Financial Management Class Notes Bba Iv Semester: Unit I

FINANCIAL MANAGEMENT
CLASS NOTES
BBA IV SEMESTER
Unit I
Nature of Financial Management: Scope of Financial Management; Profit Maximization, Wealth
Maximization - Traditional and Modern Approach; Functions of finance – Finance Decision,
Investment Decision, Dividend Decision; Objectives of Financial Management; Concept of Time
Value of Money: present value, future value, Risk & Return: Systematic & unsystematic risk.
Unit II
Long -term investment decisions: Capital Budgeting - Principles and Techniques; Nature and
meaning of capital budgeting; Evaluation techniques - Accounting Rate of Return, Net Present
Value, Internal Rate of Return, Profitably Index Method.
Concept and Measurement of Cost of Capital: Cost of debt; Cost of Equity Share; Cost of
Preference Share; Cost of Retained Earning; Computation of over-all cost of capital (WACC)
Unit III
Capital Structure: Approaches to Capital Structure Theories - Net Income approach, Net
Operating Income approach, Traditional approach.
Dividend Policy Decision – Introduction; Dividend Payout Ratio, Factors affecting Dividend
Policy of a firm.
Unit IV
Working Capital Management: Brief Overview, Importance, Levels of Working Capital
Investment, Classification of Working Capital
Inventory Management - ABC Analysis; Minimum Level; Maximum Level; Reorder Level;
Safety Stock; Economic Order Quantity Model.
UNIT I
SCOPE AND OBJECTIVE OF FINANCIAL MANAGEMENT
INTRODUCTION
Finance is called ―The science of money‖. It studies the principles and the methods of
obtaining, control of money from those who have saved it, and of administering it by those into
whose control it passes. It is the process of conversion of accumulated funds to productive use.
Financial Management is the science of money management .It is that managerial activity which is
concerned with planning and controlling of the firms financial resources. In other words it is
concerned with acquiring, financing and managing assets to accomplish the overall goal of a
business enterprise.
MEANING, DEFINITION AND NATURE OF FINANCIAL MANAGEMENT:
Meaning and Definition
Financial Management is that managerial activity which is concerned with the planning
and controlling of the firm‘s financial resources. In other words it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly to
maximise the shareholder‘s wealth).
―Financial Management is concerned with the efficient use of an important economic
resource, namely capital funds‖ - Solomon Ezra & J. John Pringle.
―Financial Management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient business operations‖- J.L.
Massie.
―Financial Management is concerned with managerial decisions that result in the
acquisition and financing of long-term and short-term credits of the firm. As such it deals with the
situations that require selection of specific assets (or combination of assets), the selection of
specific liability (or combination of liabilities) as well as the problem of size and growth of an
enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds
and their effects upon managerial
objectives‖. -Phillippatus.
'Financial Engineering'
The creation of new and improved financial products through innovative design
or repackaging of existing financial instruments.
Financial engineers use various mathematical tools in order to create new investment
strategies. The new products created by financial engineers can serve as solutions to problems or
as ways to maximize returns from potential investment opportunities.
The management of the finances of a business / organisation in order to achieve financial
objectives
Taking a commercial business as the most common organisational structure, the key
objectives of Financial Management would be to:
Financial Management
• Create wealth for the business
• Generate cash, and
• Provide an adequate return on investment - bearing in mind the risks that the business is taking
and the resources invested.
There are three key elements to the process of Financial Management:
(1) Financial Planning

Management need to ensure that enough funding is available at the right time to meet the
needs of the business. In the short term, funding may be needed to invest in equipment and stocks,
pay employees etc.
In the medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions.
(2) Financial Control
Financial control is a critically important activity to help the business ensure that the business is
meeting its objectives. Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with business rules?
(3) Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:
• Investments must be financed in some way – such as selling new shares, borrowing from banksor
taking credit from suppliers etc.
• A key financing decision is whether profits earned by the business should be retained rather than
distributed to shareholders via dividends. If dividends are too high, the business may be starved of
funding to reinvest in growing revenues and profits further.
Nature of Financial Management
 It is an indispensable organ of business management.

 Its function is different from accounting function.

 It is a centralised function.

 Helpful in decisions of top management.

 It applicable to all types of concerns.

 It needs financial planning, control and follow-up.

 It related with different disciplines like economics, accounting, law, information
technology, mathematics etc.
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SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT:

The scope of Financial Management has undergone changes over the years . Until the
middle of this century, its scope was limited to procurement of funds. In the modern times ,the
Financial Management includes besides procurement of funds ,the three different kinds of decision
as well namely investment, financing and dividend .Scope and importance of Financial
Management includes-
 Estimating the total requirements of funds for a given period.

 Raising funds through various sources, both national and international, keeping in mind the
cost effectiveness;

 Investing the funds in both long term as well as short term capital needs;

 Funding day-to-day working capital requirements of business;

 Collecting on time from debtors and paying to creditors on time;

 Managing funds and treasury operations;

 Ensuring a satisfactory return to all the stake holders;

 Paying interest on borrowings;

 Repaying lenders on due dates;

 Maximizing the wealth of the shareholders over the long term;

 Interfacing with the capital markets;

 Awareness to all the latest developments in the financial markets;

 Increasing the firm‘s competitive financial strength in the market; and

 Adhering to the requirements of corporate governance.
The above scope of activities can be grouped in to three functions-
FUNCTIONS OF FINANCIAL MANAGEMENT:
The modern approach to the Financial Management is concerned with the solution of major
problems like investment financing and dividend decisions of the financial operations of a business
enterprise. Thus, the functions of Financial Management can be broadly classified into three major
decisions, namely:
(a) Investment decisions,
(b) Financing decisions,
(c) Dividend decisions.
1. Investment decisions: These decisions relate to the selection of assets in which funds will
beinvested by a firm .Funds procured from different sources have to be invested in various kinds
of assets . Long term funds are used in a project for various fixed assets and also for current assets.
The investment of funds in a project has to be made after careful assessment of the various
projects through capital budgeting .A part of long term fund is also to be kept for financing the
working capital requirements.
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2. Financing decision : These decisions relate to acquiring the optimum finance to meet
financialobjectives and seeing that fixed and working capital are effectively managed. It includes
sources of available funds and their respective cost ,capital structure,i.e. a proper balance between
equity and debt capital. It segregate profit and cash flow, financing decisions also call for a good
knowledge of evaluation of risk.
3. Dividend decision- These decisions relate to the determination as to how much and
howfrequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders, and the amount to be retained to support the growth of the organisation .The
level and regular growth of dividends represent a significant factor in determining a profit making
company‘s market value i.e. the value placed on its shares by the stock market.
All the above three type of decisions are interrelated ,the first two pertaining to any kind of
organisation while the third relates only to profit making organisations, thus it can be seen that
Financial Management is of vital importance at every level of business activity ,from a sole trader
to the largest multinational corporation.
FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
  Capital Budgeting
  Working Capital Management
  Dividend Policies
  Acquisitions and Mergers
  Corporate Taxation
  Determining Financial Needs
  Determining Sources of Funds
  Financial Analysis
  Optimal Capital Structure
  Cost Volume Profit Analysis
  Profit Planning and Control
  Fixed Assets Management
 Project Planning and Evaluation.
OBJECTIVE OF FINANCIAL MANAGEMENT :
Financial Management as the name suggests is management of finance. It deals with
planning and mobilization of funds required by the firm. Managing of finance is nothing but
managing of money. Every activity of an organization is reflected in its financial statements.
Financial Management deals with activities which have financial implications. Efficient Financial
Management requires the existence of some objectives or goals because judgment as to whether or
not a financial decision is efficient must be made in the light of some objectives. It includes-
  Profit maximisation and wealth /value maximisation

  Achieving a higher growth rate.
  Attaining a large market share.
  Promoting employee welfare
  Increasing customer satisfaction.
 Improve community life.
Financial Management Page 8
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Among these, a conflict included in profit maximisation and weaalth /value maximisation
objective i.e.-
The primary objective of a business is to earn profit; hence the objective of Financial
Management is also profit maximisation. If profit is given undue immportance, a number of
problems can arise, such as-
 It does not take into account the time pattern of returns.

 It fails to take intto account the social consideration to workerss, customers etc.

 The term profit is vague – it conveys a different meaning to different people .e.g.
total profit, rate of profit etc.
In wealth maximisatioon business firm maximise its market value ,it implies that business
decision should seek to increaase the net present value of the economic profit of the firm .It is the
duty of the finance manager to see that the share holders get good retuurn on the share (EPS -
Earning per Share). Hence, the value of the share should increase in the stoock market.
The wealth maximisattion objective is generally in accord with the interest of the various
groups such as owners, emplooyees etc.
Owing to limitation (ttiming, social consideration etc.) in profit maximisation, in today‘s
real world situations which is uncertain and multi-period in nature, wealth maximisation is a better
objective .Where the time period is short and degree of uncertainty is not great, wealth
maximisation and profit maximisation amount to essentially the same.
TIME VALUE OF MONEY AND MATHEMATICS OF

FINANCE Concept
We know that 100 in hand today is more valuable than 1000 receivable after a year.
We will not part with 100 now if the same sum is repaid after a year. But we might part with
100 now if we are assured thhat 110 will be paid at the end of the firsst year. This ―additional
Compensation‖ required for parting 100 today, is called ―interest‖ or ―the time value of money‖.
It is expressed in termms of percentage per annum.
Money should have time valuee for the following reasons:
 Money can be employed productively to generate real returns;

 In an inflationary periiod, a rupee today has higher purchasing poower than a rupee in the
future;

 Due to uncertainties in the future, current consumption is preferred to
future Consumption.

 The three determinannts combined together can be expressed too determine the rate of
interest as follows :
Nominal or market interest rate
= Real rate of interest or return (+) Expected rate of inflation (+) Risk premiums to compensate
for uncertainty.

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Time Value of Money and maathematics

(1) Compounding: We find the Future Values (FV) of all the cash flows at the end of the time
period at a given rate of intereest.
(2) Discounting: We determinne the Time Value of Money at Time ―O‖ by comparing the initial
outflow with the sum of the Present Values (PV) of the future inflows at a given rate of interest.
Time Value of Money
Compounding Discounting
(Future Value) (Present Value)
(a) Single Flow (a) Single Flow
(b) Multiple Flows (b) Uneven Multiple Flows
(c) Annuity (c) Annuity
Future Value of a Single Flow

It is the process to dettermine the future value of a lump sum amouunt invested at one point
of time.
FVn = PV (1+i)n
Where,
FVn = Future value of initial cash outflow after n years
PV = Initial cash outflow
i = Rate of Interest p.a.
n = Life of the Investmment
and (1+i)n = Future Vaalue of Interest Factor (FVIF)
Example
The fixed deposit scheme of Punjab National Bank offers the following interest rates :
Period of Deposit Rate Per Annum
46 days to 179 days 5.0
180 days < 1 year 5.5
1 year and above 6.0
An amount of Rs. 15,000 inveested today for 3 years will be compounded too :
FVn = PV (1+i)n
= PV × FVIF (6, 3)
= PV × (1.06)3
= 15,000 (1.191)
= 17,865

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Present Value of a Single Floow :

FVn
PV=
Where, PV = Present Value

FVn = Future Value receivable after n years
i = rate of interest
n = time period
Example
Calculate P.V. of 50,000 reeceivable for 3 years @ 10%
P.V. = Cash Flows × Annuity @ 10% for 3 years.

= 50,000 × 2.4868 = 1,24,340/-
CONCEPT OF RISK AND RETURN

Return expresses the amount which an investor actually earned onn an investment during a
certain period. Return includees the interest, dividend and capital gains; while risk represents the
uncertainty associated with a particular task. In financial terms, risk is thhe chance or probability
that a certain investment may or may not deliver the actual/expected return s.
Investors make investmment with the objective of earning some tangible benefit. This benefit
in financial terminology is termed as return and is a reward for taking a speecified amount of risk.
Risk is defined as thee possibility of the actual return being diffeerent from the expected
return on an investment over the period of investment. Low risk leads to loow returns. For
instance, in case of government securities, while the rate of return is low, the risk of defaulting is
also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term
returns on stocks are much higher than the returns on Government securities, but thee risk of losing
money is also higher.
The risk and return trade off says that the potential return rises withh an increase in risk. It
is important for an investor to deecide on a balance between the desire for the lowest possible risk
and highest possible return.
Rate of return on an investment can be calculated using the following form
ula-Return = (Amount received - Amount invested) / Amount invested
The functions of Financial Management involves acquiring funds for meeting short term and long
term requirements of the firm, deployment of funds, control over the use of funds and to trade-off
between risk and return.

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UNIT II
INVESTMENT DECISION
Capital budgeting
Investment decision relates to the determination of total amount of assets to be held in the
firm ,the composition of these assets and the business risk complexions of the firm as perceived by
its investors .It is the most important financial decision that the firm makes in pursuit of making
shareholders wealth.
Investment decision can be classified under two broad groups.
 Long –term investment decision i.e. Capital budgeting.

 Short-term investment decision i.e. Working Capital Management.
The evaluation of long-term investment decisions or investment analysis to be consistent

with the firm‘s goal involves the following three basic steps.
1. Estimation or determination of cash flows.
2. Determining the rate of discount or cost of capital.
3. Applying the technique of capital budgeting to determine the viability of the investment
proposal.
1. Estimation of relevant cash flows.
If a firm makes an investment today ,it will require an immediate cash outlay, but the
benefits of this investment will be received in future .There are two alternative criteria available
for ascertaining future economic benefits of an investment proposal-
1. Accounting profit
2. Cash flow.
The term accounting profit refers to the figure of profit as determined by the Income
statement or Profit and Loss Account, while cash flow refers to cash revenues minus cash
expenses. The difference between these two criteria arises primarily because of certain non-cash
expenses, such as depreciation, being charged to profit and loss account .Thus, the accounting
profits have to be adjusted for such non-cash charges to determine the actual cash inflows. In fact,
cash flows are considered to be better measure of economic viability as compared to accounting
profits.
2. Determining the rate of discount or cost of capital.
It is the evaluation of investment decisions on net present value basis i.e. determine the rate of
discount .Cost of capital is the minimum rate of return expected by its investors.
3. Applying the technique of capital budgeting to determine the viability of the investment
proposal.
Capital Budgeting is the process of making investment decisions in capital expenditures. A
capital expenditure may be defined as an expenditure the benefit of which are expected to be
received over period of time exceeding one year. Capital Budgeting technique helps to determine
the viability of the investment proposal or taking long-term investment decision.

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CAPITAL BUDGETING PRROCESS :

A Capital Budgeting decision involves the following process :
(1) Identification of investtment proposals.
(2) Screening the proposalls.
(3) Evaluation of various proposals.
(4) Fixing priorities.
(5) Final approval and preparation of capital expenditure budget.
(6) Implementing proposal.
(7) Performance review.
The overall objective of capital budgeting is to maximise the profitability of a firm or the
return on investment. There are many methods of evaluating profitability of capital investment
proposals.
METHODS OF CAPITAAL BUDGETING OR EVALUATION OF INVESTMENT
PROPOSALS (INVESTMENT APPRAISAL TECHNIQUES)
The various commonly used methods are as follows.
I . Traditional methods
(1) Pay back period method or pay out or pay off method.(PBP)
(2) Accounting Rate of Return method or Average Rate of Return. (ARR)
II. Time adjusted method or discounted method
(3)Net Present Value method.(NPV)
(4)Profitability Index method (PI)
(5)Internal Rate of Retturn method (IRR)
(6)Net Terminal Valuee method (NTV)
(1) Pay back period method or pay out or pay off method.(PBP)
The basic element of this method is to calculate the recovery time, by year wise
accumulation of cash inflows (inclusive of depreciation) until the cash inflows equal the amount of
the original investment. The time taken to recover such original investment is the ―payback
period‖ for the project.
―The shorter the payback period, the more desirable a project‖.
The pay back period can be caalculated in two different situation as follows-
(a)When annual cash inflow are equal
Pay back period = Original cost of the project (cash outlay))

Annual net cash inflow (net earnings)
Example-. A project cost 1,00,000 and yields an annual cash inflow of 20,000 for 8 years,
calculate pay back period.

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Pay back period = Origginal cost of the project (cash outlay)

Annnual net cash inflow (net earnings)
1, 00, 000
= =5
years. 200, 000
(b) When annual cash inflowws are unequal
It is ascertained by cumulating cash inflows till the time when the cumulative cash inflows
become equal to initial investmment.
B
Pay back period =Y+
C
Y=No of years immediately preceding the year of final recovery.
B=Balance amount still to be recovered.
C=Cash inflow during the year of final recovery.
Example: Initial Investment = 10,000 in a project

Expected future cash inflows 2000, 4000, 3000, 2000
Solution :
Calculation of Pay Back periood.
Year Cash Inflowss ( ) Cumulative Cash Inflows ( )
1 2000 2000
2 4000 6000
3 3000 9000
4 2000 11000
The initial investment is recovvered between the 3rd and the 4th year.
Pay back period =Y+ B = 3+ 1000 years = 3+ 1 years= 3year 6months

C 2000 2
Merits of Pay back period :
(1) No assumptions about futuure interest rates.
(2) In case of uncertainty in fuuture, this method is most appropriate.
(3) A company is compelled to invest in projects with shortest payback period, ifcapital is a
constraint.
(4) It is an indication for the prospective investors specifying the payback period of their
investments.
(5) Ranking projects as per their payback period may be useful to firmms undergoing liquidity
constraints.

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Demerits of Pay back periodd:

(1) Cash generation beyond paayback period is ignored.
(2) The timing of returns and the cost of capital is not considered.
(3) The traditional payback method does not consider the salvage value of an investment.
(4) Percentage Return on the capital invested is not measured.
(5)Projects with long payback periods are characteristically those involved in long-term planning,
which are ignored in this appproach.
(2) Accounting Rate of Return method or Average Rate of Return (ARRR)
This method measures the increase in profit expected to result from investment.
It is based on accounting profiits and not cash flows.
ARR= Average income or retuurn 100

Average investment
Average investment = Originaal investment+Salvage

value 2
Example.
A project costing 10 lacss. EBITD (Earnings before Depreciation, Intterest and Taxes) during
the first five years is expectted to be 2,50,000; 3,00,000; 3,500,000; 4,00,000 and
5,00,000. Assume 33.99% tax and 30% depreciation on WDV Method.
Solution :
Computation of Project AR R :
Particulars Yr1 Yr 2 Yr3 Yr 4 Yr 5 Average
EBITD 2,50,0000 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000

Less : Depreciation 3,00,0000 2,10,000 1,47,000 1,02,900 72,030 1,66,386
EBIT (50,0000) 90,000 2,03,000 2,97,100 4,27,970 1,93,614
Less : Tax @ 33.99% - 13,596 69,000 1,00,984 1,4 5,467 65,809
Total (50,0000) 76,404 1,34,000 1,96,116 2,882,503 1,27,805
Book Value of Investment :

Beginning 10,00,0000 7,00,000 4,90,00 3,43,000 2,40,100
End 7,00,0000 4,90,000 3,43,000 2,40,100 1,68,070
Average 8,50,000 5,95,000 4,16,500 2,91,550 2,004,085 4,71,427

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ARR= Average income or retuurn 100=127805100== 27.11%

Average investment 471427
Note : Unabsorbed depreciatioon of Yr. 1 is carried forward and set-off against profits of Yr. 2.
Taxis calculated on the balance off profits
= 33.99% (90,000 – 500,000)
= 13,596/-
Merits of ARR
(1) This method considers all the years in the life of the project.
(2) It is based upon profits and not concerned with cash flows.
(3) Quick decision can be taken when a number of capital investmeent proposals are being
considered.
Demerits of ARR
(1) Time Value of Money is not considered.
(2) It is biased against short-term projects.
(3) The ARR is not an indiicator of acceptance or rejection, unless the rates are compared with
the arbitrary managemennt target.
(4) It fails to measure the ratte of return on a project even if there are uniform cash flows.
(3) Net Present Value methood.(NPV)
NPV= Present Value of Cashh Inflows – Present Value of Cash Outflow s
The discounting is done by thee entity‘s weighted average cost of capital.
The discounting factors is given by : n (1+ i)
1
Where
i = rate of interest per annum
n = no. of years over which diiscounting is made.
Example.
Z Ltd. has two projects under consideration A & B, each costing 60 lacs.
The projects are mutually excclusive. Life for project A is 4 years & projeect B is 3 years. Salvage
value NIL for both the projectts. Tax Rate 33.99%. Cost of Capital is 15%.
Net Cash Inflow ( in Lakhs)
At the end of the year Project A Project B P.V. @ 155%
1 60 100 0.870
2 110 130 0.756
3 120 50 0.685
4 50 — 0.572
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Solution :
Computation of Net Present Value of the Projects.
Project A ( in Lakhs)
Yr1 Yr. 2 Yr. 3 Yr. 4
1. Net Cash Inflow 60.00 110.00 120.00 50.00
2. Depreciation 15.00 15.00 15.00 15.00
3. PBT (1–2) 45.00 95.00 105.00 35.00
4. Tax @ 33.99% 15.30 32.29 35.70 11.90
5. PAT (3–4) 29.70 62.71 69.30 23.10
6. Net Cash Flow 44.70 77.71 84.30 38.10
(PAT+Deprn)
7. Discounting Factor 0.870 0.756 0.685 0.572
8. P.V. of Net Cash Flows 388.89 58.75 57.75 21.79
9. Total P.V. of Net Cash Floww = 177.18
10. P.V. of Cash outflow (Initial Investment) = 60.00
Net Present Value = 117.18
Project B
Yr. 1 Yr. 2 Yr. 3
1. Net Cash Inflow 100.00 130.00 50.00
2. Depreciation 20.00 20.00 20.00
3. PBT (1–2) 80.0 110.00 30.00
4. Tax @ 33.99% 27.19 37.39 10.20
5. PAT (3–4) 52.81 72.61 19.80
6. Next Cash Flow 72.81 92.61 39.80
(PAT+Dep.)
7. Discounting Factor 0.870 0.756 0.685
8. P.V. of Next Cash Flows 63.345 70.013 27.263
9. Total P.V. of Cash Inflows = 160.621
10. P.V. of Cash Outflows = 60.00
(Initial Investment)
Net Present Value = 100.621
As Project ―A‖ has a higher Net Present Value, it has to be taken up.

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Merits of Net Present Value method
(1) It recognises the Time Value of Money.

(2) It considers total benefits during the entire life of the Project.
(3) This is applicable in case of mutually exclusive Projects.
(4) Since it is based on the assumptions of cash flows, it helps in determining Shareholders Wealth.
Demerits of Net Present Value method

(1) This is not an absolute measure.
(2) Desired rate of return may vary from time to time due to changes in cost of capital.
(3) This Method is not effective when there is disparity in economic life of the projects.
(4) More emphasis on net present values. Initial investment is not given due importance.
(4)Profitability Index method (PI)
Profitability Index = P.V. of cash outflow

P.V. of cash inflow
If P.I > 1, project is accepted
P.I < 1, project is rejected
The Profitability Index (PI) signifies present value of inflow per rupe e of outflow. It helps to
compare projects involving different amounts of initial investments.
Example
Initial investment 20 lacs. Expected annual cash flows 6 lacs for 10 years. Cost of
Capital @ 15%.
Calculate Profitability Index.
Solution :
Cumulative discounting factor @ 15% for 10 years = 5.019
P.V. of inflows = 6.00 × 5.019 = 30.114 lacs.
Profitability Index =P.V. of cash outflow
P.V. of cash inflow
30.114
Profitability Index = =1.51
20
Decision : The project should be accepted.
(5)Internal Rate of Return method (IRR)

Internal Rate of Return is a percentage discount rate applied in capiital investment
decisions which brings the cost of a project and its expected future cash flows intto equality, i.e.,
NPV is zero.

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Example.
Project Cost Rs. 1,10,000
Cash Inflows :
Year 1 60,000
―2 20,000
―3 10,0000
―4 50,000
Calculate the Internal Rate of Return.
Solution :
Internal Rate of Return will be calculated by the trial and error method. The cash flow is not
uniform. To have an approximate idea about such rate, we can calculate the ―Factor‖. It represent
the same relationship of investment and cash inflows in case of payback calculation i.e.
F=I/C
Where F = Factor
I = Original investmennt
C = Average Cash infllow per annum
110000
Factor for the project = = 3.14.
350000
The factor will be located fRom the table ―P.V. of an Annuity of 1‖ representing number of years
corresponding to estimated useful life of the asset.
The approximate value of 3.144 is located against 10% in 4 years.
We will now apply 10% and 12% to get (+) NPV and (–) NPV [Which means IRR lies in between]
Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

( ) ( ) ( )
1 60,000 0.909 54,540 0.893 53,580
2 20,000 0.826 16,520 0.797 15,940
3 10,000 0.751 7,510 0.712 7,120
4 50,000 0.683 34,150 0.636 31,800
P.V. of Inflows 1,12,720 1,08,440
Less : Initial Investment 1,10,000 1,10,000
NPV 2,720 (1,560)

BBA IV
Graphically,
For 2%, Difference = 4,280
↓ ↓
10% 12%
NPV 2,720 (1560)
IRR may be calculated in two ways :
Forward Method : Taking 10%, (+) NPV
NPV at 10%
IRR =10%+  Difference in rate
Total Difference
2720
IRR =10%+ 2%
= 10% + 1.27% = 11.27%
Backward Method : Taking 12%, (–) NPV
(1560)
IRR =12%+ 2%
= 12% – 0.73% = 11.27%
The decision rule for the internal rate of return is to invest in a project if its rate of return is greater
than its cost of capital.
For independent projects and situations involving no capital rationing, then :
Situation Signifies Decision
IRR = Cost of Capital the investment is expected Indifferent between

not to change shareholder Accepting & Rejecting
wealth.
IRR > Cost of Capital The investment is expected Accept
to increase shareholders
wealth
IRR < Cost of Capital The investment is expected Reject
to decrease shareholders
wealth

BBA IV
Merits of Internal Rate of Return method :

(i) The Time Value of Money is considered.
(ii) All cash flows in thhe project are considered.
Demerits of Internal Rate of Return method
(i) Possibility of multiple IRR, interpretation may be difficult.
(ii) If two projects with differrent inflow/outflow patterns are compared, IRR will lead to peculiar
situations.
(iii) If mutually exclusive projects with different investments, a project with higher investment but
lower IRR contributes moore in terms of absolute NPV and increases thhe shareholders‘ wealth.
When evaluating mutuually exclusive projects, the one with the highest IRR may not be
the one with the best NPV.
The conflict between NPV & IRR for the evaluation of mutually exclusive projects is due
to the reinvestment assumption:
- NPV assumes cash fllows reinvested at the cost of capital.
-IRR assumes cash flows reinvested at the internal rate of return.
The reinvestment assumption may cause different decisions due to :
- Timing difference of cash flows.
- Difference in scale of operations.
-Project life disparity.
(6)Net Terminal Value methhod (NTV)
Assumption :
(1) Each cash flow is reinvest ed in another project at a predetermined rate of interest.
(2) Each cash inflow is reinvested elsewhere immediately after the complettion of the
project. Decision-making
If the P.V. of Sum Total of the Compound reinvested cash flows is greater than the P.V.
of the outflows of the project undder consideration, the project will be acceptedd otherwise not.
Example :
Original Investment 40,000
Life of the project 4 years
Cash Inflows 25,000 for 4 years
Cost of Capital 10% p.a.
Expected interest rates at whicch the cash inflows will be reinvested:
Year-end 1 2 3 4
% 8 8 8 8

BBA IV
Solution :
First of all, it is necessary to find out the total compounded sum which wiill be discounted back to
the present value.
Year Cash Inflows Rate of Int. (%) Yrs. of Compounding Total
( ) Investment Factor Compounding
( ) Sum ( )
1 25,000 8 3 1.260 31,500
2 25,000 8 2 1.166 29,150
3 25,000 8 1 1.080 27,000
4 25,000 8 0 1.000 25,000
1,12,650
Present Value of the sum of coompounded values by applying the discount rate @ 10%
Compounded Value of Cash Inflow = 112650 =

(1 i )n (1.10)4
= 1,12,650 × 0.683 = 76,940/ -
[ 0.683 being the P.V. of 1 receivable after 4 years ]
NTV=76,940-40,000.=36940
Decision: The present value of reinvested cash flows, i.e., 76,940 is greater than the original cash
outlay of 40,000.
The project should be accepted as per the Net terminal value criterion.

BBA IV
COST OF CAPITAL
The financing decision relates to the composition of relative proportion of various sources
of finance .The sources could be:
1. Shareholders fund: Equity share capital, Preference share capital, Accumulated profits.
2. Borrowing from outside agencies: Debentures, Loans from Financial Institutions.
Whether the companies choose shareholders funds or borrowed funds or a combination of both,
each type of fund carries a cost.
The cost of equity is the minimum return the shareholders would have received if they had
invested elsewhere. Borrowed funds cost involve interest payment.
Both types of funds incur cost and this is the cost of capital to the company. This means,
cost of capital is the minimum return expected by the company.
COST OF CAPITAL AND FINANCING DECISION.
James C. Van Horne: The cost of capital is ―a cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the market
price of the stock‖.
Soloman Ezra : ―Cost of Capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure‖.
It is the discount rate /minimum rate of return/opportunity cost of an investment.
IMPORTANCE OF COST OF CAPITAL :
The cost of capital is very important in Financial Management and plays a crucial role in
the following areas:
i) Capital budgeting decisions: The cost of capital is used for discounting cash flows under Net
Present Value method for investment proposals. So, it is very useful in capital budgeting decisions.
ii) Capital structure decisions: An optimal capital structure is that structure at which the value of
the firm is maximum and cost of capital is the lowest. So, cost of capital is crucial in designing
optimal capital structure.
iii) Evaluation of financial performance: Cost of capital is used to evaluate the
financialperformance of top management. The actual profitability is compared to the expected and
actual cost of capital of funds and if profit is greater than the cost
of capital the performance may be said to be satisfactory.
iv) Other financial decisions: Cost of capital is also useful in making such other
financialdecisions as dividend policy, capitalization of profits, making the rights issue, etc.
Explicit and Implicit Cost:Explicit costof any source of finance is the discount rate whichequates
the present value of cash inflows with the present value of cash outflows. It is the internal rate of
return.
BBA IV
Implicit cost also known as thhe opportunity cost is the opportunity foregoone in order to take up
aparticular project. For examplle, the implicit cost of retained earrings is thee rate of return
available to shareholders by investing thhe funds elsewhere.
ESTIMATION OF COMPOONENTS OF COST OF CAPITAL

Components of cost of capital includes individual source of financce in business. From the
viewpoint of capital budgetinng decisions, the long term sources of funnds are relevant as they
constitute the major sources of financing the fixed assets. In calculating the cost of capital,
therefore components include-
1. Long term debt (includding Debentures)
2. Preference capital
3. Equity Capital.
4. Retained Earnings
5. Weighted Average Cost of Capital
6. Marginal Cost of Capital
1. Cost of Debt (kd) ( Longg term debt (including Debentures))
Debt may be perpetual or redeemable debt. Moreover, it may be issueed at par, at premium or
discount. The computation of cost of debt in each is explained below.
Perpetual / irredeemable de bt :
Kd = Cost of debt before tax = I/NP
Kd = Cost of debt; I= interest; NP = Net Proceeds
kd(after-tax) = I (1-t)
NP
Where t = tax rate

Example
Y Ltd issued 2,00,000, 9% debentures at a premium of 10%. The costs of floatation are 2%. The
tax rate is 50%. Compute the after tax cost of debt.
I Rs.18000
Answer : kd (after-tax) = (1-t)= (1- 0.5) =4.17%
NP Rs.215600
[Net Proceeds = 2,00,000 + 20,000 – (2/100×2,20,000)]

Redeemable debt
The debt repayable after a certtain period is known as redeemable debt.
I1
i) Before-tax cost of febt=
/n(PNP)1
(P
NP)
2

BBA IV
I = interest : P = proceeds at par;

NP = net proceeds; n = No. of years in which debt is to be redeemed ii)
After tax cost of debt = Beffore – tax cost of debt × (1 -t)
Example
A company issued Rs. 1,00,000, 10% redeemble debentures at a discount of 5%. The cost
of floatation amount to Rs. 3,000. The debentures are redeemable after 5 years. Compute before –
tax and after – tax cost of debtt. The tax rate is 50%.
Solution :
I 1 / n ( P  NP)
Before-tax cost of febt=
2
100001 / 5(10000092000)
Before-tax cost of febt = =12.08%
1
(100000  920000)
2
[NP = 1,00,000 – 5,000 – 3,0000 = 92,000]
After tax cost of debt = Beforee – tax cost x (1-t) = 12.08 X (1-.5) = 6.04%
2.Cost of Preference Capitall (kP)

In case of preference share dividend are payable at a fixed rate. However, the dividends are
allowed to be deducted for computation of tax. So no adjustment for tax is required. Just like
debentures, preference share may be perpetual or redeemable. Further, theey may be issued at par,
premium or discount.
Perpetual Preference Capitaal

i) If issued at par ; Kp = D/P
Kp = Cost of preferencce capital
D = Annual preferencee dividend
P = Proceeds at par value
ii) If issued at premium or discount
Kp = D/NP Where NP = Net Proceeds.
Example :
A company issued 10,,000, 10% preference share of . 10 each, Cost of issue is . 2 per
share. Calculate cost of capital if these shares are issued (a) at par, (b) att 10% premium, and (c)
at5% discount.
Solutions : Cost of preference capital, (Kp) = D/NP
a) When issued at par :
10000
Kp = 100 =12.5%
100000  20000

BBA IV
[Cost of issue = 10,0000 × 2 = Rs. 20,000]

b) When issued at 10%% premium
10000 100 =11.11%
Kp=
100000 10000  20000

c) When issued at 5% discount :
Kp= 10000 100 =13.33%

100000  5000  20000
3.Cost of Equity capital

Cost of Equity is the expected rate of return by the equity shareholdders. Some argue that,
as there is no legal compulsion for payment, equity capital does not involve any cost. But it is not
correct. Equity shareholders normally expect some dividend from the company while making
investment in shares. Thus, the rate of return expected by them beco mes the cost of equity.
Conceptually, cost of equity share capital may be defined as the minimum rate of return that a firm
must earn on the equity part of total investment in a project in order to leavve unchanged the
market price of such shares. For the determination of cost of equity capital it may be divided into
two categories:
i) External equity or new issuee of equity shares.
ii) Retained earnings.
The cost of external equity ca n be computed as per the following approaches:
Dividend Yield / Divi dend Price Approach : According to this approach, the cost of equity
will be that rate of expected dividends which will maintain the present market price of equity
shares. It is calculated with the following formula :
Ke = D/NP (for new equity shares)
Or
Ke = D/MP (for existi ng shares)
Where,
Ke = Cost of equity
D = Expected dividend per share
NP = Net proceeds per share
MP = Market price per share
This approach rightly recognizes the importance of dividends. However, it ignores the
importance of retained earnings on the market price of equity shares. This method is suitable only
when the company has stable earnings and stable dividend policy over a peeriod of time.

BBA IV
Example:
A company issues, 10,000 equity shares of . 100 each at a premium of 10%. The
company has been paying 20%% dividend to equity shareholders for the pastt five years and
expected to maintain the same in the future also. Compute cost of equity capital. Will it make any
difference if the market price of equity shhare is 150 ?
Solution:
D 20
Ke= 100 = 100 =18.18%
NP 110
If the market price per share =Rs.150
D 20
Ke= 100= 10=13.33%
MP 150
Dividend yield plus Growth in dividend methods
According to this method, thee cost of equity is determined on the basis of the expected dividend
rate plus the rate of growth in dividend. This method is used when dividennds are expected to
grow at a constant rate.
Cost of equity is calculated as :
Ke = D1 /NP +g (for new equity issue)
Where,
D1 = expected dividend per share at the end of the year. [D11 = Do(1+g)]
NP = net proceeeds per share
g = growth in dividend for existing share is calculated as:
D1 / MP + g
Where,
MP = market price per share.
Example:
ABC Ltd plans to issue 1,00,,000 new equity share of 10 each at par. The floatation costs are
expected to be 5% of the share price. The company pays a dividend off 1 per share and the
growth rate in dividend is exppected to be 5%. Compute the cost of new eqquity share. If the
current market price is 15, computee the cost of existing equity share.
Solution:
Cost of new equity shaares = (Ke) = D/NP +g
Ke = 1 / (10-0.5) + 0.05 = 1 / 9.5 + 0.05
= 0.01053 + 0.05
= 0.1553 or 15.53%
Cost of existing equity share: ke = D / MP + g
Ke = 1/ 15 + 0.05 = 0.0667 or 11.67%

BBA IV
Earnings Yield Method –

According to this apprroach, the cost of equity is the discount rate that capitalizes a stream
of future earnings to evaluate the shareholdings. It is computed by taking earnings per share (EPS)
into consideration. It is calculaated as :
i) Ke = Earnings per shhare / Net proceeds = EPS / NP [For new share]
ii) Ke = EPS / MP [ Foor existing equity]
Example
XYZ Ltd is planning for an expenditure of 120 lakhs for its expansion programme.
Number of existing equity shaares are 20 lakhs and the market value of equity shares is 60. It has
net earnings of 180 lakhs. Compute the cost of existing equity share and the cost of new equity
capital assuming that new shaare will be issued at a price of 52 per shaare and the costs of new
issue will be 2 per share.
Solutions :
EPS
a) Cost of existing equuity= (Ke) =
MP
18000000
Earnings per share (EPPS) = =. 9
2000000
Ke =9/60=0.15 or 15%%
b) Cost of new equity capital (Ke) = EPS/NP=9/52-2=9/50=0.18 or 18%
4.Cost of Retained Earnings (Kr)

Retained earnings refeer to undistributed profits of a firm. Out of the total earnings, firms
generally distribute only part of them in the form of dividends and the resst will be retained within
the firms. Since no dividend is required to paid on retained earnings, itt is stated that ‗retained
earnings carry no cost‘. Buut this approach is not appropriate. Retaiined earnings have the
opportunity cost of dividends in alternative investment, which becomes cost of retained earnings.
Hence, shareholders expect a return on retained earnings at least equity.
Kr = Ke = D/NP+g
However, while calcullating cost of retained earnings, two adjustm ents should be made :a)
Income-tax adjustment as the shareholders are to pay some income tax out of dividends, and b)
adjustment for brokerage cost as the shareholders should incur some brokerage cost while invest
dividend income. Therefore, after these adjustments, cost of retained earninngs is calculated as :
Kr = Ke (1-t)(1-b) Where, Kr = cost of retained earnings

Ke = Cost of equity
t = rate of tax
b = cost of purchasing new securities or brokerage cost.

BBA IV
Example
A firm‗s cost of equity (Ke) is 18%, the average income tax rate of shareholders is 30%and
brokerage cost of 2% is excepted to be incurred while investing their dividends in alternative
securities. Compute the cost of retained earnings.
Solution:
Cost of retained earnings = (Kr) = Ke (1-t)(1-b)=18(1-.30)(1-.02)
=18x.7x.98=12.35%
5. Weighted Average Cost of Capital
It is the average of the costs of various sources of financing. It is also known as composite
or overall or average cost of capital.
After computing the cost of individual sources of finance, the weighted average cost of
capital is calculated by putting weights in the proportion of the various sources of funds to the total
funds. Weighted average cost of capital is computed by using either of the following two types of
weights:
1) Market value 2) Book Value
Market value weights are sometimes preferred to the book value weights as the market
value represents the true value of the investors. However, market value weights suffer from the
following limitations:
i) Market value are subject to frequent fluctuations.
ii) Equity capital gets more importance, with the use of market value
weights. Moreover, book values are readily available.
Average cost of capital is computed as followings:
x
Kw = 
 w
Where, Kw = weighted average cost of capital
X = cost of specific sources of finance
W = weights (proportions of specific sources of finance in the total)
The following steps are involved in the computation of weighted average cost of capital :
i) Multiply the cost of each sources with the corresponding weight.
ii) Add all these weighted costs so that weighted average cost of capital is obtained.
6. Marginal Cost of Capital

An average cost is the combined cost or weighted average cost of various sources of
capital. Marginal cost refers to the average cost of capital of new or additional funds required by a
firm. It is the marginal cost which should be taken into consideration in investment decisions.
Example: WACC and Marginal WACC Computation
XYZ Ltd. (in 40% Tax bracket) has the following book value capital structure —

BBA IV
Equity Capital (in shares of 10 each, fully paid-up at par) 15 Crores

11% Prefernece Capital (in shares of 100 each, fully paid-up at
par) 1 Crore
Retained Earnings
13.5% Debentures (of 1000 each)
200 Crores
15% Term Loans
100 Crores
122.5 Crores
The next expected dividend on Equity Shares is Rs. 3.60 per share. Dividends are expected to
grow at 7% and the Market price per share is 40.
-Preference Stock, redeemable after ten years, is currently selling att 75 per share.
-Debentures, redeemabble after 6 years, are selling at 80 per debenture.
Required :
1. Compute the present WACC using (a) Book Value Proportions and (b) Market Value
Proportions.
2. Compute the weighted Marginal Cost of Capital if the Company raisess 10 Cores next year,
given the following informatioon—
- The amount will be raiseed by equity and debt in equal proportions.
- The Company expects to retain 1.5 Cores earnings next year.
- The additional issue of Equity Shares will result in the net price per shhare being fixed at 32.
- The Debt capital raised by way of Term Loans will cost 15% for the first . 2.5 Cores and
16% for the next 2.5 Cores.
Solution :
1. Computation of Cost of Equuity under Dividend Approach
Present Cost of Equity under Dividend Approach :
Ke= Dividend per share +gg (Growth Rate) = Ke= 3.60 +7% =16.00%%
Market price per share 40.00
Revised Cost of Equity under Dividend Approach :
Ke= Dividend per share +gg (Growth Rate) = Ke= 3.60 +7% =18.25%%
Market price per share 32.00

BBA IV
2. Computation of Cost of Preeference Share Capital

11 (100  75) 10
Preference Dividend+(RV-Net Proceeds)  N  
RV+Net Proceeds  2 = 100  75  2 = 15.43%
 
3. Computation of Cost of Debt
Present Cost of Debentures :
Preference Dividend+(RV-Neet Proceeds)  N 
13.5 60%  (100 80) 6 
RV+Net Proceeds  2 = 100  80  2 = 12.70%
 
Present Cost of Term Loans = Kd = Interest (100%—Tax Rate) = 15% × (1100% –40%) = 9.00%.
Cost of Additional Debt for first Rs. 2.50 Crores=Interest (100%–Tax Ratee) = 15%×60%= 9. 00%
Cos fo Additional Debt for next Rs. 2.50 Crores=Interest (100%–Tax Rate)=16%×60%=9.60%.
3. Computation of Presennt WACC base on Book Value Proportions
Particulars Amount Proportion Individual Cost WACC

Equity Capital 15 Crore 15/58.5 16.00% 4.10%
Preference Capital 1 Crore 1/58.5 15.43% 0.26%
Retained Earnings 20 Crores 20/58.5 16.00% 5.47%

Debentures 10 Crores 10/58.5 12.70% 2.17%
Loans 12.5 Crores 12.5/58.5 9.00% 1.92%
Total 58.5 Crores 100% K0=13.92%
4. Computation of Present WAACC base on Market Value Proportions
Particulars Amount Proportion Individual Cost WACC
Equity Capital 60 Crores 60/81.25 16.00% 11.82%
Preference Capital . 0.75Crore

Retained Earnings Noot applicable* 0.75/81.25 15.43% 0.14%
Debentures 8 Crores 8/81.25 12.70% 1.25%
Loans 12.5 Crores 12.5/81.25 9.00% 1.38%
Total 81.25Crores 100% K0=14.59%
*Retained Earnings Included in Market Value of Equity Share Capital, hennce not applicable

BBA IV
6. Computation of Marginal Cost of Capital
Marginal Cost of Capital is coomputed in different segments as under —
For the first 1.5 Crores of Equity and Debt each — since retained earninngs are 1.5 Cores. For
the next 1 Crores of Debt and Equity each — since cost of debt changes beyond . 2.5 Crores
debt. For the balance 2.5 Crores of Debt and Equity each.
Particulars Debt Equity Total Individual Marginal WACC

Cost
First 1.5 1.5 1.5 Kd = 9.00% (9.00%×50%)+(16.00%×50%)

Crores Crores Crores 3Crores Ke = 16.00% = 12.50%
Next 1.5 Kd = 9.60% (9.60%×50%)+(18.25%×50%)

Crores 1 Crores 1 Crores 2Crores Ke = 18.25% = 13.93%
Balance 5 Kd = 9.60% (9.60%×50%)+(18.25%×50%)

amount 2.5Crores 2.5Crores Crores Ke = 18.25% = 13.93%
UNIT III
CAPITAL STRUCTURE THEORY
The capital structure of a company refers to a combination of the long-term finances used
by the firm. The theory of capital structure is closely related to the firm‘s cost of capital. The
decision regarding the capital structure or the financial leverage or the financing is based on the
objective of achieving the maximization of shareholders wealth. To design capital structure, we
should consider the following two propositions:
(i) Wealth maximization is attained.
(ii) Best approximation to the optimal capital structure.
Factors Determining Capital Structure
(1) Minimization of Risk :
(a) Capital structure must be consistent with business risk.
(b) It should result in a certain level of financial risk.
(2) Control : It should reflect the management‘s philosophy of control over the firM
(3) Flexibility : It refers to the ability of the firm to meet the requirements of the changing
situations.
(4) Profitability : It should be profitable from the equity shareholders point of view.
(5) Solvency : The use of excessive debt may threaten the solvency of the company.
(6)Financial leverage or Trading on equity.
(7) Cost of capital.
(8)Nature and size of the firm.
Process of Capital Structure Decisions
Capital Budgeting Decision

↓
Long-term sources of funds
↓
Capital Structure Decision
↓
Debt-Equity
↓
Effect on Cost of Capital
↓
Value of the Firm
THEORIES OF CAPITAL STRUCTURE:

Equity and debt capital are the two major sources of long-term funds for a firm. The
theories of capital structure suggest the proportion of equity and debt in the capital structure.
Assumptions
(i) There are only two sources of funds, i.e., the equity and the debt, having a fixed interest.
(ii) The total assets of the firm are given and there would be no change in the investment decisions
of the firm.
(iii) EBIT (Earnings Before Interest & Tax)/NOP (Net Operating Profits) of the firm are given and
is expected to remain constant.
(iv) Retention Ratio is NIL, i.e., total profits are distributed as dividends. [100% dividend pay-out
ratio]
(v) The firm has a given business risk which is not affected by the financing decision.
(vi) There is no corporate or personal taxes.
(vii) The investors have the same subjective probability distribtuion of expected operating profits
of the firm.
(viii) The capital structure can be altered without incurring transaction costs.
In discussing the theories of capital structure, we will consider the following notations :
E = Market value of the Equity
D = Market value of the Debt
V = Market value of the Firm = E +D
I = Total Interest Payments
T = Tax Rate
EBIT/NOP = Earnings before Interest and Tax/Net Operating
Profit PAT = Profit After Tax
D0 = Dividend at time 0 (i.e. now)
D1 = Expected dividend at the end of Year 1.
Po = Current Market Price per share
P1 = Expected Market Price per share at the end of Year 1.
Different Theories of Capital Structure
(1) Net Income (NI) approach
(2) Net Operating Income (NOI) Approach
(3) Traditional Approach
(4) Modigliani-Miller Model
(a) without taxes
(b) with taxes.
Net Income Approach
As suggested by David Durand, this theory states that there is a relationship between the
Capital Structure and the value of the firm.
Assumptions
(1) Total Capital requirement of the firm are given and remain constant
(2) Kd < Ke
(3) Kd and Ke are constant
(4) Ko decreases with the increase in leverage
BBA IV
Example
Firm A Firm B
Earnings Before Interest and Tax (EBIT) 2,00,000 2,00,000

Interest (I) - 50,000
Equity Earnings (Ee) 2,00,000 1,50,000
Cost of Equity (Ke) 12% 12%
Cost of Debt (Kd) 10% 10%
Market Value of Equity (E)= Ee 16,66,667 12,50,000

Ke
I
Market Value of Debt (D)
Kd NIL 5,00,000
Total Value of the Firm [E+DD]
16,66,667 17,50,000
Overall cost of capital (K0) EBIT
ED
12% 11.43%
Net Operating Income (NOII) Approach

According to David Durand, under NOI approach, the total valuee of the firm will not be
affected by the composition of capital structure.
Assumptions
(1) K0 and Kd are constant.
(2) Ke will change with the degree of leverage.
(3) There is no tax.
Example
A firm has an EBIT of 5,00,000 and belongs to a risk class of 10%. What is the cost of
Equity if it employs 6% debt to the extent of 30%, 40% or 50% of the total capital fund of . 2.5
Crores debt.
Solution
30% 40% 50%
Debt ( ) 6,00,000 8,00,000 10,00,0000
Equity ( ) 4,00,000 12,00,000 10,00,0000
EBIT ( .) 5,00,00 5,00,000 5,00,0000
Ko 10% 10% 10%
Value of the Firm (V) ( ) 50,00,000 50,00,000 50,00,0000
(EBIT/Ko)

Value of Equity (E) ( .) 44,00,000 42,00,000 40,00,0000
(V–D)
Interest @ 6% ( ) 36,000 48,000 60,0000
Net Profit (EBIT–Int.) ( ) 4,64,000 4,52,000 4,40,0000
Ke (NP/E) 10.545% 10.76% 11%
Traditional Approach :
It takes a mid-way between th e NI approach and the NOI
approach Assumptions
(i) The value of the firm increases with the increase in financial leverage, upto a certain
limit only.
(ii) Kd is assumed to be less than Ke.
BBA IV
DIVIDEND DECISION
The term dividend refers to that part of profits of a company which is distributed by the
company among its shareholders. It is the reward of the shareholders for investments made by
them in the shares of the company. The investors are interested in earning the maximum return on
their investments and to maximize their wealth. A company, on the other hand, needs to provide
funds to finance its long-term growth. If a company pays out as dividend most of what it earns,
then for business requirements and further expansion it will have to depend upon outside resources
such as issue of debt or new shares. Dividend policy of a firm, thus affects both the long-term
financing and the wealth of shareholders. As a result, the firm‘s decision to pay dividends must be
reached in such a manner so as to equitably apportion the distributed profits and retained earnings.
Since dividend is a right of Shareholders to participate in the profits and surplus of the company
for their investment in the share capital of the company, they should receive fair amount of the
profits. The company should, therefore, distribute a reasonable amount as dividends (which should
include a normal rate of interest plus a return for the risks assumed) to its members and retain the
rest for its growth and survival.
FACTORS AFFECTING DIVIDEND POLICY:

There is a controversy amongst financial analysts regarding impact of dividends on market
price of a company‘s shares. Some argue that dividends do not have any impact on such price
while others hold a different opinion. However, preponderance of evidence suggests that dividend
policies do have a significant effect on the value of the firm‘s equity shares in the stock exchange.
Having accepted this premise, it will now be appropriate to consider those factors which affect the
dividend policy of a firm.
The factors affecting the dividend policy are both external as well as internal.
External factors
1.General state of economy - The general state of economy affects to a great extent
themanagement‘s decision to retain or distribute earnings of the firm. In case of uncertain
economic and business conditions, the management may like to retain the whole or a part of the
firm‘s
earnings to build up reserves to absorb shocks in the future. Similarly in periods of depression, the
management may also withhold-dividends payment to retain a large part of its earnings to preserve
the firm‘s liquidity position. In periods of prosperity the management may not be liberal in
dividend payments though the earning power of a company warrants it because of availability of
larger profitable investment opportunities similarly in periods of inflation, the management may
withhold dividend payments in order to retain larger proportion of the earnings for replacement of
worn-out assets.
2. Legal restrictions - A firm may also be legally restricted from declaring and paying
dividends.For example, in India, the companies Act, 1956 has put several restrictions regarding
payments and declaration of dividends. Some of these restrictions are as follows :
(i) Dividends can only be paid out of (a) the current profits of the company, (b) the past
accumulated profits or (c) money provided by the Central or State Governments for the payment
of dividends in pursuance of the guarantee given by the Government. Payment of dividend out of
capital is illegal.
(ii) A company is not entitled to pay dividends unless (a) it has provided for present as well as all
arrears of depreciation, (b) a certain percentage of net profits of that year as prescribed by the
entral Government not exceeding 10%, has been transferred to the reserves of the company.
(iii) Past accumulated profits can be used for declaration of dividends only as per the rules framed
by the Central Government in this behalf.
Similarly, the Indian Income Tax Act also lays down certain restrictions on payment of
dividends. The management has to take into consideration all the legal restrictions before taking
the dividend decision otherwise it may be declared as ultra vires .
Internal factors
The following are the internal factors which affect the dividend policy of a firm:
1. Desire of the shareholders - Of course, the directors have considerable liberty regarding the
disposal of the firm‘s earnings, but the shareholders are technically the owners of the companyand,
therefore, their desire cannot be overlooked by the directors while deciding about the dividend
policy.
Shareholders of a firm expect two forms of return from their investment in a firm:
(i) Capital gains - The sharehoolders expect an increase in the market value of the equity shares
held by them over a period of tim e. Capital gain refers to the profit resulting from the sale of
capital investment i.e., the equity shares in case of shareholders. For example, if a shareholder
purchases a share for 40 and later on sells it for 60 the amount of capital gain is a sum of 20.
(ii) Dividends - The shareholdders also expect a regular return on their inveestment from the firm.
In most cases the shareholders‘ desire to get dividends takes priority over the desire to earn
capitalgains because of the followingg reasons:
(a) Reduction of uncertainty - Capital gains or a future distribution of earnings involves more
uncertainty than a distribution of current earnings.
(b) Indication of strength - The declaration and payment of cash dividend carries an information
content that the firm is reasonably strong and healthy.
(c) Need for current income - Many shareholders require income from thhe investment to pay for
their current living expenses. Such shareholders are generally reluctant to sell their shares to earn
capital gain.
2. Financial needs of the commpany - The financial needs of the company are to be considered by the
management while taking the dividend decision. Of course, the financiial needs of the company may be
in direct conflict with the desire of the shareholders to receive largge dividends. However, a
prudent management should give more weightage to the financial needss of the company rather than
the desire of the sharehollders. In order to maximize the shareholders‘ wealth, it is advisable to
retain earnings in the business only when company has better profitable investment opportunities
as compared to the shareholdeers. However, the directors must retain some earnings, whether or
not profitable investment opporttunity exists, to maintain the company as a sound and solvent
enterprise.
3. Desire of control - Dividend policy is also influenced by the desire of shareholders or the
management to retain control over the company. The issue of additional equity shares for
procuring funds dilutes contrrol to the detriment of the existing equity shareholders who have a
dominating voice in the commpany. At the same time, recourse to longg-term loans may entail
financial risks and may provee disastrous to the interests of the shareholders in times of financial
difficulties.
In case of a strong dessire for control, the management may be reluctant to pay substantial
dividends and prefer a smallerr dividend pay out ratio. This is particularly true in case of
companies which need funds for financin g profitable investment opportunities and an outside
group is seeking to gain control over the compaany.
However, where the management is strongly in control of the commpany either because of
substantial shareholdings or because of the shares being widely held, the firm can afford to have a
high dividend pay out ratio.
4. Liquidity position - The payyment of dividends results in cash outflow fr om the firm. A firm
may have adequate earnings but it may not have sufficient cash to pay divvidends. It is, therefore,
important for the management to take into account the cash position and the overall liquidity
position of the firm before annd after payment of dividends while taking the dividend decision. A
firm may not, therefore, be inn a position to pay dividends in cash or at a higher rate because of
insufficient cash resources. Such a problem is generally faced by growing firms which need
constant funds for financing thheir expansion activities.
TYPES OF DIVIDEND POLICY :

The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired
persons, widows and other economically weaker persons prefer to get regular dividends.
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet their day-today
living expenses.
f. If profits are not distributed regularly and are retained, the shareholders may have to pay a
higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings. A company should establish the regular dividend
at a lower rate as compared to the average earnings of the company.
2. Stable Dividend Policy
The term ‗stability of dividends‘ means consistency or lack of variability in the stream
ofdividend payments. In more precise terms, it means payment of certain minimum amount of dividend
regularly. A stable dividend policy may be established in any of the following three forms.
Constant dividend per share: Some companies follow a policy of paying fixed dividend per
share irrespective of the level of earnings year after year. Such firms, usually, create a ‗Reserve for
Dividend Equalisation‘ to enable them to pay the fixed dividend even in the year when the
earnings are not sufficient or when there are losses. A policy of constant dividend per share is most
suitable to concerns whose earnings are expected to remain stable over a number of years. Figure
given below shows the behaviour of dividend in such policy.
2. Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d. Fear of adverse effects of regular dividends on the financial standing of the company.
4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of its unfavourable
working capital position or on account of requirements of funds for future expansion and growth.
5. Residual Dividend Policy
When new equity is raised floatation costs are involved. This makes new equity costlier
than retained earnings. Under the Residual approach, dividends are paid out of profits after making
provision for money required to meet upcoming capital expenditure commitments.
BBA IV
UNIT IV
WORKING CAPITAL MANAGEMENT
The term working capital is commonly used for the capital required for day-to-day working
in a business concern, such as for purchasing raw material, for meeting day-to-day expenditure on
salaries, wages, rents rates, advertising etc. But there are much disagreement among various
financial authorities (Financiers, accountants, businessmen and economists) as to the exact
meaning of the term working capital.
DEFINITION AND CLASSIFICATION OF WORKING CAPITAL :
Working capital refers to the circulating capital required to meet the day to day operations of a
business firm. Working capital may be defined by various authors as follows:
1. According to Weston & Brigham - ―Working capital refers to a firm‘s investment in short term
assets, such as cash amounts receivables, inventories etc.
2. Working capital means current assets. —Mead, Baker and Malott
3. ―The sum of the current assets is the working capital of the business‖ —J.S.Mill Working
capital is defined as ―the excess of current assets over current liabilities and provisions‖.
But as per accounting terminology, it is difference between the inflow and outflow of
funds. In the Annual Survey of Industries (1961), working capital is defined to include ―Stocks of
materials, fuels, semi-finished goods including work-in-progress and finished goods and by-
products; cash in hand and bank and the algebraic sum of sundry creditors as represented by (a)
outstanding factory payments e.g. rent, wages, interest and dividend; b)purchase of goods and
services; c) short-term loans and advances and sundry debtors comprising amounts due to the
factory on account of sale of goods and services and advances towards tax payments‖.
The term ―working capital‖ is often referred to ―circulating capital‖ which is frequently
used to denote those assets which are changed with relative speed from one form to another i.e.,
starting from cash, changing to raw materials, converting into work-in-progress and finished
products, sale of finished products and ending with realization of cash from debtors. Working
capital has been described as the ―life blood of any business which is apt because it constitutes a
cyclically flowing stream through the business‖.
Concepts of working capital
1. Gross Working Capital: It refers to the firm‘s investment in total current or circulating assets.
2. Net Working Capital: The term ―Net Working Capital‖ has been defined in two different ways:
i. It is the excess of current assets over current liabilities. This is, as a matter of fact, the most
commonly accepted definition. Some people define it as only the difference between current assets
and current liabilities. The former seems to be a better definition as compared to the latter.
ii. It is that portion of a firm‘s current assets which is financed by long-term funds.
3. Permanent Working Capital: This refers to that minimum amount of investment in all current
assets which is required at all times to carry out minimum level of business activities. In other
words, it represents the current assets required on a continuing basis over the entire year. Tandon
Committee has referred to this type of working capital as ―Core current assets‖.

BBA IV
The following are the characteristics of this type of working capital:

1. Amount of permanent working capital remains in the business in one form or another. This is
particularly important from the point of view of financing. The suppliers of such working capital
should not expect its return during the life-time of the firm.
2. It also grows with the size of the business. In other words, greater the size of the business,
greater is the amount of such working capital and vice versa Permanent working capital is
permanently needed for the business and therefore it should be financed out of long-term funds.
4. Temporary Working Capital: The amount of such working capital keeps on fluctuating from
time to time on the basis of business activities. In other words, it represents additional current
assets required at different times during the operating year. For example, extra inventory has to be
maintained to support sales during peak sales period. Similarly, receivable also increase and must
be financed during period of high sales. On the other hand investment in inventories, receivables,
etc., will decrease in periods of depression. Suppliers of temporary working capital can expect its
return during off season when it is not required by the firm. Hence, temporary working capital is
generally financed from short-term sources of finance such as bank credit.
5. Negative Working Capital: This situation occurs when the current liabilities exceed the current
assets. It is an indication of crisis to the firm.
Need for Working Capital
Working capital is needed till a firm gets cash on sale of finished products. It depends on two
factors:
i. Manufacturing cycle i.e. time required for converting the raw material into finished product;
and ii. Credit policy i.e. credit period given to Customers and credit period allowed by creditors.
Thus, the sum total of these times is called an ―Operating cycle‖ and it consists of the
following six steps:
o Conversion of cash into raw materials.
o Conversion of raw materials into work-in-process.
o Conversion of work-in-process into finished products.
o Time for sale of finished goods—cash sales and credit sales.
o Time for realisation from debtors and Bills receivables into cash.
o Credit period allowed by creditors for credit purchase of raw materials, inventory
and creditors for wages and overheads.
DETERMINANTS OF WORKING CAPITAL:
The factors influencing the working capital decisions of a firm may be classified as two
groups, such as internal factors and external factors. The internal factors includes, nature of
business size of business, firm‘s product policy, credit policy, dividend policy, and access to
money and capital markets, growth and expansion of business etc. The external factors include
business fluctuations, changes in the technology, infrastructural facilities, import policy and the
taxation policy etc. These factors are discussed in brief in the following lines.

BBA IV
I. Internal Factors
1. Nature and size of the business
The working capital requirements of a firm are basically influenced by the nature and size
of the business. Size may be measured in terms of the scale of operations. A firm with larger scale
of operations will need more working capital than a small firm. Similarly, the nature of the
business - influence the working capital decisions. Trading and financial firms have less
investment in fixed assets. But require a large sum of money to be invested in working capital.
Retail stores, business units require larger amount of working capital, where as, public utilities
need less working capital and more funds to invest in fixed assets.
2. Firm‘s production policy
The firm‘s production policy (manufacturing cycle) is an important factor to decide the
working capital requirement of a firm. The production cycle starts with the purchase and use of
raw material and completes with the production of finished goods. On the other hand production
policy is uniform production policy or seasonal production policy etc., also influences the working
capital decisions. Larger the manufacturing cycle and uniform production policy –larger will be
the requirement of working capital. The working capital requirement will be higher with varying
production schedules in accordance with the changing demand.
3. Firm‘s credit policy
The credit policy of a firm influences credit policy of working capital. A firm following
liberal credit policy to all customers require funds. On the other hand, the firm adopting strict
credit policy and grant credit facilities to few potential customers will require less amount of
working capital.
4. Availability of credit
The working capital requirements of a firm are also affected by credit terms granted by its
suppliers – i.e. creditors. A firm will need less working capital if liberal credit terms are available
to it. Similarly, the availability of credit from banks also influences the working capital needs of
the firm. A firm, which can get bank credit easily on favourable conditions, will be operated with
less working capital than a firm without such a facility.
5.Growth and expansion of business
Working capital requirement of a business firm tend to increase in correspondence with
growth in sales volume and fixed assets. A growing firm may need funds to invest in fixed assets
in order to sustain its growing production and sales. This will, in turn, increase investment in
current assets to support increased scale of operations. Thus, a growing firm needs additional
funds continuously.
6.Profit margin and dividend policy
The magnitude of working capital in a firm is dependent upon its profit margin and
dividend policy. A high net profit margin contributes towards the working capital pool. To the
extent the net profit has been earned in cash, it becomes a source of working capital. This depends
upon the dividend policy of the firm. Distribution of high proportion of profits in the form of cash
dividends results in a drain on cash resources and thus reduces company‘s working capital to that
extent. The working capital position of the firm is strengthened if the management follows
conservative dividend policy and vice versa.

BBA IV
7. Operating efficiency of the firm

Operating efficiency means the optimum utilisation of a firm‘s resources at minimum cost.
If a firm successfully controls operating cost, it will be able to improve net profit margin which,
will, in turn, release greater funds for working capital purposes.
8. Co-ordinating activities in firm
The working capital requirements of a firm is depend upon the co-ordination between
production and distribution activities. The greater and effective the co-ordinations, the pressure on
the working capital will be minimized. In the absence of co-ordination, demand for working
capital is reduced.
II. External Factors
1. Business fluctuations
Most firms experience fluctuations in demand for their products and services. These
business variations affect the working capital requirements. When there is an upward swing in the
economy, sales will increase, correspondingly, the firm‘s investment in inventories and book debts
will also increase. Under boom, additional investment in fixed assets may be made by some firms
to increase their productive capacity. This act of the firm will require additional funds. On the
other hand when, there is a decline in economy, sales will come down and consequently the
conditions, the firm try to reduce their short-term borrowings. Similarly the seasonal fluctuations
may also affect the requirement of working capital of a firm.
2. Changes in the technology
The technological changes and developments in the area of production can have immediate
effects on the need for working capital. If the firm wish to install a new machine in the place of old
system, the new system can utilise less expensive raw materials, the inventory needs may be
reduced there by working capital needs.
3. Import policy
Import policy of the Government may also effect the levels of working capital of a firm
since they have to arrange funds for importing goods at specified times.
4. Infrastructural facilities
The firms may require additional funds to maintain the levels of inventory and other
current assets, when there is good infrastructural facilities in the company like, transportation and
communications.
5. Taxation policy
The tax policies of the Government will influence the working capital decisions. If the
Government follow regressive taxation policy, i.e. imposing heavy tax burdens on business firms,
they are left with very little profits for distribution and retention purpose. Consequently the firm
has to borrow additional funds to meet their increased working capital needs. When there is a
liberalised tax policy, the pressure on working capital requirement is minimised. Thus the working
capital requirements of a firm is influenced by the internal and external factors.

BBA IV
Importance or Advantages of Adequate Working Capital

Working capital is the life blood and nerve centre of a business. Jusst as circulation of
blood is essential in the human boddy for maintaining life, working capital is veery essential to
maintain the smooth running of a busin ess. No business can run successfully withouut an
adequate amount of working capital. The main addvantages of maintaining adequate amount of
working capital are as follows:
1. Solvency of the business:: Adequate working capital helps in maintaining solvency of the
business by providing uninterrrupted flow of production.
2. Goodwill: Sufficient working capital enables a business concern to makke prompt payments and
hence helps in creating and maintaining goodwill.
3. Easy loans: A concern haviing adequate working capital, high solvency and good credit standing
can arrange loans from banks and other on easy and favourable terms.
4. Cash discounts: Adequate working capital also enables a concern to avaail cash discounts on the
purchases and hence it reduces costs.
5. Regular supply of raw m aterials: Sufficient working capital ensures regular supply of raw
materials and continuous prodduction.
6. Regular payment of salariees, wages and other day-to-day commitmentss: A company which
has ample working capital can make regular payment of salaries, wagess and other day-to-day
commitments which raises the morale of its employees, increases thheir efficiency, reduces
wastages and costs and enhances production and profits
7. Exploitation of favourable market conditions: Only concerns with adequate working capital can
exploit favourable market connditions such as purchasing its requirements in bulk when the prices
are lower and by holding its innventories for higher prices.

BBA IV
8. Ability to face crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression because during such periods, generally, there‘s much pressure on
working capital.
9. Quick and regular return on investments: Every Investor wants a quick and regular return on his
investments. Sufficiency of working capital enables a concern to pay quick and regular dividends
to its investors as there may not be much pressure to plough back profits. This gains the confidence
of its investors and creates a favourably market to raise additional funds i.e., the future.
10. High morale: Adequacy of working capital creates an environment of security, confidence,
high morale and creates overall efficiency in a business.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its business
operations. It should have neither redundant or excess working capital nor inadequate or shortage
of working capital. Both excess as well as short working capital positions are bad for any business.
However, out of the two, it is the inadequacy of working capital which is more dangerous from the
point of view of the firm.
Disadvantages of Redundant or Excessive Working Capital
1. Excessive Working Capital means ideal funds which earn no profits for the business and hence
the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses
3. Excessive working capital implies excessive debtors and defective credit policy which may
cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial institutions
may not be maintained.
6. Due to low rate of return on investments, the value of shares may also fall.
7.The redundant working capital gives rise to speculative transactions
Disadvantages or Dangers of Inadequate Working Capital
1. A concern which has inadequate working capital cannot pay its short-term liabilities in time.
Thus, it will lose its reputation and shall not be able to get good credit facilities.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and its creates inefficiencies,
increases costs and reduces the profits of the business.
5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid
funds.
6. The rate of return on investments also falls with the shortage of working capital.

BBA IV
MANAGEMENT OF WORKING CAPITAL :

Working Capital Management involves management of different components of working
capital such as cash, inventories, accounts receivable, creditors etc. A brief description follows
regarding the various issues involved in the management of each of the above components of
working capital.
INVENTORY MANAGEMENT:
Inventory constitutes an important item in the working capital of many business concerns.
Net working capital is the difference between current assets and current liabilities. Inventory is a
major item of current assets. The term inventory refers to the stocks of the product of a firm is
offering for sale and the components that make up the product Inventory is stores of goods and
stocks. This includes raw materials, work-in-process and finished goods. Raw materials consist of
those units or input which are used to manufactured goods that require further processing to
become finished goods. Finished goods are products ready for sale. The classification of
inventories and the levels of the components vary from organisaion to organisation depending
upon the nature of business. For example steel is a finished product for a steel industry, but raw m
aterial for an automobile manufacturer. Thus, inventory may be defined as ―Stock of goods thatis
held for future use‖. Since inventories constitute about 50 to 60 percent of current assets, the
management of inventories is crucial to successful working capital management. Working capital
requirements are influenced by inventory holding. Hence, the need for effective and efficient
management of inventories. Inventory management refers to an optimum investment in
inventories. It should neither be too low to effect the production adversely nor too high to block
the funds unnecessarily. Excess investment in inventories is unprofitable for the business. Both
excess and inadequate investment in inventories is not desirable. The firm should operate within
the two danger points. The purpose of inventory management is to determine and maintain the
optimum level of inventory investment.
Techniques of Inventory Control
The following are the various measures of selective control of inventory :
A. Economic Ordering Quantity (EOQ):It is important to note that only the correct quantity
ofmaterials is to be purchased. For this purpose, the factors such as maximum level, minimum
level, danger level, re-ordering level, quantity already on order, quantity reserved, availability of
funds,
quantity discount, interest on capital, average consumption and availability of storage
accommodation are to be kept in view. There should not be any over stock vis-à-vis no question of
non-stock. Balance should be made between the cost of carrying and cost of non-carrying i.e. cost
of stock-out. Cost of carrying includes the cost of storage, insurance, obsolescence, interest on
capital invested. Cost of not carrying includes the costly purchase, loss of production and sales and
loss of customer‘s goodwill. Economic Ordering Quantity (EOQ) is the quantity fixed at the point
where the total cost of ordering and the cost of carrying the inventory will be the minimum. If the
quantity of purchases is increased, the cost of ordering decreases while the cost of carrying
increases. If the quantity of purchases is decreased, the cost of ordering increases while the cost of
carrying decreases. But in this case, the total of both the costs should be kept at minimum. Thus,
EOQ may be arrived at by Tabular method by preparing purchase order quantity tables showing
the ordering cost, carrying cost and total cost of various sizes of purchase orders.
B. Fixing levels (Quantity Control) - For fixing the various levels such as maximum,
minimum,etc., average consumption and lead time i.e. the average time taken between the
initiation of purchase order and the receipt of materials from suppliers are to be estimated for each
item of materials.
a. Maximum Stock Level - The maximum stock level is that quantity above which
stocksshould not normally be allowed to exceed. The following factors are taken into
consideration while fixing the maximum stock level:
1. Average rate of consumption of material.
2. Lead time.
3. Re-order level.
4. Maximum requirement of materials for production at any time.
5. Storage space available cost of storage and insurance.
6. Financial consideration such as price fluctuations, availability of capital, discounts due to
seasonal and bulk purchases, etc.
7. Keeping qualities e.g. risk of deterioration, obsolescence, evaporation, depletion and natural
waste, etc.
8. Any restrictions imposed by local or national authority in regard to materials
i.e. purchasing from small scale industries and public sector undertakings, price preference
clauses, import policy, explosion in case of explosive materials, risk of fire, etc.; and
9. Economic ordering quantity is also considered.
Formula
Maximum Level = Re-order level—(Minimum consumption) × (Minimum lea d times)
+Reordering quantity
b. Minimum Stock Level - The minimum stock level is that quantity below which
stocksshould not normally be allowed to fall. If stocks go below this level, there will be danger of
stoppage of production due to shortage of supplies. The following factors are taken into account
while fixing the minimum stock level:

BBA IV
1. Average rate of consumption of material.

2. Average lead time. The shorter the lead time, the lower is the minimum level.
3. Re-order level.
4. Nature of the item.
5. Stock out cost.
Formula
Minimum Level = Re-order level – (Average usage × Average lead time)
c. Re-order Level - This is the point fixed between the maximum and minimum
stocklevels and at this time, it is essential to initiate purchase action for fresh supplies of the
material. In order to cover the abnormal usage of material or unexpected delay in delivery of fresh
supplies, this point will usually be fixed slightly higher than the minimum stock level. The
following factors are taken into account while fixing the re-order level:
1. Maximum usage of materials
2. Maximum lead time
3. Maximum stock level
4. Minimum stock level
Formula
Re-order level = Maximum usage X Maximum lead time or Minimum level +
Consumption during lead time.
Re-ordering Quantity (How much to purchase): It is also called Economic Ordering
Quantity.
d. Danger level.- This is the level below the minimum stock level. When the stock
reachesthis level, immediate action is needed for replenishment of stock. As the normal lead time
is not available, regular purchase procedure cannot be adopted resulting in higher purchase cost.
Hence, this level is useful for taking corrective action only. If this is fixed below the reorder level
and above the minimum level, it will be possible to take preventive action.
C. ABC Analysis for Inventory Control: ABC analysis is a method of material control
accordingto value. The basic principle is that high value items are more closely controlled than the
low value items. The materials are grouped according to the value and frequency of replenishment
during a Period.
‗A‘ Class items: Small percentage of the total items but having higher values.
‗B‘ Class items: More percentage of the total items but having medium values.
‗C‘ Class items: High percentage of the total items but having low values.
D. V.E.D. Classification: The V.E.D. classification is applicable mainly to the spare parts. Spares
are classified as vital (V), essential (E) and desirable (D). Vital class spares have to be stocked
adequately to ensure the operations of the plant but some risk can be taken in the case of ‗E‘ class
spares. Stocking of desirable spares can even be done away with if the lead time for their
procurement is low. Similarly, classification may be done in respect of the plant and machinery as
vital, essential, important and normal (VEIN).

BBA IV
E. Just in Time (JIT): Normally, inventory costs are high and controlling inventory is
complexbecause of uncertainties in supply, dispatching, transportation etc. Lack of coordination
between suppliers and ordering firms is causing severe irregularities, ultimately the firm ends-up in
inventory problems. Toyota Motors has first time suggested just – in – time approach in 1950s.
This means the material will reach the points of production process directly form the suppliers as
per the time schedule. It is possible in the case of companies with respective process. Since, it
requires close coordination between suppliers and the ordering firms, and therefore, only units with
systematic approach will be able to implement it.
CASH MANAGEMENT
Cash management is one of the key areas of working capital management. Cash is the most
liquid current assets. Cash is the common denominator to which all current assets can be reduced
because the other major liquid assets, i.e. receivable and inventory get eventually converted into
cash. This underlines the importance of cash management. The term ―Cash‖ with reference to
management of cash is used in two ways. In a narrow sense cash refers to coins, currency, cheques,
drafts and deposits in banks. The broader view of cash includes near cash assets such as
marketable securities and time deposits in banks. The reason why these near cash assets are
included in cash is that they can readily be converted into cash. Usually, excess cash is invested in
marketable securities as it contributes to profitability.
Cash is one of the most important components of current assets. Every firm should have
adequate cash, neither more nor less. Inadequate cash will lead to production interruptions, while
excessive cash remains idle and will impair profitability. Hence, the need for cash management.
Thus, the aim of cash management is to maintain adequate cash balances at one hand and
to use excess cash in some profitable way on the other hand.
Motives
Motives or desires for holding cash refer to various purposes. The purpose may be different
from person to person and situation to situation. There are four important motives to hold cash.
a. Transactions motive - This motive refers to the holding of cash, to meet routine
cashrequirements in the ordinary course of business. A firm enters into a number of transactions
which requires cash payment. For example, purchase of materials, payment of wages, salaries,
taxes, interest etc. Similarly, a firm receives cash from cash sales, collections from debtors, return
on investments etc. But the cash inflows and cash outflows do not perfectly synchronise.
Sometimes, cash receipts are more than payments while at other times payments exceed receipts.
The firm must have to maintain sufficient (funds) cash balance if the payments are more than
receipts. Thus, the transactions motive refers to the holding of cash to meet expected obligations
whose timing is not perfectly matched with cash receipts. Though, a large portion of cash held for
transactions motive is in the form of cash, a part of it may be invested in marketable securities
whose maturity conform to the timing of expected payments such as dividends, taxes etc.
b. Precautionary motive - Apart from the non-synchronisation of expected cash receipts
andpayments in the ordinary course of business, a firm may be failed to pay cash for unexpected
contingencies. For example, strikes, sudden increase in cost of raw materials etc. Cash held to meet
these unforeseen situations is known as precautionary cash balance and it provides a caution
against them. The amount of cash balance under precautionary motive is influenced by two factors
i.e. predictability of cash flows and the availability of short term credit. The more unpredictable
the cash flows, the greater the need for such cash balances and vice versa. If the firm can borrow at

BBA IV
short-notice, it will need a relatively small balance to meet contingencies and vice versa. Usually
precautionary cash balances are invested in marketable securities so that they contribute something
to profitability.
c. Speculative motive - Sometimes firms would like to hold cash in order to exploit, the
profitableopportunities as and when they arise. This motive is called as speculative motive. For
example, if the firm expects that the material prices will fall, it can delay the purchases and make
purchases in future when price actually declines. Similarly, with the hope of buying securities
when the interest rate is expected to decline, the firm will hold cash. By and large, firms rarely
hold cash for speculative purposes.
d. Compensation motive - This motive to hold cash balances is to compensate banks and
otherfinancial institutes for providing certain services and loans. Banks provide a variety of
services to business firms like clearance of cheques, drafts, transfer of funds etc. Banks charge a
commission or fee for their services to the customers as indirect compensation. Customers are
required to maintain a minimum cash balance at the bank. This balance cannot be used for
transaction purposes. Banks can utilise the balances to earn a return to compensate their cost of
services to the customers. Such balances are compensating balances. These balances are also
required by some loan agreements between a bank and its customers. Banks require a chest to
maintain a minimum cash balance in his account to compensate the bank when the supply of credit
is restricted and interest rates are rising. Thus cash is required to fulfil the above motives. Out of
the four motives of holding cash balances, transaction motive and compensation motives are very
important. Business firms usually do not speculate and need not have speculative balances. The
requirement of precautionary balances can be met out of short-term borrowings.
MANAGEMENT OF RECEIVABLES
Receivables means the book debts or debtors and these arise, if the goods are sold on
credit. Debtors form about 30% of current assets in India. Debt involves an element of risk and bad
debts also. Hence, it calls for careful analysis and proper management. The goal of receivables
management is to maximize the value of the firm by achieving a trade off between risk and
profitability. For this purpose, a finance manager has:
1. to obtain optimum (non-maximum) value of sales;
2. to control the cost of receivables, cost of collection, administrative expenses, bad debts and
opportunity cost of funds blocked in the receivables.
3. to maintain the debtors at minimum according to the credit policy offered to customers.
4. to offer cash discounts suitably depending on the cost of receivables, bank rate of interest and
opportunity cost of funds blocked in the receivables.
Factors Affecting the Size of Receivables
The size of accounts receivable is determined by a number of factors. Some of the
important factors are as follows
1. Level of sales - Generally in the same industry, a firm having a large volume of sales will
behaving a larger level of receivables as compared to a firm with a small volume of sales. Sales
level can also be used for forecasting change in accounts receivable. For example, if a firm
predicts that there will be an increase of 20% in its credit sales for the next period, it can be
expected that there will also be a 20% increase in the level of receivables.

BBA IV
2. Credit policies - The term credit policy refers to those decision variables that influence
theamount of trade credit, i.e., the investment in receivables. These variables include the quantity
of trade accounts to be accepted, the length of the credit period to be extended, the cash discount to
be given and any special terms to be offered depending upon particular circumstances of the firm
and the customer.
3. Terms of trade - The size of the receivables is also affected by terms of trade (or credit
terms)offered by the firm. The two important components of the credit terms are (i) Credit
period and (ii) Cash discount.
Credit Policy
A firm should establish receivables policies after carefully considering both benefits and costs
of different policies. These policies relate to:
(i) Credit Standards, (ii) Credit Terms, and (iii) Collection Procedures.
i. Credit standards -
The term credit standards represent the basic criteria for extension of credit to customers. The
levels of sales and receivables are likely to be high if the credit standards are relatively loose, as
compared to a situation when they are relatively tight. The firm‘s credit standards are
generallydetermined by the five ―C‘s‖. Character, Capacity, Capital, Collateral and Conditions of
customer.
ii. Credit terms
It refers to the terms under which a firm sells goods on credit to its customers. As stated earlier, the
two components of the credit terms are (a) Credit Period and (b) Cash Discount.
(a) Credit period - Extending the credit period stimulates sales but increases the cost on account of
more tying up of funds in receivables.
(b) Cash discount - The effect of allowing cash discount can also be analysed on the same pattern
as that of the credit period. Attractive cash discount terms reduce the average collection period
resulting in reduced investment in accounts receivable.
iii. Collection procedures
A stringent collection procedure is expensive for the firm because of high out-of-pocket
costs and loss of goodwill of the firm among its customers. However, it minimises the loss on
account of bad debts as well as increases savings in terms of lower capital costs on account of
reduction in the size of receivables. A balance has therefore to be stuck between the costs and
benefits of different collection procedures or policies.
*****
References:A major part of the text/notes has been obtained from the study/ reading material
available for School of Distance Education, University of Calicut.
Prepared by:
Ratheesh K. Nair,
Assistant Professor,
Govt. College, Madappally.
Scrutinised by:
Dr.K.Venugopalan,
Associate Professor,
Department of Commerce,
Govt. College, Madappally.

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FINANCIAL MANAGEMENT

(1) Financial Planning

SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT:

  Profit maximisation and wealth /value maximisation

TIME VALUE OF MONEY AND MATHEMATICS OF

Financial Management Page 9

Time Value of Money and maathematics

Time Value of Money

Future Value of a Single Flow

Financial Management Page 10

Present Value of a Single Floow :

Where, PV = Present Value

P.V. = Cash Flows × Annuity @ 10% for 3 years.

CONCEPT OF RISK AND RETURN

Financial Management Page 11

The evaluation of long-term investment decisions or investment analysis to be consistent

Financial Management Page 12

CAPITAL BUDGETING PRROCESS :

Pay back period = Original cost of the project (cash outlay))

Financial Management Page 13

Pay back period = Origginal cost of the project (cash outlay)

Example: Initial Investment = 10,000 in a project

Pay back period =Y+ B = 3+ 1000 years = 3+ 1 years= 3year 6months

Financial Management Page 14

Demerits of Pay back periodd:

ARR= Average income or retuurn 100

Average investment = Originaal investment+Salvage

Particulars Yr1 Yr 2 Yr3 Yr 4 Yr 5 Average

EBITD 2,50,0000 3,00,000 3,50,000 4,00,000 5,00,000 3,60,000

Total (50,0000) 76,404 1,34,000 1,96,116 2,882,503 1,27,805

Book Value of Investment :

Financial Management Page 15

ARR= Average income or retuurn 100=127805100== 27.11%

Net Present Value = 117.18

Financial Management Page 17

Merits of Net Present Value method

(1) It recognises the Time Value of Money.

Demerits of Net Present Value method

(4)Profitability Index method (PI)

Profitability Index = P.V. of cash outflow

(5)Internal Rate of Return method (IRR)

Financial Management Page 18

Year Cash Inflows P.V. @ 10% DCFAT P.V. @ 12% DCFAT

P.V. of Inflows 1,12,720 1,08,440

Less : Initial Investment 1,10,000 1,10,000

NPV 2,720 (1,560)

Financial Management Page 19

Forward Method : Taking 10%, (+) NPV

= 10% + 1.27% = 11.27%

Backward Method : Taking 12%, (–) NPV

= 12% – 0.73% = 11.27%

IRR = Cost of Capital the investment is expected Indifferent between

Financial Management Page 20

Merits of Internal Rate of Return method :

Financial Management Page 21

Compounded Value of Cash Inflow = 112650 =

= 1,12,650 × 0.683 = 76,940/ -

[ 0.683 being the P.V. of 1 receivable after 4 years ]

Financial Management Page 22