividend

pay out ratio is 100%
10
.15(10 10)
.10
.10
= ` 100
10
.10(10 10)
.10
.10
= ` 100
10
.08(10 10)
.10
.10
= ` 100
Comments
1. Firm A is a growth firm because its internal rate of return (r = 15%) is greater than the cost of capital (Ke
= 8%). This firm may re-invest its retained earnings at a rate which is higher than the rate expected by
share holders. Firm A will maximise its share value when dividend pay out ratio is 0%. At this ratio, the
value of share is ` 150. The market price of share increases as dividend pay out ratio declines and
reverse otherwise. So optimum pay out ratio for growth firm A is zero.
2. Firm B is the normal firm because for this firm r = Ke (i.e. 10%). The dividend pay out ratio for the firm is
irrelevant as it does not affect the market price of its share. It is same i.e. ` 100 at different level of
dividend pay out ratios.
3. Firm C is declining firm because the rate of return (i.e. 8%) on the investment for this firms is lower
than the cost of capital (i.e. 10%). Investors of this firm would like earnings to be distributed to them
so that they may either spend it or invest it elsewhere to get a rate higher than earned by this firm. The
optimum pay out ratio for this firm is 100% because at this ratio market price of its share is maximum
i.e. ` 100.
Question No. 55
Bajaj Auto Ltd. has outstanding 1,20,000 shares selling at ` 20 per share. The company hopes to make a net
income of ` 3,50,000 during the year ending on March 2013. The company is thinking of paying a dividend of `
2 per share at the end of current year. The capitalisation rate for risk class of this firm has been estimated to be
15%. Assuming no taxes, answer questions listed below on the basis of the Modigliani Miller dividend Valuation
Model:
(a) What will be the price of share at the end of March 31, 2013.
(i) If the dividend is paid and
(ii) If the dividend is not paid.
504 PP-FT&FM
(b) How many new shares must the company issue if the dividend is paid and company needs ` 7,40,000
for an approved investment expenditure during the year.
(i) Price of the share if the dividend is paid
Po
Where Po
D1 P1
(1 K e )
stands for prevailing market price of shares.
D1
stands for dividend to be received at the end of period.
Ke
stands for the cost of equity capital.
P1
stands for market price of share at the end of period one.
` 20
` 2 P1
(1 0.15)
` 20 (1 + 0.15) =
(` 2 + P1)
` 20 (1.15)
` 2 + P1
P1 = ` 23 ` 2 =
` 21.
(ii) Price of the share if dividends is not paid.

` 20
0 P1
(1 .15)
` 20
0 P1
(115)
.
P1 = ` 20 (1.15)
P1 = ` 23
(iii) Number of new equity to be issued
I (E ND1)
P1
Rs. 7,40,000 (Rs. 3,50,000 120

, ,000 Rs. 2)
Rs. 21
Rs. 7,40,000 (Rs. 3,50,000 2,40,000)

Rs. 21
Rs. 7,40,000 Rs. 110

, ,000
Rs. 21
Rs. 6,30,000
Rs. 21
= 30,000 shares.

Question No. 56
From the given information for Alpha & Company you are required to:
(i) Find out whether the firms dividend pay-out ratio is optimal according to Walters formula. The firm was
starting a year before with equity capital of ` 40 lakhs.
Earnings of the firm
` 4,00,000
Dividend paid
` 3,20,000
Price earning ratio
12.5
Number of share outstanding
40,000 @ ` 100 each.
(ii) Will the Company change its dividend policy if P/E ratio is 8 instead of 12.5?
According to J. Walter, the price of share may be find out by using the following formula:
D (E D)
r
Ke
Ke
stands for price per equity shares.
stands for dividend per share.
stands for earnings per share.
Ke
stands for cost of capital.
stands for internal rate of return on investments.
(ED)
stands for retained earnings per share
Substitute the information in above formula we may get
10%
(10 8)
8%
8%
.10
(2)
.08
.08
20
8
P
8 / 100
8
64 20
8
P
8 / 100
P
84 100 8400
8
8
64
2100
16
P = 131.25
506 PP-FT&FM
Working Notes
Ke is the reciprocal of 1/12.5% = 8%
EPS
D
r
Total Earnings of the firm ` 4,00,000
Rs. 10.00
` 40,000
Number of shares
Amount of Dividend Paid ` 3,20,000
Rs. 8
Number of Shares
` 40,000
Total Earnings of the firm
`4,00,000
100 10%
Total Equity Capital of the firm ` 40,00,000
At present, the firm pay out ratio which is 80% is not optimal. The zero dividend pay out ratio is considered
maximum because at this point the price of share would be maximum.
It is evident from the following calculations.
10%
(10 0)
8%
8%
.10
(10)
.08
.08
0 125
. 10
.08
12.5
100
8
= ` 156.25
(ii) The firm will change its dividend policy if P/E ratio is 8. It is because at this level of P/E ratio, the value of Cost
of Capital (Ke = 12.5%) is greater than that of internal rate of return of investment (r = 10%). The optimum
dividend policy for company in this case is to go for 100% dividend pay out ratio. Since Ke > r, 100% dividend
pay out ratio would maximise the value of share.
Question No. 57
Consider a common stock whose dividends are expected to grow at a 25 percent rate for 2 years, after which
the growth rate is expected to fall to 5 percent. The dividend paid last period was ` 2. The investor desires a 12
per cent return. You are required to find the value of this stock.
Compute the dividends during the supernormal growth period and find their present value. Assuming D0. is ` 2,
g is 15 per cent, and r is 12 percent :
D1 = D0 (1 + g) = ` 2 (1 + 0.25) = ` 2.50
D2 = D0 (1 + g)2 = ` 2 (1.563)
= ` 3.125 or
D2 = D1 (1 + g) = ` 2.50 (1.25) = ` 3.125

PV of dividends
D1
1
(1 r)
D2
(1 r)
Rs`. 2.50 Rs`. 3.125
(1 0.12)1 (1 0.12)2

= ` 2.50 (PVIF 12%, 1) + ` 3.125 (PVIF 12%, .2)
= ` 2.50 (0.8929) + ` 3.125 (0.7972)
= ` 2.23 + ` 2.49 = ` 4.72.
Find the price of the stock at the end of the supernormal growth period. The dividend for the third year
D3 = D2 (1 + g), where g = 5%
= ` 3.125 (1 + 0.05) = ` 3.28
The price of the stock is therefore :
P2
D3
Rs. 3.28
Rs. 46.86
r g 0.12 0.05
PV of stock price = ` 46.86 (PVIF 12% .2)

= ` 46.86 (0.7972) = ` 37.36.
Add the two PV figures obtained above to find the value of the stock
P0 = ` 4.72 + ` 37.36 = ` 42.08
Question No. 58
Harish Engineering company has a cost of equity capital 15%. The current market value of the firm is ` 60,00,000
@ ` 30 per share. Assume value for I (New Investment) ` 18,00,000, E (Earnings) ` 10,00,000 and total dividends
(D) ` 6,00,000. You are required to show that under the MM assumptions the payment of dividend does not
affect the value of the firm.
(a) Price of a share when dividend is declared
P0
D1 P1
(1 K e )
Where
P0 = Price of share at time period 0.
D1 = Dividend to be received at the end of time period 1.
P1 = Price of share at the end of time period 1.
Ke = Cost of capital.
Substituting the values in the above formula, we may get
` 30 =
Rs`. 3 P1
1.15
P1 = ` 30 x 1.15 ` 3 = ` 31.50
Price of a share when dividend is not declared
` 30 =
P1
P
1 or P = ` 34.50
1
1 .15 1.15
508 PP-FT&FM
Amount of New-Financing
(i) When dividend is declared
I (E nD1)
Where I = New Investment, E = Earnings of the Firm during the period
n = The Number of shares outstanding at the beginning of the year
D1 = Dividend paid to the shareholder at the end of time period 1.
Substituting the value in above equation, we may get
= ` 18,00,000 (` 10,00,000 ` 6,00,000)
= ` 14,00,000
Rs.14,00,000
n
Rs. 31.50
(Here D n = The change in the number of shares outstanding during the year)
(ii) When dividend is not declared
=IE
= ` 18,00,000 ` 10,00,000
= ` 8,00,000
New shares to be issued are
Rs. 8,00,000
n
Rs. 34.50
(b) (i) Value of Firm (V) when dividend is declared:
1
[nD1 (n n) P1 I E nD1 ]
(1 K e )
Rs`. 6,00,000 2,00,000
14,00,000
31.50
Rs`.31.50 Rs`.18,00,000 Rs`. 10,00,000 Rs. 6,00,000
1.15
63,00,000 14,00,000
Rs
` .14,00,000
Rs
` . 6,00,000
` .31.50 Rs
31.50
1.15
Rs
` . 6,00,000 Rs
` . 77,00,000 Rs
` .14,00,000 Rs
` . 69,00,000
1.15
1.15
= ` 60,00,000
(ii) Value of Firm (V) when dividend is not declared:
1
[(n n) P1 I E]
(1 K e )
8,00,000
` . 34.50 Rs
` .18,00,000 Rs
` .10,00,000
2,00,000 34.5 Rs
1.15
[Rs`. 69,00,000 `8,00,000]

34.5 Rs
` . 8,00,000
34.5
1.15
Rs
` . 77,00,000 Rs
` . 8,00,000 Rs
` . 69,00,000
1.15
1.15
= ` 60,00,000
Thus, it is clear from above that under MM Hypothesis dividend payment does not affect the value of the firm.
Question No. 59
The shares of XYZ is presently at ` 50 and the company is currently paying dividend of ` 4 per share with a
growth rate expected at 8 per cent per annum. It plans to raise fresh equity share capital. The merchant banker
has suggested that an underprice of Rupee 1 is necessary, in pricing the new issue besides involving a cost of
50 paise per share on miscellaneous expenses. You are required to find out the cost of existing equity shares as
well as the new equity given that the dividend rate and growth rate are not expected to change.
Current Price Share
Current Dividend Payment
Annual Growth Rate
Po = ` 50
Do = 4
g = 8%
F = ` 0.50 + ` 1 = ` 1.50
K new
D1
4 (1.080 )
g
0.08 16.91%
(Po F)
(50 1.50)
Question No. 60
The earning per share of a company is ` 10. Its has an internal rate of return of 15 percent and the capitalization
rate of risk class is 12.5 percent. If Walters model is used:
(i) What should be the optimum pay out ratio of the firm?
(ii) What should be the price of share at this pay out?
(iii) How shall the price of share be affected if different pay out were employed?
According to Walter Model
Market Price per share =
DPS (r / K e ) (EPS DPS)

Ke
Where, DPS = Dividend per share, EPS = Earning per share, r = return on Investment and Ke = Capitalization
rate.
(i) If r/Ke > 1, the value of the share of a firm will increase as EPS increases under this type of firm situation
the has ample opportunities for investment and growth. The price of the share would be maximum when
the firm retains all its earnings. Thus, the optimum payout ratio in this case is zero.
(ii) When the optimum payout is zero, the price of the share of the firm is as under:
510 PP-FT&FM
0 (0.15 / 0.125 ) (10 0)

12
Rs. 96
0.125
0.125
(iii) If the firm, under the condition r/Ke > 1, chooses a payout other than zero, the price of the share will fall.
Suppose the firm has a payout of 20 per cent, the price of the share will be:
2 (0.15 / 0.125 ) (10 2) 2 (1.2) (8) 2 9.6 11.60
Rs. 92.80
0.125
0.125
0.125
0.125
Question No. 61
A closely-held toys manufacturing company has been following a dividend policy, which can maximise the
market value of the company as per Walters Model. Accordingly, each year at dividend time, the capital budget
is reviewed in conjunction with the earnings for the period and alternative investment opportunities for the
shareholders. In the current year, the company reports net profits of ` 10,00,000. It is estimated that the company
can earn ` 2,50,000 if such profits are retained. The investors have alternative investment opportunities that will
yield them 12%. The company has 1,00,000 shares outstanding. What would be the dividend payout ratio of the
company, if it wishes to maximise the wealth of the shareholders?
Divident Payout (DP) ratio of the company should be zero for miximising the wealth of shareholders. At this ratio,
market price of the share would be the maximum as shown by the following calculation:
P = [D + (r/Ke) (E D)]/Ke
R = (` 2,50,000/` 10,00,000) x 100 = 25%
E = ` 10,00,000/1,00,000 = ` 10
P = [0 + 0.25/0.12 (` 10 0)]/0.12
= (2.083 x 10)/0.12
= 20.83/0.12
= ` 173.58
FOREX MANAGEMENT
Question No. 62
Blue Ltd. is engaged in the production of synthetic yarn and planning to expand its operations. In this context,
the company is planning to import a multi-purpose machine from Japan at a cost of 2,460 lakh. The company
is in a position to borrow funds to finance import at 12% interest per annum with quarterly rests. India based
Tokyo branch has also offered to extend credit of 90 days at 2% per annum against opening of an irrevocable
letter of credit. Other informations are as under.
Present exchange rate
` 100 = 246.
90 Days forward rate
` 100 = 250.
Commission charges for letter of credit at 4% per 12 months.

Advise whether the offer from the foreign branch should be accepted.

Evaluation of Options
Option I : Financing Import by borrowing at 12% p.a.
Cost of Machine
` (in lakhs)
2,460 lakhs yen in ` [@ ` 100 = 246 yen]
1,000.00
+ Interest at 3% for Quarter
30.00
Total Outflow in `
1,030.00
Option II : Offer from Foreign Branch
` (in lakhs)
Cost of Letter of credit (Commission) at 1% (for quarter) on 2460 lakhs yen @ ` 100 = 246 yen
+ Interest for Quarter (3% of 10 lakhs)
10.00
.30
10.30 (a)
Payment at the end of 90 days:

Cost of Machine
Interest at 2% p.a. [2460 x 2/100 x 90/365]
2,460.00 lakh yen

12.13 lakh yen
2,472.13 lakh yen
Conversion cost of 2,472.13 lakh Yen at ` 100 = 250 yen: 2,472.13 lakhs
100
= ` 988.85 lakhs (b)
250
Total Cost = (a) + (b) = 10.30 lakhs + 988.85 lakhs = ` 999.15 lakhs.
The above calculation shows that Option II i.e. offer from Foreign Branch is cheaper and hence better. Therefore,
it should be accepted.
Question No. 63
Horizon Ltd. has to make a US $ 5 million payment in three months time. The required amount in dollars is
available with Syntex Ltd. The management of the company decides to invest them for three months and following
information is available in this context:
The US $ deposit rate is 9% per annum.
The sterling pound deposit rate is 11% per annum.
The spot exchange rate is $ 1.82/pound.
The three month forward rate is $ 1.80/pound.
Answer the following questions
(i) Where should the company invest for better returns?
(ii) Assuming that the interest rates and the spot exchange rate remain as above, what forward rate would
yield an equilibrium situation?
(iii) Assuming that the US interest rate an the spot and forward rates remain as above, where should the
company invest if the sterling pound deposit rate were 15% per annum?
(iv) With the originally stated spot and forward rates and the same dollar deposit rate, what is the equilibrium
sterling pound deposit rate?
512 PP-FT&FM
(i) US$ Deposit Rate
9% per annum
Sterling Pound Deposit Rate
11% per annum
Spot Exchange Rate
$ 1.82 / pound
Three Month Forward Rate
$ 1.80 / pound
Option I:
Invest in $ deposit @ 9% per annum for 3 months
Income = 50,00,000
9
3
$ 1,12,500
100 12
Option II:
Available dollars may be converted to pounds at spot rate. Cover forward position and invest @ 11% p.a. for
three months.
Spot exchange rate = $ 1.82 /
So, $ 5 million
5,000,000
= 2747252.747
1.82
Interest earning on 2747252.747 @ 11% p.a. = 2747252.747
11 3 months
75549.450
100
12
Maturity Amount after 3 months = 2747252.747 + 75549.450 = 2822802.197

Pound converted to dollar at 1.80 / pound Forward rate = 2822802.197 x 1.80 = $ 5081043.954
Gain = $50,81,043.954 $5,000,000 = $ 81043.954
Hence, Gain Option I = $ 1,12,500
Gain Option II = $ 81043.95
Therefore, Syntex Ltd. must invest under Option I in $ at 9%.
(ii) For an equilibrium situation, amount at the end of three months should be equal. Therefore, amount invested
in sterling covered by forward rate.
= $ 50,00,000 + $ 1,12,500 = $ 51,12,500
Let forward rate be $ x /
at equilibrium 2822802.197 equals 2822802.197 x = $ 51,12,500
51,12,500
x
1.811
28,22,802.197
Forward rate = $ 1.811/
(iii) Interest earned in pounds given same spot and forward rates and interest rate is 15%:
15
3
103021.978
= 2747252.747
100 12
Total
= 2747252.747 + 1,03,021.978 = 28,50,274.725
Total $ = 2850274.725 x 1.80
= $ 5130494.505

Gain
= $ 51,30,494.505 $ 50,00,000 = $ 130494.505
Earlier Gain
= $ 1,12,500
Therefore, at 15% Syntex Ltd. should invest in $ Sterling.

(iv) For equilibrium sterling deposit rate, amount invested in sterling equals
$ 51,12,500 after three months.
Now, $ 51,12,500 converted to at forward rate =
$ 5,112,500
2840277.777
1.80
Let sterling rate be X% p.a.
2747252 .747
X
3
2747252 .747 2840277 .777

100 12
6868.131867X + 2747252.742 = 2840277.777

6868.131867X = 93025.035
X = 13.54% per annum
Question No. 64
The following quotes are available for 3-months options in respect of a share currently traded at ` 31:
Strike price
` 30
Call option
`3
Put option
`2
An investor devises a strategy of buying a call and selling the share and a put option. Draw his profit/loss profile
if it is given that the rate of interest is 10% per annum. What would be the position if the strategy adopted is
selling a call and buying the put and the share?
Strategy I: (Buying a Call and Selling a Put and a Share)
Initial Cash Inflow (` 31 ` 3 + ` 2)
` 30
Interest Rate
10%
Amount grows in 3 months to (30 x e1 x .25)
` 30.76*
If the share price is greater than ` 30, he would exercise the call option and buy one share for ` 30 and his net
profit is ` 0.76 (i.e., ` 30.76 30).
However, if the share price is less than ` 30, the counter-party would exercise the put option and the investor
would buy one share at ` 30. The net profit to the investor is again ` 0.76.
Strategy II: (Selling a Call and Buying a Put and a Share)
In this case, the investor has to arrange a loan @ 10% of ` 30 (i.e., ` 31 + 2 3).
This amount would be repaid after 3 months. Amount payable is:
30 x e1 x .25
` 30.76
After 3 months, if the market price is more than ` 30, the counter-party would exercise the call option and the
investor would be required to sell the share at ` 30. The loss to the investor would be ` 0.76 (i.e., ` 30.76 30).
514 PP-FT&FM
However, if the rate is less than ` 30, the investor would exercise the put option and would get ` 30 from the rate
of share. The loss to the buyer would again be ` 0.76.
*Interest can also be calculated on a simple interest basis instead of continuous compound interest.
Question No. 65
A company operating in a country having the $ as its unit of currency has today invoiced sales to an Indian
company, the payment being due 3 months from the date of invoice. The invoice amount is $13,750. At todays
spot rate, it is equivalent is ` 5,00,000. It is anticipated that the exchange rate will decline by 5% over the 3
months period and in order to protect the $ payments, the importer proposes to take appropriate action in the
foreign exchange market. The 3 months forward rate is presently quoted at $ 0.0273. You are required to
calculate the expected loss and to show how it can be hedged by a forward contract.
Calculation of Expected Exchange Loss
Spot rate
$13,750
Rs. 5,00,000
= $ 0.0275/Re 1
3 months forward rate = $ 0.0273/` 1
Expected spot rate after 3 months = ($ 0.0275 5%)
= ($ 0.0275 0.001375) = 0.026125
Present Cost of $ 13,750 = ` 5,00,000
(A)
Cost after 3 months

($ 13,750 @ 0.026125/Re 1) = ` 5,26,316*
(B)
Expected Exchange Loss (A B) = ` 26,316
(C)
If a forward contract is taken for 3 months @ $0.0273/` 1 then
$13,750
Net amount payable $0.0273 / Re 1 = ` 5,03663
So, Exchange Loss will be
= ` 5,00,000 ` 503,663
= ` 3,663
(D)
Thus, by comparing C and D, by forward contract, the firm can cover ` 22,653 (i.e.) ` 26,316 ` 3,663)
Therefore, firm can take a forward contract.
$13,750
* $0.026126 / Re 1 Rs. 5,26,316

TABLE 1 : PRESENT VALUE OF RUPEE ONE
RATE
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
10
11
12
13
14
15
5%
0.9524
0.9070
0.8638
0.8227
0.7835
0.7462
0.7107
0.6768
0.6446
0.6139
0.5847
0.5568
0.5303
0.5051
0.4810
6%
0.9534
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
0.5268
0.4970
0.4688
0.4423
0.4173
7%
0.9346
0.8734
0.8163
0.7629
0.7130
0.6663
0.6227
0.5820
0.5439
0.5083
0.4751
0.4440
0.4150
0.3878
0.3624
8%
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0.5835
0.5403
0.5002
0.4632
0.4289
0.3971
0.3677
0.3405
0.3152
9%
0.9174
0.8417
0.7722
0.7084
0.6499
0.5963
0.5470
0.5019
0.4604
0.4224
0.3875
0.3555
0.3262
0.2992
0.2745
10%
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855
0.3505
0.3186
0.2897
0.2633
0.2394
11%
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346
0.4817
0.4339
0.3909
0.3522
0.3173
0.2858
0.2575
0.2320
0.2090
12%
0.8929
0.7972
0.7118
0.6355
0.5674
0.5066
0.4523
0.4039
0.3606
0.3220
0.2875
0.2567
0.2292
0.2046
0.1827
13%
0.8850
0.7831
0.6931
0.6133
0.5428
0.4803
0.4251
0.3762
0.3329
0.2946
0.2607
0.2307
0.2042
0.1807
0.1599
14%
0.8772
0.7695
0.6750
0.5921
0.5194
0.4556
0.3996
0.3506
0.3075
0.2697
0.2366
0.2076
0.1821
0.1597
0.1401
15%
0.8696
0.7561
0.6575
0.5718
0.4972
0.4323
0.3759
0.3269
0.2843
0.2472
0.2149
0.1869
0.1625
0.1413
0.1229
16%
0.8621
0.7432
0.6407
0.5523
0.4761
0.4104
0.3538
0.3050
0.2630
0.2267
0.1954
0.1685
0.1452
0.1252
0.1079
17%
0.8547
0.7305
0.6244
0.5337
0.4561
0.3898
0.3332
0.2848
0.2434
0.2080
0.1778
0.1520
0.1299
0.1110
0.0949
18%
0.8475
0.7182
0.6086
0.5158
0.4371
0.3704
0.3139
0.2660
0.2255
0.1911
0.1619
0.1372
0.1163
0.0985
0.0835
19%
0.8403
0.7062
0.5934
0.4987
0.4190
0.3521
0.2959
0.2487
0.2090
0.1756
0.1476
0.1240
0.1042
0.0876
0.0736
20%
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
0.1346
0.1122
0.0935
0.0779
0.0649
21%
0.8264
0.6830
0.5645
0.4665
0.3855
0.3186
0.2633
0.2176
0.1799
0.1486
0.1228
0.1015
0.0839
0.0693
0.0573
22%
0.8197
0.6719
0.5507
0.4514
0.3700
0.3033
0.2486
0.2038
0.1670
0.1369
0.1122
0.0920
0.0754
0.0618
0.0507
23%
0.8130
0.6610
0.5374
0.4369
0.3552
0.2888
0.2348
0.1909
0.1552
0.1262
0.1026
0.0834
0.0678
0.0551
0.0448
24%
0.8065
0.6504
0.5245
0.4230
0.3411
0.2751
0.2218
0.1789
0.1443
0.1164
0.0938
0.0757
0.0610
0.0492
0.0397
25%
0.8000
0.6400
0.5120
0.4096
0.3277
0.2621
0.2097
0.1678
0.1342
0.1074
0.0859
0.0687
0.0550
0.0440
0.0352
516 PP-FT&FM
TABLE 2 : PRESENT VALUE OF AN ANNUITY OF RUPEE ONE
RATE
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
YEAR
10
11
12
13
14
15
5%
0.9524
1.8594
2.7232
3.5460
4.3295
5.0757
5.7864
6.4632
7.1078
7.7217
8.3064
8.8633
9.3936
9.8986
10.3797
6%
0.9434
1.8334
2.6730
3.4651
4.2124
4.9173
5.5824
6.2098
6.8017
7.3601
7.8869
8.3838
8.8527
9.2950
9.7122
7%
0.9346
1.8080
2.6243
3.3872
4.1002
4.7665
5.3893
5.9713
6.5152
7.0236
7.4987
7.9427
8.3577
8.7455
9.1079
8%
0.9259
1.7833
2.5771
3.3121
3.9927
4.6229
5.2064
5.7466
6.2469
6.7101
7.1390
7.5361
7.9038
8.2442
8.5595
9%
0.9174
1.7591
2.5313
3.2397
3.8897
4.4859
5.0330
5.5348
5.9952
6.4177
6.8052
7.1607
7.4869
7.7862
8.0607
10%
0.9091
1.7355
2.4869
3.1699
3.7908
4.3553
4.8684
5.3349
5.7590
6.1446
6.4951
6.8137
7.1034
7.3667
7.6061
11%
0.9009
1.7125
2.4437
3.1024
3.6959
4.2305
4.7122
5.1461
5.5370
5.8892
6.2065
6.4924
6.7499
6.9819
7.1909
12%
0.8929
1.6901
2.4018
3.0373
3.6048
4.1114
4.5638
4.9676
5.3282
5.6502
5.9377
6.1944
6.4235
6.6282
6.8109
13%
0.8850
1.6681
2.3612
2.9745
3.5172
3.9975
4.4226
4.7988
5.1317
5.4262
5.6869
5.9176
6.1218
6.3025
6.4624
14%
0.8772
1.6467
2.3216
2.9137
3.4331
3.8887
4.2883
4.6389
4.9464
5.2161
5.4527
5.6603
5.8424
6.0021
6.1422
15%
0.8696
1.6257
2.2832
2.8550
3.3522
3.7845
4.1604
4.4873
4.7716
5.0188
5.2337
5.4206
5.5831
5.7245
5.8474
16%
0.8621
1.6052
2.2459
2.7982
3.2743
3.6847
4.0386
4.3436
4.6065
4.8332
5.0286
5.1971
5.3423
5.4675
5.5755
17%
0.8547
1.5852
2.2096
2.7432
3.1993
3.5892
3.9224
4.2072
4.4506
4.6586
4.8364
4.9884
5.1183
5.2293
5.3242
18%
0.8475
1.5656
2.1743
2.6901
3.1272
3.4976
3.8115
4.0776
4.3030
4.4941
4.6560
4.7932
4.9095
5.0081
5.0916
19%
0.8403
1.5465
2.1399
2.6386
3.0576
3.4098
3.7057
3.9544
4.1633
4.3389
4.4865
4.6105
4.7147
4.8023
4.8759
20%
0.8333
1.5278
2.1065
2.5887
2.9906
3.3255
3.6046
3.8372
4.0310
4.1925
4.3271
4.4392
4.5327
4.6106
4.6755
21%
0.8264
1.5095
2.0739
2.5404
2.9260
3.2446
3.5079
3.7256
3.9054
4.0541
4.1769
4.2784
4.3624
4.4317
4.4890
22%
0.8197
1.4915
2.0422
2.4936
2.8636
3.1669
3.4155
3.6193
3.7863
3.9232
4.0354
4.1274
4.2028
4.2646
4.3152
23%
0.8130
1.4740
2.0114
2.4483
2.8035
3.0923
3.3270
3.5179
3.6731
3.7993
3.9018
3.9852
4.0530
4.1082
4.1530
24%
0.8065
1.4568
1.9813
2.4043
2.7454
3.0205
3.2423
3.4212
3.5655
3.6819
3.7757
3.8514
3.9124
3.9616
4.0013
25%
0.8000
1.4400
1.9520
2.3616
2.6893
2.9514
3.1611
3.3289
3.4631
3.5705
3.6564
3.7251
3.7801
3.8241
3.8593
Test Papers 517
PP-FT&FM
TEST PAPERS
A Guide to CS Students
To enable the students in achieving their goal to become successful professionals, Institute has prepared a
booklet A Guide to CS Students providing the subject specific guidance on different papers and subjects
contained in the ICSI curriculum. The booklet is available on ICSI website and students may down load from
http://www.icsi.edu/Portals/0/AGUIDETOCSSTUDENTS.pdf
WARNING
It is brought to the notice of all students that use of any malpractice in Examination is misconduct as provided
in the explanation to Regulation 27 and accordingly the registration of such students is liable to be cancelled
or terminated. The text of regulation 27 is reproduced below for information:
27. Suspension and cancellation of examination results or registration
In the event of any misconduct by a registered student or a candidate enrolled for any examination conducted
by the Institute, the Council or the Committee concerned may suo motu or on receipt of a complaint, if it is
satisfied that, the misconduct is proved after such investigation as it may deem necessary and after giving
such student or candidate an opportunity to state his case, suspend or debar the person from appearing in
any one or more examinations, cancel his examination result, or studentship registration, or debar him from
future registration as a student, as the case may be.
Explanation - Misconduct for the purpose of this regulation shall mean and include behaviour in a disorderly
manner in relation to the Institute or in or near an Examination premises/centre, breach of any regulation,
condition, guideline or direction laid down by the Institute, malpractices with regard to postal or oral tuition or
resorting to or attempting to resort to unfair means in connection with the writing of any examination conducted
by the Institute.
518 PP-FTFM

TEST PAPER 1
(This Test Paper is for recapitulate and practice for the students. Students need not to submit
responses/answers to this test paper to the Institute.)
Time Allowed : 3 Hours
Maximum Marks : 100

Attempt All Questions
1. Balwinder has been retained as a management consultant by Square Pants, Inc., a local specialty retailer, to
analyze two proposed capital investment projects, projects X and Y. Project X is a sophisticated working capital
and inventory control system based upon a powerful personal computer, called a system server and PC software
specifically designed for inventory processing and control in the retailing business. Project Y is a similarly
sophisticated working capital and inventory control system based upon a powerful personal computer and
general- purpose PC software. Each project has a cost of ` 10,000, and the cost of capital for both projects is
12%. The projects expected net cash flows are as follows :
Years
Expected Net Cash Flows

Project X
Project Y
(` 10,000)
(` 10,000)
6,500
3,500
3,000
3,500
3,000
3,500
1,000
3,500
(a) Calculate each projects nominal payback period, net present value (NPV), internal rate of return (IRR),
and profitability index (PI).
(12 marks)
(b) Should both projects be accepted if they are interdependent?
(4 marks)
(c) Which project should be accepted if they are mutually exclusive?
(4 marks)
2. (a) Distinguish between the following with reference to foreign exchange market:
(i) Fixed exchange rate and Flexible exchange rate.
(ii) Forward exchange contract and future contract.
(4 marks each)
(b) In considering the most desirable capital structure for a company, the following estimates of the cost of
debt and equity capital (after tax) have been made at various levels of debt-equity mix :
Debt as percentage of
total capital employed
Cost of debt (%)
Cost of equity (%)
(1)
(2)
(3)
7.0
15.0
10
7.0
15.0
20
7.0
15.5
30
7.5
16.0
40
8.0
17.0
Test Paper 1/2014 519

50
8.5
19.0
60
9.5
20.0
You are required to determine the optimal debt-equity mix for the company by calculating composite
cost of capital.
(8 marks)
OR
2A. (a) Discuss the relationship between Treasury Management and Financial Management.
(6 marks)
(b) Given are the details of three companies A Ltd, B Ltd and C Ltd.
A Ltd.
B Ltd.
C Ltd.
R= 15%
R= 10%
R = 8%
Ke= 10%
Ke= 10%
Ke= 10%
E = Rs. 10
E = Rs. 10
E = Rs. 10
When the terms R, Ke and E have their usual meanings,

(i) Calculate the value of an equity share of each company when dividend pay-out ratio is (x) 20% (y)
50% (z) 0% and (w) 100%
(8 marks)
(ii) Comment on the results drawn.
(2 marks)
3. (a) The following table summarizes risk premiums for stocks relative to treasury bills and bonds, for different
time periods:
Stocks - T. Bills
Stocks - T. Bonds
Arithmetic Mean Geometric Mean
Arithmetic Mean
Geometric Mean
1926-2010
8.41%
6.41%
7.24%
5.50%
1962-2010
4.10%
2.95%
3.92%
3.25%
1981-2010
6.05%
5.38%
0.13%
0.19%
(i) What does this premium measure?

(ii) Why is the geometric mean lower than the arithmetic mean for both bonds and bills?
(iii) If you had to use a risk premium, would you use the most recent data (1981-2010), or would you
use the longer periods? Give reasons.
(2 marks each)
(b) Write short note on
(i) Intrinsic Value of Option
(ii) Time Value of Option
(5 marks each)
OR
3.A (a) Discuss the settlement of Option Contracts
(6 marks)
(b) The following information is available in respect of Security-X and Security-Y:

Security
Expected Rate of Return
1.8
22.00%
1.6
20.40%
520 PP-FTFM
Rate of return of market portfolio is 15.3%.
If risk-free rate of return is 7%, are these securities correctly priced? What would be the risk-free rate of
return, if they are correctly priced?
(10 marks)
4. Lockers Pvt. Ltd. is considering the use of a lockbox system to handle its daily collections. The companys
credit sales are ` 160 crore per year, and it currently processes 1,300 cheques per day. The cost of the lockbox
system is ` 95,000 per year. The system allows for up to 1,000 cheques per day. Any additional cheques are
processed at an additional charge of ` 1.50 per cheque. The company estimates that the system will reduce its
float by 3 days. The firms discount rate for equally risky projects is 15 per cent, its tax rate is 40 per cent, and its
cost of short-term capital is 12 per cent. (Assume a 360-day year).
(a) How much cash will be released for other uses if the lockbox system is used?
(b) What net benefit will Lockers Ltd. gain from using lockbox system?
(c) Should Lockers Ltd. adopt the proposed lockbox system?
(d) Assume now that the institution that offers the lockbox system requires a ` 7,00,000 compensating
balance to be held for the complete year in a non-interest-bearing account. Should Lockers Ltd. adopt
the system?
(4 marks each)
5. (a) Given the details of M Limited
Installed capacity is 5000 units. Annual Production and sales at 60% of installed capacity. Selling price
per unit is ` 25 Variable cost per unit is ` 15
Fixed cost:
Situation 1 : ` 10,000
Situation 2 : ` 12,000
Capital structure:
Financial Plan
X (`)
Y (`)
Equity
25,000
50,000
Debt (10%)
50,000
25,000
75,000
75,000
Calculate the operating, financial and combined leverage under situations 1 and 2 and the financial
plans for X and Y respectively from the following information relating to the operating and capital structure
of a company, and also find out which financial plan gives the highest and the least value ? (8 marks)
(b) A futures contract is available on a company that pays an annual dividend of ` 5 and whose stock is
currently priced at ` 200. Each futures contract calls for delivery of 1,000 shares of stock in one year,
daily marking to market, an initial margin of 10% and a maintenance margin of 5%. The corporate
treasury bill rate is 8%.
(i) Given the above information, what should be the price of one futures contract?
(2 marks)
(ii) If the company stock price decreases by 7%, what will be the change, (if any), in futures price?
(2 marks)
(iii) As a result of the company stock price decrease, will an investor that has a long position in one

futures contract of this company realizes a gain or loss? Also calculate, the amount of this gain or
loss?
(4 Marks)
(a) Advantages of mutual funds
(b) Operating cycle
(c) Securitisation of mortgages
(d) Social cost-benefit analysis.
(4 marks each)
522 PP-FTFM
TEST PAPER 2
(This Test Paper is for recapitulate and practice for the students. Students need not to submit
responses/answers to this test paper to the Institute.)
Time Allowed : 3 Hours
Maximum Marks : 100
Attempt All Questions

1. (a) (i) Depreciation is a non-cash item of an expense and it is believed to be a source of finance. Discuss.
(5 marks)
(ii) What is credit rating and how does it benefit the investors and the company?
(5 marks)
(b) Explain the Capital Assets Pricing Model (CAPM). How does it help in the estimation of expected return
on security?
(10 marks)
2. (a) A factory uses 40,000 tonnes of raw material, priced at ` 50/- per tonne. The holding cost is Rs 10 per
tonne of inventory. The order cost is ` 200 per order.
(i) Find the EOQ.
(2 marks)
(ii) Will this EOQ be maintained if the supplier introduces 5% discount on the order lot of 2000 tonnes
or more?
(6 marks)
(b) Blue Ltd. is engaged in the production of synthetic yarn and planning to expand its operations. In this
context, the company is planning to import a multi-purpose machine from Japan at a cost of 2,460
lakh. The company is in a position to borrow funds to finance import at 12% interest per annum with
quarterly rests. India based Tokyo branch has also offered to extend credit of 90 days at 2% per annum
against opening of an irrevocable letter of credit. Other information is as under.
Present exchange rate : ` 100 = 246
90 Days forward rate : ` 100 = 250.
Commission charges for letter of credit at 4% per 12 months.
Advise whether the offer from the foreign branch should be accepted.
(8 marks)
OR
2 A.(a) Harish Engineering company has cost of equity capital of 15%. The current market value of the firm is
` 60,00,000 @ ` 30 per share. Assume values for I (New Investment) ` 18,00,000, E (Earnings) Rs.
10,00,000 and total dividends (D) ` 6,00,000. Given the facts show that under the MM assumptions the
payment of dividend does not affect the value of the firm.
(8 marks)
(b) A bank in Canada displays the following spot quotation. C$/$ : 1.3690/1.4200
At the same time, a bank in New York quotes $/C$ : 0.7100/0.7234
Is there an arbitrage opportunity?
(2 marks)
If the Canadian bank lowers its ask rate to 1.3742, Is there an arbitrage opportunity?
(2 marks)
If you buy one million U.S. $ from Canada and sell them in U.S.A after the Canadian lowers its ask rate.
What is the riskless profit you will make?
(4 marks)
3. (a) Bajaj Auto Ltd. has 1,20,000 shares outstanding which are selling at ` 20 per share. The company
hopes to make a net income of ` 3,50,000 during the year ending on March 2003. The company is
thinking of paying a dividend of ` 2 per share at the end of current year. The capitalisation rate for risk
class of this firm has been estimated to be 15%. Assuming no taxes, answer questions listed below on
the basis of the Modigliani Miller dividend Valuation Model:

(i) What will be the price of share at the end of March 31, 2003.
A. If the dividend is paid
(2 marks)
B. If the dividend is not paid,
(2 marks)
(ii) How many new shares must the company issue if the dividend is paid and company needs ` 7,40,000
for an approved investment expenditure during the year.
(4 marks)
(b) Two companies Rita Ltd. and Gita Ltd. are considering entering into a swap agreement with each other.
Their corresponding borrowing rates are as follows:
Name of Company
Floating Rate
Fixed Rate
Rita Ltd.
LIBOR
11%
Gita Ltd.
LIBOR + 0.3%
12.5%
Rita Ltd. requires a floating rate loan of 8.million while Gita Ltd. requires a fixed rate loan of 8 million.
(i) Show which company had advantage in floating rate loans and which company has a comparative
advantage in fixed loans.
(4 marks)
(ii) If Rita Ltd. and Gita Ltd. engage in a swap agreement and the benefits of the swap are equally split,
at what rate will Rita Ltd. be able to obtain floating finance and Gita Ltd. be able to obtain fixed rate
finance? Ignore bank charges.
(4 marks each)
OR
3A. Andhra Pradesh Udyog is considering a new automatic blender. The new blender would last for 10 years
and would be depreciated to zero over the 10 year period. The old blender would also last for 10 more years and
would be depreciated to zero over the same 10 year period. The old blender has a book value of ` 20,000 but
could be sold for ` 30,000 (the original cost was ` 40,000). The new blender would cost ` 1,00,000. It would
reduce labour expense by ` 12,000 a year. The company is subject to a 50% tax rate on regular income and a
30% tax rate on capital gains. Their cost of capital is 8%. There is no investment tax credit in effect. You ate
required to
(a) Identify all the relevant cash flows for this replacement decision.
(6 marks)
(b) Compute the present value, net present value and profitability index.
(6 marks)
(c) Find out whether this is an attractive project?
(4 marks)
4. (a) Describe the meaning of index futures.
(4 marks)
(b) What are the steps taken by financial institutions while appraising the project? How do the financial
institutions monitor the projects financed by them?
(6 marks)
(c) Dhanpat, an investor, is seeking the price to pay for a security, whose standard deviation is 5%. The
correlation coefficient for the security with the market is 0.75 and the market standard deviation is 4%.
The return from risk-free securities is 6% and from the market portfolio is 11%. Dhanpat knows that only
by calculating the required rate of return, he can determine the price to pay for the security. Find out the
required rate of return on the security?
(6 marks)
5. (a) A firm is considering a new project which would be similar in terms of risk to its existing rojects. The firm
needs a discount rate for evaluation purposes. The firm has enough cash on hand to provide the necessary
equity financing for the project. Also, the firm has 10,00,000 common shares outstanding current price
` 11.25 per share. Next years dividend expected to be Re. l per share. Firm estimated that the dividends
will grow @ 5% per year. It has 1,50,000 preferred shares outstanding. The current price of preference
share is Rs.9.50 per share and dividend is ` 0.95 per share. If new preference shares are issued, they
524 PP-FTFM
must be sold at 5% less than the current market price (to ensure they sell) and involve direct flotation
costs of ` 0.25 per share. It has a total of ` 100, 00,000 (par value) in debt outstanding. The debt is in the
form of bonds with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%.
Currently, the bonds sell at 106% of par value. Flotation costs for new bonds would equal 6% of par
value. The firms tax rate is 40%. What is the appropriate discount rate for the new project?
(10 marks)
(b) Depository system functions just like the banking system. Comment on the statement.
(6 marks)

(a) Venture Capital
(b) Role and responsibilities of Treasury Manager
(c) Spot contract v. Forward Contract
(d) Direct and Indirect Quote.
(4 marks each)

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STUDY MATERIAL

THE INSTITUTE OF COMPANY SECRETARIES OF INDIA

Public Dealing Timings

Laser Typesetting by AArushi Graphics, Prashant Vihar, New Delhi, and

FINANCIAL, TREASURY AND FOREX MANAGEMENT

LIST OF RECOMMENDED BOOKS

: Financial Management Text and Problems; Tata McGraw Hill Publishing

: Financial Management Theory & Practice; Tata McGraw Hill Publishing

: Strategic Financial Management Taxmann Publication Pvt. Ltd.

: Contemporary Financial Management; West Publishing Company.

6. Rajiv Srivastava &

: Financial Management, Oxford University Press

: Strategic Financial Management Taxmann Publication Pvt. Ltd.

: Strategic Financial Management Taxmann Publication Pvt. Ltd.

ARRANGEMENT OF STUDY LESSONS

Nature and Scope of Financial Management

Capital Structure Decisions

Securities Analysis and Portfolio Management

Derivatives and Commodity Exchanges An Overview

Practical Problems and Case Studies

Objectives of Financial Management

Profit Maximization Versus Shareholder Wealth Maximization

Economic Value-Added (EVA)

Value of Firm-Risk and Return

Costing and Risk

Financial Distress and Insolvency

Financial Management as Science or Art

Functions of Financial Executives

Financial Sector Role and Functions

Financial Sector Reforms in India Background

Financial Sector Reforms in India: Philosophy and Strategy

Salient Features of Financial Sector Reforms in India

Improvement in Financial Health

Financial Sector Legislative Reforms Commission, 2011

Financial Sector Reforms: Some Criticisms

Financial Management A New Look

Use of Time Value of Money

Future Value of a lump sum

Present Value of a cash flow stream

Net Present Value

Capital Budgeting- Planning and Control of Capital Expenses

Need for Capital Investment

Importance of Capital Budgeting

Factors Influencing Investment Decision

Rationale of Capital Budgeting Decisions

Kinds of Capital Budgeting Decisions

Planning of Capital Expenditure

Capital Budgeting Process

The Payback Method

The Average Accounting Rate of Return (ARR) Method

Discounted Cash Flow (DCF) Method

Comparison of Net Present Value and internal rate of return approach

Risk Evaluation and Sensitivity Analysis

Simulation for Risk Evaluation

Linear Programming and Capital Budgeting Decisions

Application of Linear Programming Model

Some Case Studies

Meaning of Capital Structure

Significant of capital structure