Financial Management

LESSON - 1

NATURE OF FINANCIAL MANAGEMENT

Learning ObjectivesAfter reading this lesson you should be able to:

• Know the meaning of financial management.• Identify the changes in the concept of finance.• Understand the goals of financial management.• Detail the scope of finance function.• Explain the functions of Finance Manager.

Lesson Outline

A. Financial Management as a branch of managementB. Evolutionary changes in the concept of financeC. Definitions of Financial ManagementD. Goals of Financial ManagementE. Scope of finance functionF. Functions of Treasurer and ControllerG. Routine Duties of Financial ManagerH. Social Responsibility of Financial Manager

Finance is to business what blood is to the human body. Thus it is the lifeblood ofbusiness. Fortunately for the human body there is an automatic regulation of thequantity and quality of blood required. No such auto control is available in the case of abusiness firm. Hence the necessity to manage finances of that the firm may have at itsdisposal adequate funds of various types but at the same time avoiding idleness offunds. There was a time when it was thought that financial management consistedmerely of providing funds required by the various departments or divisions of the firm.This has now changed completely and it is accepted that proper financial managementconsists of a dynamic approach towards the achievement of firm's objectives.

A. Financial Management as a Branch of Management

Of all the branches of management, financial management is of the highest importance.The primary purpose of a business firm is to produce and distribute goods and servicesto the society in which it exists. We need finance for the production of the goods andservices as well as their distribution. The efficiency of production, personnel andmarketing operations is directly influenced by the manner in which the finance functionof the enterprise is performed by the finance personnel. Thus it may be stated that all

the functions or activities of the business are ultimately related to finance function. Thesuccess of the business depends on how best all these functions can be coordinated. Atree keeps itself green and growing as long as its roots sap the life juice from the soil anddistribute the same among the branches and leaves. The activities of an organisationalso keep going smoothly as long as finance flows through its veins. Any and everybusiness activity will ultimately be reflected through its finance the mirror and also thebarometer of the enterprise functions.Finance and Other Functional Areas of Management

Financial Management and Research & Development:

The R&D manager has to justify the money spent on research by coming up with newproducts and process which would help to reduce costs and increase revenue. If theR&D department is like a bottomless pit only swallowing more and more money but notgiving any positive results in return, then the management would have no choice but toclose it. No commercial entity runs an R&D department for conducting infructuousbasic research.For instance, until 5 years ago, 80% of the R&D efforts of Bush India, the 45-year oldconsumer electronics company, well known for its audio systems, was in TVs and only20% was in audio. But the fact that a 15-year stint in the TV market starting from 1981when the company shifted its interest from the audio line to TV manufacturing, led thecompany’s decline to near oblivion, pushing the once famous Bush brand name to nearanonymity, called for a change in production and re-orientation of R&D, strategy. Thecompany has also identified and shut down some of its non-productive divisions andtrimmed its workforce. At the beginning of 1992, Bush had 872 employees. By the endthis was cut down to 550. The company had to further cut it down to 450 by the end of1993.

Financial Management and Materials Management:

Likewise the materials manager should be aware that inventory of different items instores is nothing but money in the shape of inventory. He should make efforts to reduceinventory so that the funds released could be put to more productive use. At the sametime, he should also ensure that inventory of materials does not reach such a low level asto interrupt the production process. He has to achieve the right balance between toomuch inventory and too little inventory. This is called the 'liquidity-profitability trade-off' about which you will read more in the lessons on Working Capital Management.

The same is true with regard to every activity in an organisation. The results of allactivities in an organisation are reflected in the financial statements in rupees.

Financial Management and Production Management:

In any manufacturing firm, the Production Manager controls a major part of theinvestment in the form of equipment, materials and men. He should so organize hisdepartment that the equipment under his control are used most productively, theinventory of work-in-process or unfinished goods, and stores and spares is optimised

and the idle time and work stoppages are minimised. If the Production Manager canachieve this, he would be holding the cost of the output under control and thereby helpin maximizing profits. He has to appreciate the fact that whereas the price at which theoutput can be sold is largely determined by factors external to the firm like competition,government regulations etc., the cost of production is more amenable to his control.Similarly, he would have to make decisions regarding make or buy, buy or lease etc., forwhich he has to evaluate the financial implications before arriving at a decision.

Financial Management and Marketing Management:

Marketing is one of the most important areas on which the success or failure of the firmdepends to a very great extent. The philosophy and approach to the pricing policy arecritical elements in the company's marketing effort, image and sales level.Determination of the appropriate price for the firm's products is important both to themarketing and the financial managers and, therefore, should be a joint decision of both.The marketing manager provides information as to how different prices will affect thedemand for the company's products in the market and the firm’s competitive positionwhile the finance manager can supply information about costs, change in costs atdifferent levels of production, and the profit margins required to carry on the business.Thus, the finance manager contributes substantially towards formulation of the pricingpolicies of the firm.

Financial Management and Personnel Management:

The recruitment, training and placement of staff is the responsibility of the PersonnelDepartment. However, all this requires finances and, therefore, the decisions regardingthese aspects cannot be taken by the Personnel Department in an isolation of theFinance Department. Thus, it will be seen that the financial management is closelylinked with all other areas of management. As a matter of fact, the financial managerhas a grasp over all areas of the firm because of his key position. Moreover, the attitudeof the firm towards other management areas is largely governed by its financial position.A firm facing a critical financial position will devise its recruitment, production andmarketing strategies keeping the overall financial position in view. A firm having acomfortable financial position may give flexibility to the other management functions,such as, personnel, materials, purchase, production, marketing and other policies.

B. Evolutionary Change in the Concept of Finance

The word "finance" has been interpreted differently by different authorities. Moresignificantly, the concept of finance has changed markedly from time to time. For theconvenience of analysis different viewpoints on finance have been categorized into threemajor groups.

1. Finance means Cash only: Starting from the early part of the present century,finance was described to mean cash only. The emphasis under this approach is only onliquidity and financing of the firm. Since nearly every business transaction involves

cash, directly or indirectly, finance is concerned with everything that takes place in theconduct of the business. However, it must be noted that this meaning of finance is toobroad to be meaningful.

2. Finance is raising of funds: The second grouping, also called the 'traditionalapproach', is concerned with raising funds used in an enterprise. It covers, (a)instruments, institutions, practices through which funds are raised and (b) the legal andaccounting relationships between a company and its sources of funds, including theredistribution of income and assets among these sources. This concept of finance is, ofcourse, broader than the first, as it is concerned with raising of funds.

Finance, during the forties through the early fifties, was dominated by this traditionalapproach. However, it could not last for long because of some shortcomings. First, thisapproach emphasised the perspective of an outsider lender.It only analysed the firm and did not emphasis decision-making within the firm. Second,this approach laid heavy emphasis on areas of external sources of long-term finance.However, short-term finance, i.e. working capital is equally important. Third, thefunction of efficient employment of resources was totally ignored.

3. Finance is raising and utilisation of funds: The third grouping is called theIntegrated Approach or 'Modern Approach'. According to this approach, the concept offinance is concerned not only with the optimum way of raising of funds but also theirproper utilisation in time and low cost in a manner that each rupee is made to work atits optimum without endangering the financial solvency of the firm. This approach tofinance is concerned with (a) determining the total amount of funds required in thefirm, (b) allocating these funds efficiently to the various assets, (c) obtaining the bestmix of financing-type and amount of corporate securities, (d) use of financial tools toensure proper and efficient use of funds.

C. Definitions of Financial ManagementIn general, finance may be defined as the provision of money at the time it iswanted. However, as a management function it has a special meaning. Finance functionmay be defined as the procurement of funds and their effective utilisation. Some of theauthoritative definitions are as follows:

According to Ezra Solomon, "Financial management is concerned with the efficientuse of an important economic resource, namely Capital Funds".

In the words of Howard and Upton, "Finance may be defined as that administrativearea or set of administrative functions in an organisation which relate with thearrangement of cash and credit so that the organisation may have the means to carry outits objectives as satisfactorily as possible".

Phillippatus has given a more elaborate definition of the term 'financial management'.According to him "Financial management is concerned with the managerial decisionsthat result in the acquisition and financing of long-term and short-term credits for thefirm. 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) aswell as the problem of size and growth of an enterprise. The analysis of these decisions isbased on the expected inflow and outflow of funds and their effects upon managerialobjectives".

Financial Management may also be defined as "planning, organising, direction andcontrol of financial resources with the objectives of ensuring optimum utilisation of suchresources and providing insurance against losses through financial deadlock". Thisdefinition clearly explains four broad elements viz., planning, organising, direction andcontrol. The details under these elements are as follows:

a) Ascertainment of need Planningb) Determination of sources Planningc) Collection of funds Organizingd) Allocation of funds Organizinge) Communication of planned objective Direction

f) Monitoring of funds (though 'financial discipline' inrespect of funds utilization) Control

g) Knowing performance actuals Control

h) Judging performance against norms, standards, targetsetc. Control

i) Taking corrective action which in turn involvesremoval of snags as well as revision of targets. Control

While the functions under planning and organising are mostly of 'discrete' nature(undertaken from time to time and very often independently) those under control areaare 'continuous' in nature. All the principles, steps and weapons of managerial controlare applicable in proper control of financial resources and their utilisation. Hence, it isrightly said by Howard and Upton that financial management is an application ofgeneral managerial principles to the area of financial decision making viz., fundsrequirement decision, investment decision, financing decision and dividend decision.Hunt, William and Donaldson have rightly called it as 'Resource Management'.

Financial management is intimately interwoven into the fabric of management itself.Not only is this because the results of management's actions are expressed in financialterms, but also principally because the central role of financial management isconcerned with the same objectives as those of management itself and with the way inwhich the resources of the business are employed and how it is financed. Because it isabout making profits and profits will be determined by the way in which the resources ofthe business in terms of people, physical resources, capital, and any other specifictalents are organized.

Financial management is concerned with identifying sources of profit and the factorswhich affect profit. That is to say with operating activities in the way in which the assetsare used, and from a longer term point of view, the process of allocating funds to usewithin the business. In these activities, financial managers form part of a managementteam applying their specialist advice and processing and marshalling the data uponwhich decisions are based.

D. Goals of Financial Management

The goal of the financial management should be to achieve the objective of the businessowners, who are the suppliers of capital. In the case of company, the owners areshareholders. The financial manager’s function is not to fulfill his own objectives, whichmay include higher salaries, earning reputation, or maintaining and advancing hispersonal power and prestige. If the manager is successful in company's endeavour, hewill also achieve his personal objectives. It is generally agreed that the financialobjective of the firm should be the maximization of owner’s wealth. However, there isdisagreement as to how the economic welfare of owners can be maximized. Two wellknown and widely discussed criteria which are put forth for this purpose are: (a) profitmaximization, and (b) wealth maximization.

(a) Profit Maximization:

Traditionally, the business has been considered as an economic institution and profithas come to be accepted as a rationally valid criterion of measuring efficiency. As a goal,however, profit maximization suffers from certain basic weaknesses:

- it is vague,

- it is a short-run point of view,

- it ignores risks, and

- it ignores the timing of returns.

Please use headphones

An unambiguous meaning of the profit maximization objective is neither available norpossible. It is rather very difficult to know about these: Does it mean short-term profitsor long-term profits? Does it refer to profit before or after tax? Does it refer to totalprofits or profit per share?

Besides it being ambiguous, the profit maximization objective takes a short-run point ofview. Professor Drucker and Professor Galbraith contradict the theory of profitmaximization and observe that exclusive attention on profit maximization misdirectsmanagers to the point where they may endanger the survival of the business. Prof.Galbraith gives the following points to argue his line of reasoning: (1) it undermines thefuture for today’s profit; (2) it shortchanges research promotion and other investments;(3) it may shy away from any capital expenditure that may increase the invested capitalbase against which profits are based, and the result is dangerous obsolescence ofequipment. In other words, the managers are directed into the worst practices ofmanagement. Risk and timing factors are also ignored by this objective. The streams ofbenefits may possess different degrees of certainty and uncertainty. Two firms may havesame total expected earnings, but if the earnings of one firm fluctuate considerably ascompared to the other, it will be more risky. Also, it does not make a difference betweenreturns received in different time periods i.e., it gives no consideration to the time valueof money and value benefits received today and benefits after six months or oneyear. For these reasons, the profit maximization objective cannot be taken as theobjective of financial management.

(b) Wealth Maximization:

The maximization of wealth is a more viable objective of financial management. Thesame objective, if expressed in other terms, would convey the idea of net present worthmaximization. Any financial action which creates wealth or which has a net presentworth is a desirable one and should be undertaken. Wealth of the firm is reflected in themaximization of the present value of the firm i.e., the present worth of the firm. Thisvalue may be readily measured if the company has shares that are held by the public,because the market price of the share is indicative of the value of the company. And to ashareholder, the term ‘wealth’ is reflected in the amount of his current dividends and themarket price of share. Ezra Solomon has defined wealth maximization objective in thefollowing manner:

"The gross present worth of a course of action is equal to the capitalized value of the flowof future expected benefits, discounted (or capitalized) at a rate which reflects thecertainty or uncertainty. Wealth or net present worth is the difference between grosspresent worth and the amount of capital investment required to achieve the benefits."

From the above clarification, one thing is certain that the wealth maximization is a long-term strategy that emphasises raising the present value of the owner's investment in acompany and the implementation of projects that will increase the market value of thefirm's securities. This criterion, if applied, meets the objections raised against earliercriterion of profit maximization. The financial manager also deals with the problem of

uncertainty by taking into account the trade-off between the various returns andassociated levels of risks. It also takes into account the payment of dividends toshareholders. All these ingredients of the wealth maximization objective are the result ofthe investment, financing and dividend decisions of the firm.


E. Scope of finance functionThe question of 'scope of finance function' determines the decisions or functions to becarried out by the financial manager in pursuit of achieving the objective of wealthmaximization. The various functions of the financial manager relate to the estimation offinancial requirements, investment of funds in long-term and short-term assets,determining the appropriate capital structure, identification of the various sources offinance, decision regarding retention of earnings and distribution of dividend, andadministering proper financial controls. These decisions have been categorized into twobroad groupings:

(1) Long-term financial decisions:

The long term financial decisions pursued by the financial manager have significant longterm effects on the value of the firm. The results of these decisions are not confined to afew months but extend over several years and these decisions are mostly irreversible. Itis, therefore, necessary that before committing the scarce resources of the firm a carefulexercise is done with regard to the likely costs and benefits of various decisions like...

i. Investment Decision (capital allocation for fixed and currentassets): Investment decision (also known as capital-budgeting decision) is concernedwith the allocation of given amount of capital to fixed assets of the business. Theimportant characteristic of fixed assets is that their benefits are realized in the future(generally after one year). Thus, capital-budgeting decision adds to the total fixed assetsof the concern by selecting and investing in new investments. lt must be properlyunderstood at this stage that because the future benefits are not known with certainty,investment proposals necessarily involve risk. Consequently, they must be evaluated inrelation to their expected income and risk they add to the function as a whole.Obviously, the management will select investments adding something to the value of thefirm. The criteria of judging the profitability of projects is the difference between thecost of the investment proposals and its expected earnings. The important methodsemployed to judge the profitability of the investment proposals are:

(a) Payback method, (b) Average rate of return method, (c) Internal rate of returnmethod, and (d) Net present value method.

A careful employment of these methods helps in determining the contribution ofinvestment projects to owners' wealth.

ii. Financing Decision (capital sourcing): Financing decision (also known ascapital structure decision) is intimately tied with the investment decision. To undertakeinvestment decision the firm needs proper finance. The solution to the question ofraising finance is solved by financing decision. There are number of sources from whichfunds can be raised. The most important sources of financing are equity capital and debtcapital. The central tasks before the financial manager is to determine the proportion ofequity capital and debt capital. He must endeavour to obtain a financing mix or optimalcapital structure for the firm where overall cost of capital is the minimum or the value ofthe firm is maximum. In taking this decision, the financial manager must bear in mindthe likely effects on shareholders and the firm. The use of debt capital, for instance,affects the return and risk of the shareholders. Not only the return on equity willincrease, but also the risk. A proper balance will have to be struck between return andrisk. When the shareholder's return is maximized with minimum risk, the market valueper share will be maximized and firm's capital structure would be optimum. Once thefinancial manager is able to determine the best combination of debt and equity, he mustraise this appropriate amount through best available sources.

Fig. 1.1 Decisions, Return, Risk, and Market Value

iii. Dividend Decision: The next crucial financial decision is the dividend decision.This decision is the basis of dividends payment policy, reserves policy, etc. Thedividends are generally paid as some percentage of earnings on the paid-up capital.However, the policy pursued by management concerning dividends payment isgenerally stable in character. Stable dividends policy implies the payment of sameearnings percentage with only small variations depending upon the pattern of earnings.The stable dividends policy among other things, increases the market value of the share.The amount of undistributed profits is called 'retained earnings'. In other words,dividends payout ratio determines the amount of earnings retained in the firm. Theamount of earnings or profit to be kept undistributed with the firm must be evaluated inthe light of the objective of maximizing shareholders' wealth.

(2) Short-Term Financial Decisions (Working capital management):

i. cash,

ii. investments (marketable securities),

iii. receivables, and

iv. inventory

The job of the financial manager is not just limited to the long-term financial decisions,but also extends to the short-term financial decisions aiming at safeguarding the firmagainst illiquidity or insolvency. Surveys indicate that the largest portion of a financial

manager's time is devoted to the day-to-day internal operations of the firm; this may beappropriately subsumed under the heading Working Capital Management. Workingcapital management requires the understanding and proper appreciation of its twoconcepts - gross and net working capital. Gross working capital refers to the firm'sinvestment in current assets such as cash, short-term securities, debtors, bills receivableand inventories. Current assets have the distinctive characteristics of being convertibleinto cash within an accounting year. Net working capital refers to the difference betweencurrent assets and current liabilities. Current liabilities are those claims of outsiderswhich are expected to mature for payment within an accounting year and include tradecreditors, bills payable, bank overdraft and outstanding expenses. For the financialmanager both these concepts of gross and net working capital are relevant.

Investment in current assets affects firm's profitability, liquidity and solvency. In orderto ensure that neither insufficient nor unnecessary funds are invested in current assets,the financial manager should develop sound techniques of managing current assets. Heshould estimate firm's working capital needs and make sure that funds would be madeavailable when needed.

The cost of capital acts as the core in the framework for financial management decisionmaking. In has a two-way effect on the investment, financing and dividend decisions. Itinfluences and is in turn influenced by them. The cost of capital leads to the acceptanceor rejection of projects, as it is the cut-off criterion in investment decisions. In turn, the

profitability of projects raises or lowers the cost of capital. The financing decisions affectthe cost of capital because it is the weighted average of the cost of different sources ofcapital. The need to raise or lower the cost of capital, in turn, influences the financingdecisions. The dividend decisions try to meet the expectations of the investors raise orlower the cost of capital. The following figure explains the components of financefunctions and their interrelation.

Financial Controls: The long-term and short-term decisions, together, determine thevalue of the firm to its shareholders. In order to maximize this value, the firm shouldstrive for optimal combination of these decisions. In an endeavour to make optimaldecisions, the financial manager makes use of certain tools in the analysis, planning andcontrol activities of the firm. Some such important tools are:

a. Financial Accounting Statements

b. Analysis of Financial Ratios

c. Funds Flow Analysis and Cash Flow Analysis

d. Financial Forecasting

e. Analysis of Operating and Financial Leverage

f. Capital Expenditure Budgeting

g. Operating Budgeting and Budgetary Control

h. Costing and Cost Control Statement

i. Variance Analysis Reports

j. Cost-Volume-Profit Analysis

k. Profitability Index

l. Financial Reports

Organisation for Finance Function: Almost anything in the financial realm fallswithin such a committees realm, including questions of financing, budgets,expenditures, dividend policy, and future planning. Such is the power of financialcommittee that in most cases their recommendations are approved as a matter of courseby the full board of directors.

On the operational level, the financial management team may be headed up by afinancial Vice President. This is a recent development; the financial Vice Presidentanswers directly to the President. Serving under him are Treasurer and Controller. Anillustrative organisation chart of finance function of management in a large organisationis given below:

Board of Directors

|

President

|

---------------------------------------------------------------------------

| | | | |

VP Mktg VP Purchase VP Production VP Finance VPPersonnel

|

-------------------------

| |

Treasurer Controller

Fig. 1.3 Organization Chart of Finance Functions of Management

The chart below shows that the Vice President Finance exercises his function throughhis two deputies known as 'Controller' concerned with internal matters, and 'Treasurer'who basically handles external financial matters.

The Controller is concerned with the management and control of the firm's assets. Hisduties include providing information for formulating the accounting and financialpolicies, preparation of financial reports, direction of internal auditing, budgeting,inventory control, taxes, etc. The Treasurer is mainly concerned with management ofthe firm's funds. His duties include forecasting the financial needs, administering theflow of cash, managing credit, floating securities, maintaining relations with financialinstitutions, and protecting funds and securities. A brief description of the functions ofthe Controller and the Treasurer, as given by the Controllers Institute of America, isgiven below and in Fig. 1.4.

F. Functions of Controller and Treasurer

Functions of Controller:

1. Planning and Control: To establish, coordinate and administer, as part ofmanagement, a plan for the control of operations. This plan would provide to theextent required in the business, profit planning, programmes for capital investingand for financing, sales forecasts and expense budgets.

2. Reporting and Interpreting: To compare actual performance withoperating plans and standards, and to report and interpret the results ofoperations to all levels of management and to the owners of business. To consultwith the management about the financial implications of its actions.

3. Tax Administration: To establish and administer tax policies andprocedures.

4. Government Reporting: To supervise or coordinate the preparation ofreports to government agencies.

5. Protection of Assets: To ensure protection of business assets throughinternal control, internal auditing and assuring proper insurance coverage.

6. Economic Appraisal: To appraise economic and social forces andgovernment influences and interpret their effect upon business.

Functions of Treasurer:

1. Provision of Finance: To establish and execute programmes for theprovision of the finance required by the business, including negotiating itsprocurement and maintaining the required financial arrangements.

2. Investor Relations: To establish and maintain adequate market for thecompany's securities and to maintain adequate contact with the investmentcommunity.

3. Short-term Financing: To maintain adequate sources for the company'scurrent borrowings from the money market.

4. Banking and Custody: To maintain banking arrangements, to receive, havecustody of and disburse the company's moneys and securities and to beresponsible for the financial assets of real estate transactions.

5. Credit and Collections: To direct the granting of credit and the collection ofaccounts receivables of the company.

6. Investments: To invest the company's funds as required, and to establish andcoordinate policies for investment in pension and other similar trusts.

7. Insurance: To provide insurance coverage as may be required.

Another way of looking at these functions is...

The Controller function generally concentrates on the asset side of the balance sheet,while the Treasurer function concentrates on the claims side i.e., identifying the bestsources of finance to utilize in the business and timing the acquisition of funds.Controller's and Treasurer's Functions in the Indian Context:

The terms 'controller' and 'treasurer' are essentially used in U.S.A. However, this patternis not popular in India. Some companies do use the term 'Controller' for the official whoperforms the functions of the chief accountant or the management accountant.However, in most cases, in case of Indian companies, the term General Manager(Finance) or Chief Finance Manager is more popular. Some of the functions of theController and the Treasurer such as government reporting, insurance coverage, etc.,are taken care of by the Secretary of the company. The Treasurer's function ofmaintaining relations with its investors is also not much relevant in the Indian contextsince by and large Indian investors/shareholders are indifferent towards attending the

general meetings. The finance manager in Indian companies is mainly concerned withthe management of the firm's financial resources. His duties are not compounded withother duties generally in large companies. It is a healthy sign since the management offinances is an important business activity requiring extraordinary skill and attention. Hehas to ensure that the scarce financial resources are put to the optimum use keeping inview various constraints. It is, therefore, necessary that the finance manager devotes hisfull time attention and energies only in raising and utilising the financial resources ofthe firm.

G. Routine Duties of Financial ManagerApart from the three broad functions of financial management mentioned above, thefinancial manager has to perform certain routine or recurring functions as these:

(i) Keeping track of actual and projected cash outflows and making adequate provisionin time for any shortfall that may arise.

(ii) Managing of cash centrally and supplying the needs of various divisions anddepartments without keeping idle cash at many points.

(iii) Negotiations and relations with banks and other financial institutions.

(iv) Investment of funds available and free for a short period.

(v) Keeping track of stock exchange prices in general and prices of the company's sharesin particular.

(vi) Maintenance of liaison with production and sales departments for seeing thatworking capital position is not upset because of inventories, book debts, etc.

(vii) Keeping management informed of the financial implication of variousdevelopments in and around the company.Non-Routine Duties:

The non-recurring duties of the financial executive may involve preparation of financialplan at the time of company promotion, expansion, diversification, readjustments intimes of liquidity crisis, valuation of the enterprise at the time of acquisition and mergerthereof, etc. Today's financial manager has to deal with a variety of developments thataffect the firm's liquidity and profitability, including...

(i) High financial cost identified with risk-bearing investments in a capital-intensiveenvironment.

(ii) Diversification by firms into differing businesses, markets, and product lines.

(iii) High rates of inflation that significantly affect planning and forecasting the firmsoperations.

(iv) Emphasis on growth, with its requirements for new sources of funds and improveduses of existing funds.

(v) High rates of change in technology, with an accompanying need for expenditures onresearch and development.

(vi) Speedy dissemination of information, employing high speed computers andnationwide and worldwide networks for transmitting financial and operating data.

H. Social Responsibility of Financial Manager

Another point that deserves consideration is social responsibility: should businessesoperate strictly in the stockholder's best interest, or are firms also partly responsible forthe welfare of society at large? In tackling this question, consider first the firms whoserates of return on investment are close to normal, that is, close to the average for allfirms. If such companies attempt to be socially responsible, thereby increasing theircosts over what they otherwise would have been, and if the other business in theindustry do not follow suit, then the socially oriented firms will probably be forced toabandon their efforts. Thus , any socially responsible acts that raise costs will bedifficult, if not impossible, in industries subject to keen competition.

What about firms with profits above normal levels - can they not devote resources tosocial projects? Undoubtedly they can many large, successful firms do engage incommunity projects, employee benefit programmes, and the likes to a greater degreethan would appear to be called for by pure profit or wealth maximization. Still, publiclyowned firms are constrained in such actions by capital market factors. Suppose a saverwho has funds to invest is considering two alternative firms. One firm devotes asubstantial part of its resources to social actions, while the other concentrates on profitsand stock prices. Most investors are likely to shun the socially oriented firm, which willput it to a disadvantage in the capital market. After all, why should the stockholders ofone corporation subsidise society to a greater extent than stockholders of otherbusinesses? Thus, even highly profitable firms (unless they are closely held rather thanpublicly owned) are generally constrained against taking unilateral cost increasing socialaction.Does all this mean that firms should not exercise social responsibility? Not at all - itsimply means that most cost-increasing actions may have to be put on a mandatoryrather than a voluntary basis, at least initially, to insure that the burden of such actionfalls uniformly across all businesses. Thus, fair hiring practices, minority trainingprogrammes, product safety, pollution abatement, antitrust actions, and are more likelyto be effective if realistic rules are established initially and enforced by governmentagencies. It is critical that industry and government cooperate in establishing the rulesof corporate behavior and that firms follow the spirit as well as the letter of the law intheir actions. Thus, the rules of the game become constraints, and firms should strive tomaximize stock prices subject to these constraints.

REVIEW QUESTIONS

1. "Finance is the oil of wheel, marrow of bones and spirit of trade, commerce andindustry"- Elucidate.2. Discuss the role and significance of financial management in the functional areas ofmodern management.

3. Some of the early concerns of financial management are related to preservation ofcapital, maintenance of liquidity and reorganisation. Do you think these topics are stillimportant in our current unpredictable economic environment?

4. Who discharges the finance function and what are his specific responsibilities?

5. Contrast profit maximization and value maximization as criteria for financialmanagement decisions in practice.

6. Why is it inappropriate to seek profit maximization as the goals of financial decisionmaking? How do you justify the adoption of present value maximization as an aptsubstitute for it?

7. "The operative objective of financial management is to maximize wealth or netpresent worth'- Ezra Solomon. Explain the statement and explain the finance functionperformed by a Finance Manager to achieve this goal.

8. Explain the scope of finance function and suggest an organisational structure that youconsider suitable for an effective financial control of a large manufacturing concern.

9. Discuss the respective roles of 'Treasurer' and 'Controller' in the financial set-up of alarge corporation. Out of these two finance officers who is more important in themodern contest and why?10. As a Financial Manager of a company, how would you reconcile between financialgoals and social objectives of the concern?

SUGGESTED READINGS

1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, TataMcGraw Hill Co.2. Hampton, J.J.: Financial Decision Making, New Delhi, Prentice Hall of India.

3. Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.

4. Van Home, James C : Financial Management and Policy, New Delhi, Prentice Hall ofIndia.

- End of Chapter -

LESSON - 2

WORKING CAPITAL MANAGEMENT

Learning Objectives

After reading this lesson you should be able to:

• Understand the concept of working capital• Classify the different types of working capital• Recognize the element of working capital• Assess the requirements of working capital• Identify the strength and weakness of inadequate or excess working capital.

Lesson Outline

A. Concept of Working CapitalB. Classification of Working CapitalC. Elements of Working CapitalD. Assessment of Working Capital RequirementsE. Problems of inadequacy of Working CapitalF. Reasons for inadequacy of Working CapitalG. Excessive Working CapitalH. Principles of Working Capital

Proper management of working capital is very important for the success of anenterprise. It aims at protecting the purchasing power of assets and maximising thereturn on investment. Constant management is required to maintain appropriate levelsin the various working capital components. Sales expansion, dividend declaration, plantexpansion, new product line, increased salaries and wages, rising price levels etc. putadded strain on working capital maintenance. Failure of business is undoubtedly due topoor management and absence of a management skill. Shortage of working capital, sooften advanced as the main cause for failure of concerns, is nothing but the clearestevidence of mismanagement which is so common.


It has been found that the major portion of a financial manager's time is utilized in themanagement of working capital. Current assets account for a very large portion of thetotal investment of a firm. In some of the industrial current assets on an averagerepresent over three-fifth of the total assets. In the case of trading concerns they accountfor about 80 percent. A firm may, sometimes, be able to reduce the investment in fixedassets by renting or leasing plant and machinery. But it cannot avoid investment in cash,accounts receivable and inventory. The management of working capital also helps themanagement in evaluating various existing or proposed financial constraints andfinancial offerings. All these factors clearly indicate the importance of working capitalmanagement in a firm.

A. Concepts of Working Capital

There are two concepts regarding the meaning of Working Capital - Net working Capitaland Gross Working Capital. According to one school of thought (supported bydistinguished authorities like Lincoln, Doris, Stevens and Saliers), Working Capital isthe excess of Current Assets over Current Liabilities, as designated in the followingequation:

Working Capital = Current Assets — Current Liabilities

According to another school of thought (supported by authorities like Mead Baker,Mallot and Field), Working Capital represents only the current (capital) assets.

There is basis for both these contentions. To understand them, correct conception ofcurrent assets and liabilities is essential.

Current Assets are those assets that in the ordinary course of business can be or willbe turned into cash within a brief period (not exceeding one year, normally) withoutundergoing diminution of value and without disrupting the organisation. Examples ofcurrent assets are:

(i) Cash in hand and in bank;

(ii) Accounts receivable from customers (less reserves);

(iii) Promissory Notes and Bills receivable from customers (less reserves);

(iv) Inventories comprising of raw material, work-in-progress, finished goods (ofmanufactures)

(v) Marketable securities held as temporary investment;

(vi) Prepaid expenses;

(vii) Maintenance materials;

(viii) Accrued income.

Current Liabilities are those liabilities intended at their inception to be paid inordinary course of business within a reasonable short time (normally within a year) outof the current assets or by creating another current liability or the income of thebusiness. Its examples are:

(i) Accounts payable to creditors;

(ii) Notes or Bills payable;

(iii) Accrued expenses, such as accrued taxes, salaries and interest;

(iv) Bank over-draft, cash credit;

(v) Bonds to be paid within one year;

(vi) Dividends declared and payable.

The arguments of the first school of thought in regarding working capital as the excessof current assets over current liabilities are that:

1. It is an established definition of working capital which is in use since long;

2. This concept of working capital enables the shareholders to judge the financialsoundness of the concern and the extent of protection afforded to them. It is particularlybecause with an increase in short-term borrowings the working capital does notincrease; it will increase only by following the policy of ploughing back of profits orconversion of fixed assets into liquid assets or by procuring fresh capital fromshareholders;

3. Any concern with an excess of current liabilities can successfully tide over periods ofemergency, e.g., depression;

4. Further, there is no obligation on the part of the company to return the amountinvested by the shareholders;

5. Such a definition is of great use in ascertaining the true financial position ofcompanies having current assets of similar amount.

Those who regard working capital and current assets as synonymous advance thefollowing arguments in support of their contention:

1. Earnings in each enterprise are the outcome of both fixed as well as current assets.Individually these assets have no significance. The points of similarity in these assets arethat both are borrowed and they yield profit much more than the interest cost. But thedistinction in the two lies in the fact that fixed assets constitute the fixed capital of acompany, whereas current assets are of a circulating nature. Hence, logic demands thatcurrent assets should be considered as the working capital of the company;

2. This definition takes into consideration the fact that there would be an automaticincrease in the working capital with every increase in the funds of the company; but it isnot so according to the net concept of working capital;

3. Every management is interested in the total current assets out of which the operationof an enterprise is made possible, rather than in the sources from where the capital isprocured;

4. The former concept of working capital may hold good only in the case of sole trader orpartnership organisation; but under the modern age of company organisation, wherethere is divorce between ownership, management and control, the ownership of currentor fixed assets is of little significance.

B. Classification of Working Capital

Generally speaking, the amount of funds required for operating needs varies from timeto time in every business. But a certain amount of assets in the form of working capitalare always required, if a business has to carry out its functions efficiently and without abreak. These two types of requirements, permanent and variable, are the basis for aconvenient classification of working capital:

1. Permanent or Fixed Working Capital:

As is apparent from the adjective 'permanent' it is that part of the capital which ispermanently locked up in the circulation of current assets and in keeping it moving. Forexample, every manufacturing concern has to maintain stock of raw materials, works-in-progress (work-in-process), finished products, loose tools, and spare parts. It alsorequires money for the payment of wages and salaries throughout the year. Thepermanent or fixed working capital can again be subdivided into

(i) Regular Working Capital

It is the minimum amount of liquid capital needed to keep up the circulation of thecapital from cash to inventories to receivables and back again to cash. This wouldinclude a sufficient cash balance in the bank to discount all bills, maintain an adequatesupply of raw materials for processing, carry a sufficient stock of finished goods to giveprompt delivery and effect the lowest manufacturing costs, and enough cash to carry thenecessary accounts receivables for the type of business engaged in.

(ii) Reserve Margin or Cushion Working Capital

It is the excess over the need for regular working capital that should be provided forcontingencies that arise at unstated periods. The contingencies included

(a) raising prices, which may make it necessary to have more money to carryinventories and receivables, or may make it advisable to increase inventories;

(b) business depressions, which may raise the amount of cash required to ride outof usually stagnant periods;

(c) strikes, fires and unexpectedly severe competition, which use up extra suppliesof cash; and

(d) special operations, such as experiments with new products, or with newmethod of distribution, war contracts, contractors to supply new businesses, andthe like, which can be undertaken only if sufficient funds are available, and whichin many cases mean the survival of a business.

2. Temporary or Variable Working Capital: The variable working capital changeswith the volume of business. It may be subdivided into

(i) Seasonal Working Capital: In many lines of business (e.g. jaggery or sugar and furindustry operations are highly seasonal and, as a result, working capital requirementsvary greatly during the year. The capital required to meet the seasonal needs of industryis termed as Seasonal Working Capital.

(ii) Special Working Capital: Special Working Capital is that part of the variable workingcapital which is required for financing special operations, such as the inauguration ofextensive marketing campaigns, experiments with new products or with new methods of

distribution, carrying out of special jobs and similar to the operations that are outsidethe usual business of buying, fabricating and selling.

This distinction between permanent/fixed and temporary/variable working capital is ofgreat significance particularly in arranging the finance for an enterprise. Regular orfixed working capital should be raised in the same way as fixed capital is procured -through a permanent investment of the owner or through long-term borrowing. Asbusiness expands, this regular capital will necessarily expand. If the cash returning fromsales includes a large enough profit to take care of expanding operations and growinginventories, the necessary additional working capital may be provided by the earnedsurplus of the business. Variable needs can, however, be financed out of short-termborrowings from banks or from public in the form of deposits. The position with regardto the 'fixed working capital' and 'variable working capital' can be shown with the help ofthe following figures:

From the above figure it should not be presumed that permanent working capital shallremain fixed throughout the life of the concern. As the size of the business grows,permanent working capital too is bound to grow. The position can be depicted with thehelp of the following figure:

So unlike a static concern, the fixed working capital of a growing concern will increasewith the growth in its size.

C. Elements of Working Capital

(i) Cash: Management of cash is very important from firm’s point of view. There mustbe balance between the twin objectives of liquidity and cost while managing cash. Theremust be adequate cash to meet the requirements of all segments of the organisation.Excess cash may be costly for the concern as it will increase the cost in terms of interest.Less cash may also be harmful to the concern as it will not be able to meet the liabilitiesas the appropriate time. Thus the requirements of the cash must be estimated properlyeither by preparing cash flow statements or cash budgets. This will help themanagement to invest the idle funds remuneratively and shortages, if any, may be mettimely by making different arrangements. Therefore, it is necessary that every segmentof the organisation must have adequate cash in order to meet the requirements of thatsegment without having surplus balances. Cash management is highly centralizedwhereby cash inflows and outflows are centrally controlled but in multi-divisionalcompanies it may be possible to decentralize cash requirements so that every companymay have cash for its requirements.

(ii) Marketable (Temporary) Investments: Firms hold temporary investments forsurplus cash flows arising either during seasonal operations or out of sale of long termsecurities. In most cases the securities are held primarily for precautionary purposes —most firms prefer to rely on bank credit to meet temporary transactions or speculativeneeds, but to hold some liquid assets to guard against a possible shortage of bank credit.The cash forecast may indicate whether excess cash available is temporary or not. If it isfound that excess liquidity will be temporary, the cash should then be invested inmarketable but temporary investments.

It should be remembered that even if a substantial part of idle cash is invested eventhough for a short period, the interest earned thereon is significant.

(iii) Receivables: Management of receivables involves a trade-off between the gainsdue to additional sales on account of liberal credit facilities and additional cost ofrecovering those debts. If liberal credit facilities are given to the customers, sales willdefinitely increase. But on the other hand bad debts, collection expenses and interestcharge will increase. Similarly if the credit policy is strict, the sales will be less andcustomers may go to the competitors where liberal credit facilities are available. Thiswill result in loss of profit because of less sales but there will be saving because of lessbad debts, collection and interest charges. Management of debtors also covers analysisof the risks associated with advancing credit to a particular customer. Follow up ofdebtors and credit collection are the remaining aspects of receivables management.

(iv) Inventories: Inventories include all investments in raw materials, work-in-progress, stores, spare parts and finished goods; they constitute an important part of thecurrent assets. The purchase of inventory involves investment which must be properlycontrolled. There are many issues of inventory management which must be taken intoconsideration as fixation of minimum and maximum level, deciding the issue of pricingpolicy, setting up the procedures for receipts and inspection, determining the economicordering quantity, providing proper storage facilities, keeping control on obsolescenceand setting up an effective information system with reference to inventories. Inventorymanagement requires the attention of stores manager, production manager andfinancial manager. There must be adequate inventories in order to avoid thedisadvantages of both inadequate and excessive inventories.

(v) Creditors: Management of creditors is very important aspect of working capital. Ifthe payment of creditors is delayed there is a possibility of saving of some interest but itcan be very costly because it will spoil the goodwill of the concern in the market. As faras possible, the credit manager should try to get the liberal credit terms so that paymentmay be made at the stipulated time.

D. Assessment of Working Capital Requirements

The following factors are considered for a proper assessment of the quantum of workingcapital requirements:

(i) The Production Cycle: There is bound to be time span in raw materials input inmanufacturing process and the resultant output as finished product. To sustain suchproduction activities the requirement of investment in the form of working capital isobvious. The lesser the production cycle (or the operating cycle) the lesser will be therequirements of working capital. There are enterprises due to their nature of businesswill have shorter cycle than others. Further, even within the same group of industries,the more the application of technological advances in, will result in shortening theoperating cycle. In this context the choice of product requiring shorter or greateroperating cycle will have a direct impact on the working capital requirements. This is afactor of paramount importance irrespective of whether a new industry is venturingproduction of the first time or an ongoing business. Hence it can be said that the timespan for each stage of the process of manufacture if geared to improve upon will lead tobetter efficiency and utilisation of working capital.

(ii) Work-in-Process: A close attention is to be given to the accumulation of work-in-progress or work-in-process. Unless the sequences of production process leading toconversion into finished product is kept under close observation to achieve betterproduction and productivity, more and more working capital funds will be tied up. Inthis context, proper production planning and control is vital.

(iii) Terms of Credit from Suppliers of Materials & Services: The more theterms of credit is favourable i.e. the more the time allowed by the creditors to pay them,the lesser will be the requirement of working capital. Hence, the negotiation with thesuppliers in respect of price and the credit period is an important aspect in workingcapital management. In this process the impact of the requirement of finance is sharedby the creditors for goods and services.

(iv) Realisation from Sundry Debtors: The lesser the time span between sellingthe product and the realisation, the quicker will be the inflow of cash. This, in turn, willreduce the finance required for working capital purposes. A realistic credit control willreduce locking up of finance in the form of sundry debtors. The impact of betterrealisation will not only help in reducing the working capital fund requirement but alsocan boost up the finance needed for other operational needs. The important factors incredit control will be: (a) volume of credit sales desired; (b) terms of sales and (c)collection policy.

(v) Control on Inventories: The decision to maintain appropriate minimuminventories either in the form of raw material, stores materials, work-in-process orfinished products is an important factor in controlling finance locked up. The better thecontrol on inventories the lesser will be the requirements of working capital. Thefollowing vital factors involved in inventory management are to be considered for aneffective inventory control: (a) volume of sales, (b) seasonal variation in sales, (c) sellingoff the shelf, (d) stocking to gain from higher price under inflationary conditions, (e) theoperating cycle, i.e., the time interval between manufacturing, selling and realisation,and (f) safety or buffer stock. A minimum policy level of stock may have to bemaintained to seize the opportunity of selling when there is spark in demand for theproduct.

(vi) Liquidity versus Profitability: The management dilemma as to the optimalbalancing between liquidity (or solvency) and the profitability is another factor of greatimportance on the determination of the level of working capital requirement. In otherwords, the level of liquidity and the profitability is to be maintained according to thegoals of financial management.

(vii) Competitive Conditions: The whole question of cash inflow depends as to thequickness in selling the products and the realisation thereof. In this context, the natureof business and the product will be the two important contributory factors as to thepolicy on the quantum of working capital requirements.

(viii) Inflation and the Price Level Changes: In an inflationary trend, the impacton working capital is that more finance is needed for the same volume of activity i.e.,

one has to pay more price for the purchase of same quantity of materials or services tobe obtained. Such raising impact of prices can be fully or partly compensated byincreasing the selling price of the product. All business may not be in a position to do sodue to their nature of product, competitive market, or Government’s regulatory prices.

(ix) Seasonal Fluctuation and Market Share of Product: There are productswhich are mostly in demand in certain periods of the year. In other words, there maynot be any sale or only a fraction of the total sale in off-season due to seasonal nature ofdemand for the product. There may be shifting of demand due to better substitute of theproduct available. This means the company affected by this economics, attempts to plandiversification to sustain profit, expansion and growth of the business. In certainbusinesses, demands for products are of seasonal in nature and for certain businesses,the raw materials buying have to be done during certain seasonal timings. Naturally theworking capital requirement will be more in certain periods than in others.


(x) Management Policy on Profits, Retained Profit, Tax Planning andDividend Policy: The adequacy of profit will lead to strengthening the financialposition of the business through cash generation which will be ploughed back as internalsource of financing. Tax planning is an integral part of working capital planning. It isnot only the question of quantum of cash availability for tax payment at the appropriatetime but also through tax planning the impact of tax payable can be reduced. DividendPolicy considers the percentage of dividend to be paid to the shareholders as interimand/or final dividend. There must be cash available at the appropriate time after thedividend is declared. This way the dividend payment is connected with working capitalmanagement.

(xi) Terms of Agreement: It refers to the terms and conditions of agreement to repayloans taken from bankers and financial institutions and acceptance of ‘fixed deposits’from public. The question of fund arrangement whether for working capital needs or tolong term loans is to be decided after taking into account the repayment ability. Thecash flow projection will have to be made accordingly.

(xii) Cash (Flow) Budget: In order to meet certain cash contingencies it may benecessary to have liquidity in form of marketable securities as cash reservoir. This extracash reserve may remain as an idle fund. This type of cash reserve is necessary to meetemergency disbursements.

(xiii) Overall Financial and Operational Efficiency: A professionally managedcompany always applies appropriate tools and techniques to achieve efficiency andutilisation of working capital fund. Adequacy of assessment and control of business willlead to improve the 'working capital turnover'. Management also will have to keep itselfabreast of the environmental, technological and other changes affecting the business sothat an effective and efficient financial management can play a vital role in reducing theproblems of working capital management.

(xiv) Urgency of Cash: In order to avoid product becoming obsolete or to undercutthe competitors to hold the market share or in case of emergency for cash funds, it maybe necessary to sell out products at a cheaper rate or at a discount or allowing cashrebate for early realisation from sundry debtors (customers). This situation may boostup the cash availability. However, this sort of critical situation should be avoided as thisresults in reducing profit.

(xv) Importance of Labour Mechanisation: Capital intensive industries, i.e.mechanized and automated industries, will require lower working capital, while labourintensive industries such as small scale and cottage industries will require largerworking capital.

(xvi) Proportion of Raw Material to Total Costs : If the raw materials are costly,the firm may require larger working capital, while if raw materials are cheaper andconstitute a small part of the total cost of production, lower working capital is required.

(xvii) Seasonal variation: During the busy season, a business requires largerworking capital while during the slack season a company requires ‘lower workingcapital. In sugar industry the season is November to June, while in the woolen industrythe season is during the winter. Usually the seasonal or variable needs of working capitalare financed by temporary borrowing.

(xviii) Banking Connections: If the corporation has good banking connections andbank credit facilities, it may have minimum margin of regular working capital overcurrent liabilities. But in the absence of the availability of bank finance, it should haverelatively larger among of net working capital.

(xix) Growth and Expansion: For normal rate of expansion in the volume ofbusiness, one may have greater proportion of retained profits to provide for moreworking capital; but fast growing concerns require larger amount of working capital. Aplan of working capital should be formulated with an eye to the future as well as presentneeds of a corporation.

E. Problem of Inadequacy of Working Capital

In case of inadequacy of working capital, a business may have to face the followingproblems:

(i) Production Facilities: It may not be possible to have the full utilisation of theproduction facilities to the optimum level due to the inability of buying sufficient rawmaterial and/or major renovation of the plant and machinery.

(ii) Raw Material Purchases: Advantage of buying at cash discount or on favourableterms may not be possible due to paucity of funds.

(iii) Credit Rating: When financial crisis continues, the credit worthiness of thecompany may be lost, resulting in poor credit rating.

(iv) Seizing Business Opportunities: In case of boom for the products and for thebusiness, the company may not be in a position to produce more to earn 'opportunityprofit' as there may be inadequacy of finished products availability.

(v) Proper Maintenance of Plant and Machinery: If the business is on financialcrisis, adequate sums may not be available for regular repair and maintenance,renovation or modernisation of plant to boost up production and to reduce per unit cost.

(vi) Dividend Policy: In the absence of fund availability it may not be possible tomaintain a steady dividend policy. Under such financial constraint, whatever surplus isavailable will be kept in general reserve account to strengthen the financial soundness ofthe business.

(vii) Reduced Selling: Due to the constraint in working capital, the company may notbe in a position to increase credit sales to boost up the sales revenue.

(viii) Loan Arrangement: Due to the emergency for working capital the companymay have to pay higher rate of interest for arranging either short-term or long-termloans.

(ix) Liquidity versus Profitability: The lower liquidity position may also result inlower profitability.

(x) Liquidation of the Business: If the liquidity position continues to remain weakthe business may run into liquidation. To remedy the situation of working capital crisis,the following steps are required:

(a) An appraisal and review is to be conducted to minimize the operating cycle.(b) Adequate credit control measures are to be adopted for early and promptrealisation from the debtors.(c) Proper planning and control of cash management through cash flowforecasting.(d) Whether more credit periods can be obtained for buying is to be explored.

F. Reasons for Inadequacy of Working Capital

Inadequacy or shortage of working capital may arise for various reasons, of which, themain reasons are:

(i) Operating Losses: This may arise when the cost of production and other relatedcosts are more than the sales revenue, reduction in sales, falling prices, increaseddepreciation, etc. It is obvious that a company facing losses will not have any cashgeneration to sustain its ongoing business.

(ii) Extraordinary Losses: There may be exceptional losses due to fall in price offinished product stocks, government action, obsolescence or otherwise. The effect ofsuch a loss will be a reduction in current assets or increase in current liabilities withoutany corresponding favourable change in the working capital composition.

(iii) Expansion of Business: The company during the profitable years might haveinvested substantially in fixed capital assets, increased production and increased creditsales to make the sales volume grow rapidly. Against those activities, the pitfalls of over-trading may show its ugly face subsequently. That is why a balancing judgment betweeninvestment, liquidity and profitability is to be drawn and projected to save the businessfalling into financial crisis. Thus the continuity and growth of the business may bejeopardized. Along with the increased sales there may be increase in inventories andhigher sundry debtors. Such excessive build-up of inventories and receivables mayamount to alarming figures.

(iv) Payment of Dividend and Interest: The payment of interest from borrowingswill have to be made as per terms of agreement. Similarly, the payment of dividend mayhave to be arranged to keep up the business prestige to the public and to theshareholders. There may be profit to declare dividend but there may not be adequatecash to disburse dividend. In case of insufficient funds to meet the aforesaid liabilities,the mobilising of funds will be necessary.

G. Excessive Working Capital

The following are the major disadvantages of having or holding excessive workingcapital:

(i) Overtrading: A time may come when overtrading will engulf the financialsoundness of the business.

(ii) Excessive Inventories: The inventories holding may become excessive under theinfluence of excessive funds availability.

(iii) Liquidity versus Profitability: The situation of liquidity and the profitabilitymay be imbalanced.

(iv) Inefficient Operation: Availability of excessive production facilities may resultin higher production but sales may not be anticipated to match goods produced.

(v) Lower Return on Capital Employed: There may be reduced profit in relation tototal capital employed, resulting in lower rate of return on capital employed.

(vi) Increased Fixed Capital Expenditure: As enough fund is available, there maybe boost-up in acquiring plant and machinery to enhance production facilities. In casethere is not enough sales potentiality with adequate margin of profit such fixedinvestment may not be worthwhile for fund employment.

H. Principles of Working Capital Management

1. Principle of Risk Variation: If working capital is varied relative to sales, theamount of risk that a firm assumes is also varied and the opportunity for gain or loss isincreased. This principle implies that a definite relation exists between the degree of riskthat management assumes and the rate of return. That is, the more risk that a firmassumes, the greater is the opportunity for gain or loss. It should be noted that while thegain resulting from each decrease in working capital is measurable, the losses that mayoccur cannot be measured.

It is believed that while the potential loss, the exactly opposite, occurs if managementcontinues to decrease working capital, that is to say, potential losses are small at first foreach decrease in working capital but increase sharply if it continues to be reduced. Itshould be the goal of management to find that point of level of Working Capital at whichthe incremental loss associated with a decrease in Working Capital investment becomesgreater than the incremental gain associated with that investment. Since most of themanagers do not know what the future holds, they tend to maintain an investment inworking capital that exceeds the ideal level. It is this excess that concerns since the sizeof the investment determines firm’s rate of return on investment. The obviousconclusion is that managers should determine whether they operate in business thatreacts favourably to changes in working capital levels, if not, the gains realized may notbe adequate in comparison to the risk that must be assumed when working capitalinvestment is decreased.

2. Principle of Equity Position: Capital should be invested in each components ofworking capital as long as the equity position of the firm increases. It follows from theabove that the management is faced with the problem of determining the ideal 'level' ofworking capital. The concept that each rupee invested in fixed or variable workingcapital should contribute to the net worth of the firm should serve as a basis for such aprinciple.

3. Principle of Cost of Capital: The type of capital used to finance working capitaldirectly affects the amount of risk that a firm assumes, as well as the opportunity forgain or loss and cost of capital.

Whereas the first principle dealt with the risk associated with the amount of workingcapital employed in relation to sales, the third principle is concerned with the riskresulting from the type of capital used to finance current assets. It has been observedthat return to equity capital increases directly with the amount of risk assumed by themanagement. This is true but only to a certain point. When excessive risk is assumed, afirms opportunity for loss will eventually overshadow its opportunity for gain, and atthis point return to equity is threatened. When this occurs, the firm stands to sufferlosses. Unlike rate of return, cost of capital moves inversely with risk; that is, asadditional risk capital is employed by management, cost of capital declines. Thisrelationship prevails until the firm’s optimum capital structure is achieved; thereafter,the cost of capital increases.

4. Principle of Maturity of Payment: A company should make every effort to relatematurities of payment to its flow of internally generated funds. There should be the leastdisparity between the maturities of the firm’s short term debt instrument and its flow ofinternally generated funds because a greater risk is generated with greater disparity. Amargin of safety should, however, be provided for short term debt payments.

5. Principle of Negotiation:

The risk is not only associated with the amount of debt used relative to equity, it is alsorelated to the nature of the contracts negotiated by the borrower.

Some of the clauses of the contracts such as restrictive clauses and dates of maturitydirectly affect a firms operation. Lenders of short term funds are particularly consciousof this problem and they ask for cash flow statements. Lenders realize that a firm'sability to repay short term loan directly related to cash flow and not to earnings and,therefore, a firm should make every effort to tie maturities to its flow of internallygenerated funds. This concept serves as the basis for the final hypothesis of thispresentation. Specifically, it may be stated as follows:

"The greater the disparity between the maturities of firms short term debt instrumentand its flow of internally generated funds, the greater the risk and vice-versa".

One can see that it is possible for a firm to face insolvency or embarrassment eventhough it might be making a profit. It is extremely difficult to predict accurately a firm’scash flow in an economy such as ours. Therefore, a margin of safety should be includedin every short term debt contract; that is, adequate time should be allowed between thetime the funds are generated and the date of maturity.

Steps Involved in Efficient Management of Working Capital

1. Proper financial set up with appropriate authority and responsibility.

2. Coordination between the following functional areas in the organization:

Production planning and control

Sales credit control

Material management

Optimal utilisation of fixed plant and machinery together with other facilities

Sale of uneconomical fixed assets

Acquiring plant and machinery to augment production

Cost reduction programme

3. Financial planning and control for achieving increased profitability to have adequate'cash generation' and 'plough back' of profits so that there is adequate internal source offinance.

4. Proper cash management through projection of cash flow and source and applicationof funds flow statement.

5. Establishing appropriate Information and Reporting System.

REVIEW QUESTIONS

1. Discuss the importance of working capital for a manufacturing concern.

2. Explain the various determinants of working capital of a concern.

3. What are the advantages of having ample working capital funds?

4. Differentiate between fixed working capital and variable working capital.

5. What are the different principles of working capital management?

6. Summarise the causes for and changes in working capital of a firm.

SUGGESTED READINGS

1. Agarwal, N.K.: Working Capital Management, New Delhi, Sterling Publications (P)Ltd.

2. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw Hill Co.

3. Ramamoorthy, V.E.: Working Capital Management, Madras, Institute for FinancialManagement and Research.

- End of Chapter -

LESSON - 3

WORKING CAPITAL FORECASTING TECHNIQUES

Learning ObjectivesAfter reading this lesson you should be able to:• Know the concept of working capital cycle• Identify the working capital gap• Explain the working capital forecasting techniques

Chapter Outline

A. Percent-of-sales methodB. Regression Analysis methodC. Working Capital Cycle methodD. Illustrative examples

Working capital requirements can be determined mainly in three ways: Percent-of-salesmethod, Regression Analysis method, and the Working Capital Cycle method.

A. Percent-of-Sales Method: It is a traditional and simple method of determiningthe volume of working capital and its components, sales being a dominant factor. In thismethod, working capital is determined as a per cent of forecasted sales. It is decided onthe basis of past observations. If over the year, relationship between sales and workingcapital is found to be stable, then this relationship may be taken as a standard for thedetermination of working capital in future also.

This relationship between sales and working capital and its various components may beexpressed in three ways:

(i) as number of days of sales,

(ii) as turnover, and

(iii) as percentage of sales.

The percent-of-sales method of determining working capital is simple and easy tounderstand and is useful in forecasting of working capital requirements, particularly in

the short term. However, the greatest drawback of this method is the assumption oflinear relationship between sales and working capital. Therefore, this method cannot berecommended for universal application. It may be found suitable by individualcompanies in specific situations.


B. Regression Analysis Method: As stated earlier the regression analysis method isa very useful statistical technique of forecasting. In the sphere of working capitalmanagement it helps in making projection after establishing the average relationship inthe past years between sales and working capital (current assets) and its variouscomponents. The analysis can be carried out through the graphic portrayals (scatterdiagrams) or through mathematical formula. The relationship between sales andworking capital or various components may be simple and direct indicating completelinearity between the two or may be complex in differing degree involving simple linearregressions or simple curvilinear regression, and multiple regressions situations.

This method, with a range of techniques suitable for simple as well as complexsituations, is an undisputed refinement on traditional approaches of forecasting anddetermining working capital requirements. It is particularly suitable for long-termforecasting.

C. The Working Capital Cycle Method: The working capital cycle refers to theperiod that a business enterprise takes in converting cash back into cash. As an example,a manufacturing firm uses cash to acquire inventory of materials that is converted intosemi finished goods and then into finished goods. When finished goods are disposed ofto customers on credit, accounts receivable are generated. When cash is collected fromcustomers, we again have cash. At this stage one operating cycle is completed. Thus acircle from cash-back-to-cash is called the working capital cycle. This concept is also betermed as 'Pipe Line Theory' as popularly known.

Fig. 3.1 Working Capital Cycle

Thus we see that a working capital cycle, generally, has the following four distinctstages:1. The raw materials and stores inventory stage;

2. The semi-finished goods or work-in-progress stage;

3. The finished goods inventory stage; and

4. The accounts receivable or book debts stage.

Each of the above working capital cycle stage is expressed in terms of number of days ofrelevant activity and requires a level of investment to support it. The sum total of thesestage-wise investments will be the total amount of working capital of the firm. A seriesof such operating cycle recur one after another and chain continues till the end of theoperating period.

In this way the entire operating period has a number of operating cycles. It is importantto note that the velocity or speed of this cycle should not slacken at any stage, otherwisethe normal duration of the cycle will be lengthened, resulting in an increased need forworking fund. The faster the speed of the operating cycle, shorter will be its durationand larger will be the number of total operating cycles in a year (operating period) whichin turn would be instrumental in giving the maximum level of turnover withcomparatively lower level of working fund.

The four steps involved in this method are :

(i) computing the duration of the operating cycle,

(ii) calculating the number of operating cycles in the operating period,

(iii) estimating the total amount of annual operating expenses, and

(iv) ascertaining the total working capital requirements. Each step is discussed withsome detail in the following paragraphs.

(i) Duration of Operating Cycle : The duration is computed in days by addingtogether the average storage period of raw materials, works-in-progress, finished goodsand the average collection period and then deducting from the total the averagepayment period. The formula to express the framework of the operating cycle is: O = (R+ W + F + D) - C where:

O = Duration of operating cycleR = Raw material average storage periodW = Average period of work-in-progressF = Finished goods average storage periodD = Debtors collection periodC = Creditors payment period

The average inventory, trade creditors, work-in-progress, finished goods arid book debtscan be computed by adding the opening and closing balances at the end of the year inthe respective accounts and dividing the same by two. The average per day figures canbe obtained by dividing the concerned annual figures by 365 or the number of days inthe given period.

(ii) Number of Operating Cycle in Operating Period: This is found out bydividing the total number of days in the operating period by number of days in theoperating cycle as

N = P/O

where N = Number of operating cycle in operating period, P = Number of days in theoperating period, and O = Duration of operating cycle (in days)

Suppose the operating period is one year (365 days) and the duration of operating cycleis 73 days then the number of operating cycles in the operating period will be:

N = 365 /73 = 5 cycles

(iii) Total amount of Annual Operating Expenses: These expenses includepurchase of raw materials, direct labour costs and the overhead costs-calculated on thebasis of average storage period of raw materials and the time-lag involved in thepayment of various items of expenses. The aggregate of such separate average amountswill represent the annual operating expenses.

(iv) Estimating the Working Capital Requirement: This is calculated by dividingthe total annual operating expenses by the number of operating cycles in the operatingperiod as shown below:

R = E/N

where, R = Requirement of Working Capital (Estimated), E = Annual OperatingExpenses, and N = Number of operating cycles in the operating period.

The amount of working capital thus estimated is increased by a fixed percentage so as toprovide for contingencies and the aggregate figure gives the total estimate of workingcapital requirements. The operational cycle method of determining working capitalrequirements gives only an average figure. The fluctuations in the intervening perioddue to seasonal or other factors and their impact on the working capital requirementscannot be judged in this method. To identify these impacts, continuous short-rundetailed forecasting and budget exercises are necessary.

D. Illustrative Examples

Illustration 1

The following data have been extracted from the financial records of PrabhakarEnterprises Limited:

Raw Materials cost = Rs. 8 per unit,

Direct Labour cost = Rs. 4 per unit,

Overheads cost = Rs.80,000

Additional information:

i. The company sells annually 25,000 units @ Rs. 20 per unit. All the goods producedare sold in the market.ii. The average storage period for raw materials is 40 days and for finished goods it is 18days.iii. The suppliers give 60 days credit facility to the firm for purchases. The firm also sellsgoods on 60-days credit to its customers. iv. The duration of the production cycle is 15 days and raw material is issued at thebeginning of each production cycle.v. 25% of the average working capital is kept as cash for contingencies.

On the basis of the above information, estimate the total working capital requirementsof the firm under Operating Cycle Method.

Solution

Duration of Operating Cycle Days

i. Materials storage period 40

ii. Production cycle period 15

iii. Finished goods storage period 18

iv. Average collection period 60

-----

133

Less: Average payment period -60

----

Duration of Operating Cycle 73

Number of Operating Cycles in a year = Total Number of Days in a year divided byDuration of Operating Cycle = 365/73 = 5 Cycles in a year.

Total Annual Operating Expenses

i. Raw Material 25,000 x 8 = 2,00,000

ii. Direct Labour 25,000 x 4 = 1,00,000

iii. Overheads 80,000

----------

Total Operating Expenses for the year 3,80,000

-----------

Estimating Working Capital Requirements

= Total Annual Operating Expenses / Number of Operating Cycles in a year

= 3,80,000 / 5 = Rs. 76,000

Add: 25% of the above by cash for contingencies = Rs. 19,000

--------------

Total Working Capital Requirement = Rs. 95,000

--------------

Illustration 2 : Messrs Senthil Industries Ltd are engaged in large scale retailing.From the following information, you are required to forecast their working capitalrequirements of this trading concern.

Projected annual sales = Rs. 65 lakhs

Percentage of Net Profit on cost of sales = 25%

Average credit allowed to Debtors = 10 weeks

Average credit allowed by Creditors = 4 weeks

Average stock carrying (in terms of sales requirement) = 8 weeks

Add 10% to computed figures to allow for contingencies.

Solution

Statement of Working Capital Requirements

Note: It has been assumed that the creditors include those for both goods andexpenses, and that all such creditors allow one month credit on average.

Interpretation of Results:

The amount of working capital fund above is to be interpreted as the amount to beblocked up in inventory, debtors (minus creditors) at any time during the period (year)in view, in order that the anticipated activity (sales primarily) can go on smoothly. Theamount is not for a period of time but at any point of time. It represents the maximum(or the highest) quantum of locking up at any time during the period.

Illustration 3 : Ramaraj Brothers Private Limited sells goods on a gross profit of 25%.Depreciation is taken into account as a part of cost of production. The following are theannual figures given to you:

Sales (2 months credit) Rs. 18,00,000

Materials consumed (1 monthcredit) Rs. 4,50,000

Wages paid (1 month lag inpayment) Rs. 3,60,000

Cash manufacturing expenses (1 month lag inpayment) Rs. 4,80,000

Administration expenses (1 month lag inpayment) Rs. 1,20,000

Sales promotion expenses (paid quarterly inadvance) Rs. 60,000

Income tax payable in 4 instalments, of which one falls in the nextyear Rs. 1,50,000

The company keeps one month's stock each of raw materials and finished goods. It alsokeeps Rs. 1,00,000 in cash. You are required to estimate the working capitalrequirements of the company on cash basis assuming 15% safety margin.

Solution

Working Notes:

1. Total Manufacturing Expenses

Sales Rs. 18,00,000

Less: Gross Profit 25% of sales - Rs. 4,50,000

Total Cost Rs. 13,50,000

Less: Cost of materials - Rs. 4,50,000

Wages - Rs. 3,60,000 - Rs. 8,10,000

Total Manufacturing Expenses Rs. 5,40,000

2. Depreciation

Total Manufacturing Expenses Rs. 5,40,000

Less: Cash Manufacturing Expenses - Rs. 4,80,000

Depreciation Rs. 60,000

3. Total Cash Cost

Total Manufacturing Cost Rs. 13,50,000

Less: Depreciation - Rs. 60,000

Rs. 12,90,000

Add: Administration expenses + Rs. 1,20,000

Sales promotion expenses + Rs. 60,000

Total Cash Cost Rs. 14,70,000


REVIEW QUESTIONS

1. What are the different methods of forecasting working capital requirements?

2. Explain: (a) Core Current Assets (b) Working Capital Gap (c) Working Capital Cycle

PRACTICAL PROBLEMS

1. The Board of Directors of Guru Nanak Engineering Company Private Ltd requests youto prepare a statement showing the Working Capital Requirements Forecast for a level

of activity of 1,56,000 units of production. The following information is available foryour calculation:

A. Rs. per units

Raw materials 90

Direct Labour 40

Overheads 75

------

205

Profits 60

------

Selling price per unit 265

B.

(i) Raw materials are in stock on average one month,

(ii) Materials are in process, on average two weeks,

(iii) Finished goods are in stock, on average one month

(iv) Credit allowed by suppliers one month

(v) Time lag in payment from debtors 2 months

(vi) Lag in payment of wages 1 ½ weeks

(vii) Lag in payment of overheads is one month

Other information: 20% of the output is sold against cash. Cash in hand and at Bank isexpected to be Rs.60,000. It is to be assumed that production is carried on evenlythroughout the year, wages and overheads accrue similarly and a time period of 4 weeksis equivalent to a month.

[Ans: Working Capital Required Rs.74,13,000]

Notes: (i) Since wages and overheads accrue evenly on average, half the wages andoverheads would be included in working progress. Alternatively if it is assumed that thedirect labour and overhead are introduced at the beginning, full wages and overheadwould be included.

2. A proforma cost sheet of a company provides the following particulars:

Elements of Cost

Raw material 40%

Labour 10%

Overheads 30%

The following further particulars are available:

(a) Raw materials are to remain in stores on an average 6 weeks

(b) Processing time is 4 weeks

(c) Finished goods are required to be in stock on average period of 8 weeks

(d) Credit period allowed to debtors on average 10 weeks

(e) Lag in payment of wages 4 weeks

(f) Credit period allowed by creditors 4 weeks

(g) Selling price is Rs.50 per unit

You are required to prepare an estimate of working capital requirements adding 10%margin for contingencies for a level of activity of 1,30,000 units of production.

[Ans: Working Capital Required = Rs. 25,25,000]

3. From the following information extracted from the books of a manufacturing concern,compute the operating cycle in days -

Period covered 365 days

Average period of credit allowed by suppliers 16 days

SUGGESTED READINGS

1. Agarwal, N.K.: Working Capital Management, New Delhi, Sterling Publications (P)Ltd.

2. Kulshrestha, R.S.: Financial Management, Agra, Sahitya Bhavan.

3. Ramamoorthy, V.E.: Working Capital Management, Madras, Institute for FinancialManagement and Research.

- End of Chapter -

LESSON - 4

WORKING CAPITAL FINANCING POLICY

Learning Objectives

After reading this lesson you should be able to:- Assess the need for working capital policy.- Identify the different approaches to working capital policy.- Understand the implications of conservative policy.- Evaluate the Risk - Return in Aggressive policy.

- Arrive at a Moderate or Balanced approach to the problem of financing of currentassets.

Lesson Outline

A. Matching (Moderate) Approach

B. Aggressive Approach

C. Conservative Approach

D. Balanced Policy

E. Illustrative examples

The current assets financing plan may be readily related to the broader issue of thefinancing plan for all the firm's assets. The firm has a wide variety of financing policies itmay choose, and the fact that short-term financing usually is less costly but involvesmore risk than long-term financing plays an important part in describing the degree ofaggressiveness or conservatism of the firm's financing policy.

In comparing financing plans we should distinguish between three different kinds offinancing. A firm's investment is namely financed by a mix of these sources of financing:

(i) A permanent investment in an asset is one that the firm expects to hold for periodlonger than one year. Permanent investments are made in the firm's minimum level ofcurrent assets as well as in its fixed assets. Permanent sources of financing includeintermediate and long-term debt, preference share and equity share.

(ii) Temporary investments are comprised of the firm's investments in current assets,which will be liquidated and not replaced within the current year. For example, aseasonal increase in the level of inventory is a temporary investment as the holding upin inventories will be eliminated when it is no longer needed. Temporary source offinancing is a current liability. Thus, temporary financing consists of the various sourcesof short-term debt including secured and unsecured bank loans, commercial paper,factoring of accounts receivables, and public deposits.

(iii) Besides permanent and temporary sources of financing, there also existspontaneous sources. Spontaneous sources consist of the trade credit and otheraccounts payable that arise spontaneously in the firm’s day-to-day operations. Examplesinclude wages and salaries payable, accrued interest, and accrued taxes. These expensesgenerally arise in direct conjunction with the firm's ongoing operations; they arereferred to as spontaneous. Popular example of a spontaneous source of financinginvolves the use of trade credit. As the firm acquires materials for its inventories, creditis often made available spontaneously or on demand by the firm's suppliers. Tradecredit appears on the firm's balance sheet as accounts payable. The size of the accountspayable balance varies directly with the firm's purchases of inventory items, which in

turn are related to the firm's anticipated sales. Thus, a part of the financing needs by thefirm is spontaneously provided by its use of trade credit.

The long term working capital can be conveniently financed by (a) owners equitye.g. shares and retained earnings, (b) lenders' equity e.g. debentures, and (c) fixed assetsreduction e.g. sale of assets, depreciation on fixed assets etc. This capital can bepreferably obtained from owner's equity as they do not carry with them any fixedcharges in the form of interest or dividend and so, do not put any burden on thecompany.

Intermediate working capital funds are ordinarily raised for a period varying from3 to 5 years through loans which are repayable in installments e.g., working capitalterm-loans from the commercial banks or from finance corporations.

A. Matching (or Moderate) Approach: Matching approach is also called HedgingPrinciple. It involves matching the cash flow generating characteristics of a firm’sassets with the maturity of the source of financing used. The rationale for matching isthat since the purpose of financing is to pay for assets, when the asset is expected to berelinquished so should the financing be relinquished. Obtaining the needed funds froma long-term source (longer than one year) would mean that the firm would still have thefunds after the inventories have been sold. In this case the firm would have "excess"liquidity, which they either hold in cash or invest in low yielding marketable securities.This would result in an overall lowering of firm's profits. Similarly arranging finance forshorter periods that the assets require is also costly in that there will be extratransaction costs involved in continually arranging new short-term financing. Also,there is always the risk that new financing cannot be obtained in times of economicdifficulty.

The firm's permanent investment in assets is financed by the use of either permanentsource of financing (intermediate-and long-term debt, preference shares, and equityshares) or spontaneous source (trade credit and other accounts payable), its temporaryinvestment in assets is financed with temporary (short-term debt) and/or spontaneoussources of financing. Note the matching approach has been modified to state: Assetneeds of the firm, not financed by spontaneous sources, should be financed inaccordance with the rule: permanent asset investments financed with permanentsources and temporary investments financed with temporary sources.

Since total assets must always equal to the sum of spontaneous, temporary, andpermanent sources of financing, the hedging approach provides the financial managerwith the basis for determining the sources of financing to use at any point in time.


B. Aggressive Approach: The firm's financing plan is said to be aggressive if the firmuses more short-term negotiated financing than is needed under a matching approach.The firm is no longer financing all its permanent assets with long-term financing. Suchplans are said to be aggressive because they involve a relatively heavy use of (riskier)short-term financing. The more short-term financing used relative to long-termfinancing, the more aggressive is the financing plan. Some firms are even financing partof their long-term assets with short-term debt, which would be a highly aggressive plan.

C. Conservative Approach: Conservative financing plans are those plans that usemore long-term financing than is needed under a matching approach. The firm isfinancing a portion of its temporary current assets requirements with long-termfinancing. Also, in periods when the firm has no temporary current assets the firm hasexcess (unneeded) financing available that will be invested in marketable securities.These plans are called conservative because they involve relatively heavy use of (lessrisky) long-term financing.

Comparison of Conservative, Hedging, and Aggressive Approaches: Theseapproaches to working capital financing can be compared on the basis of (a) costconsiderations, (b) profitability considerations, and (c) risk considerations (probabilityof technical insolvency). The following statement gives a comparative evaluation.


D. Balance Policy: Because of the impracticalities in implementing the matchingpolicy and the extreme nature of the other two policies, most financial managers opt fora compromise position. Such a position is the balanced policy. As its name implies,management adopting this policy balances the trade-off between risk and profitability ina manner consistent with its attitude toward bearing risk. The long-term financing isused to support permanent current assets and part of the temporary current assets.Thus short-term credit is used to cover the refraining working capital needs duringseasonal peaks. This implies that as any seasonal borrowings are repaid, surplus fundsare invested in marketable securities. This policy has the desirable attribute of providinga margin of safety not found in the other policies. If temporary needs for current assetsexceed management’s expectations, the firm will still be able to use unused short-termlines of credit to fund them. Similarly, if the contraction of current assets is less thanexpected, short-term loan payments can still be met, but less surplus cash will beavailable for investment in marketable securities. In contrast to the other workingcapital policies, a balanced policy will demand more management time and effort.Under the policy, the financial manager will not only have to arrange and maintainshort-term sources of financing but must be prepared to manage the investment ofexcess funds.

The Appropriate Working Capital Policy

The analysis so far has offered insights into the risk-profitability trade-off inherent in avariety of different policies. Just as there is no optimal capital structure that all firmsshould adopt, there is no one optimal working capital policy that all firms shouldemploy. Which particular policy is chosen by a firm will depend on the uncertaintyregarding the magnitude and timing of cash flow associated with sales; the greater thisuncertainty, the higher the level of working capital necessary. In addition, the cashconversion cycle will influence a firm’s working policy; the longer the time required toconvert current assets into cash, the greater the risk of illiquidity. Finally, in practice,the more risk averse management is the greater will be the net working capital position.The management of working capital is an ongoing responsibility that involves manyinterrelated and simultaneous decisions about the level and financing of current assets.The considerations and general guidelines offered in this lesson should be useful inestablishing an overall net working capital policy.

E. Illustrative examples

Illustration 1

Following is the summary of Balance Sheets of a firm under the three approaches:

-------------------------------------------------------------------------------------------

Policy / Approach

------------------------------------------

Conservative Hedging Aggressive

-------------------------------------------------------------------------------------------

Liabilities

Current liabilities 5,000 15,000 25,000

Long-term loan 25,000 15,000 5,000

Equity 50,000 50,000 50,000

------------------------------------------

Total 80,000 80,000 80,000

------------------------------------------

Assets

Current assets

a) Permanent requirement 20,000 20,000 20,000

b) Seasonal requirement 15,000 15, 000 15,000

Fixed assets 45,000 45,000 45,000

------------------------------------------

Total 80,000 80,000 80,000

------------------------------------------

Additional Information

(i) The firm earns, on an average, approximately 6% on investments in current assetsand 18% on investments in fixed assets.(ii) Average cost of current liabilities is 5% and average cost of long-term funds is 12%.

Compute the costs and returns under any three different approaches, and comment onthe policies.

Solution

1. Computation of costs under the three approaches:

-------------------------------------------------------------------------------------------------

Policy / Approach

---------------------------------------------------------


--------------------------------------------------------------------------------------------------

Cost of Current liabilities, 5% on 5,000 = 250 15,000 = 750 25,000= 1,250

Cost of long-term funds, 12% on 75,000 = 9,000 65,000 = 9,000 55,000= 6,600

---------------------------------------------------------

TotalCost 9,250 9,750 7,850

--------------------------------------------------------------------------------------------------

2. Computation of returns under the three approaches:

-------------------------------------------------------------------------------------------------

Policy / Approach

---------------------------------------------------------


--------------------------------------------------------------------------------------------------

Return on Current assets, 6% on 35,000 = 2,100 35,000 = 2,100 35,000= 2,100

Return of Fixed Assets, 18% on 45,000 = 8,100 45,000 = 8,100 45,000= 8,100

---------------------------------------------------------

TotalReturn 10,200 10,200 10,200

Less: Cost offinancing (9,250) (8,550) (7,850)

--------------------------------------------------------------------------------------------------

Netreturn 950 1,650 2,350

--------------------------------------------------------------------------------------------------

Comments:

(i) Cost of financing is highest being Rs. 9,250 in conservative approach, and lowest (Rs.7,850) in aggressive approach, the total funds being the same, i.e., Rs. 80,000.

(ii) Return on investment (net) is lowest in conservative approach being Rs.950, andhighest in aggressive approach being Rs. 2,350.

(iii) Risk is measured by the amount of net working capital. The larger the net workingcapital, the lesser will be the degree of technical insolvency or the lesser will be theinability to meet obligations on maturity dates. In other words,larger net working capital means less risk. The net working capital is comparativelylarger in conservative approach and therefore, the degree of risk is low. The net workingcapital is comparatively lower in aggressive approach, and, therefore, the degree of riskis high. Risk is also measured by the degree of liquidity. The larger the degree ofliquidity, the lesser will be the degree of risk. One of the measurements of degree ofliquidity is current ratio; it is also known as 'Working Capital Ratio'. This ratio signifiesthe firm’s ability to meet its current obligations. The larger the ratio, the greater theliquidity, and the lesser the risk. In conservative approach, current ratio is the highestbeing 7:1, and in aggressive approach, this ratio is lowest being 1.4 : 1. Therefore, there islow risk in conservative approach.

The aforementioned analysis leads to the following conclusions:

(i) In conservative approach, cost is high, risk is low, and return is low.(ii) In aggressive approach, cost is low, risk is high, and return is high.(iii) Hedging approach has moderate cost, risk and return. It aims at trade-off betweenprofitability and risk.

REVIEW QUESTIONS

1. Evaluate the following statement: "A firm can reduce its risk of illiquidity with highercurrent-asset investments, but the return on capital goes down."

2. What are the risk-return trade-offs involved in choosing a mix of short-and long-termfinancing?

3. There are four different policies that managers must consider in designing theirworking capital policy. Explain the salient features of each policy. What are theadvantages and disadvantages of each such policy?

PRACTICAL PROBLEMS

1. The management of Jayant Electrical Ltd is faced with various alternatives formanaging its current assets. The company is producing 1,00,000 units of electricalheaters. This is its maximum installed capacity. Its selling price per unit is Rs.50. Theentire output is sold in the market. Fixed assets of the company are valued at Rs. 20lakhs. The company earns 10% on sales before interest and taxes. The management isfaced with three alternatives about the size of investment in current assets.

(i) To operate with current assets of Rs. 20 lakhs, or

(ii) To operate with current assets of Rs. 15 lakhs, or

(iii) To operate with current assets of Rs 10 lakhs.

You are required to show the effect of the above three alternative current assetsmanagement policies on the degree of profitability of the company.

[Ans: (i) Conservative Policy (ii) Moderate Policy (iii) Aggressive Policy]

2. (a) Total investments:

In Fixed Assets 1,20,000

In Current Assets 80,000 2,00,000

(b) Earning (EBIT) is 25%.

(c) Debt-ratio is 60%.

(d) Rs. 80,000 being (40% assets) financed by the equity shareholder, i.e., long-termsources.

(e) Cost of short-term debt and long-term debt is 14% and 16% respectively.

(f) Assume Income tax @ 50%.

As a result of the financing policy, ascertain the return on equity shares.

[Ans : Return on equity is highest in aggressive policy]

SUGGESTED READINGS

1. Agarwal, N.K: Working Capital Management, New Delhi, Sterling Publications (P)Ltd. 1983.


3. Ramamoorthy, V.E: Working Capital Management, Madras; Institute for FinancialManagement and Research, 1978

- End of Chapter -

LESSON - 5

SOURCES OF WORKING CAPITAL FINANCE

Learning Objectives


· Identify the various sources of working capital finance· Know the cost of trade credit· Understand the regulation of bank credit· Evaluate the significance of Public Deposits and inter-corporate loans/deposits· Recognise the emergence of new instruments like Commercial Papers,

Convertible Warrants, etc.

Lesson Outline

· Trade Credit - Customers Advances· Commercial Bank Credit - Cash Credit/Discounting· Regulation of Bank Credit - Tandon Committee - Chore Committee - Marathe

Committee· Commercial Papers· Inter Company Deposits/Loans· Public Deposit

One of the important tasks of the finance manager is to select an assortment ofappropriate sources to finance the current assets. A business firm has various sources tomeet its financial requirements. Normally, the current assets are supported by acombination of long term and short term sources of financing. In selecting a particularsource a firm has to consider the merits and demerits of each source in the context ofprevailing constraints. The following is a snapshot of various sources of working capitalavailable to a concern:

SOURCES OF WORKING CAPITAL

Long term, Medium term & Short term sources

The long term working capital can be conveniently financed by (a) owners’ equity e.g.shares and retained earnings, (b) preferred equity, (c) lender's equity e.g., debentures,

and (d) fixed assets reduction e.g., sale of assets, depreciation on fixed assets etc. Thiscapital can be preferably obtained from owners’ equity as they do not carry with themany fixed charges in the form of interest or dividend and so do not throw any burden onthe company.

Intermediate working capital funds are ordinarily raised for a period varying from 3 to 5years through loans which are repayable in installments e.g., term-loans from thecommercial banks or from finance corporations. Short term working capital funds canbe obtained for financing day-to-day business requirements through trade credit, bankcredit, discounting bills and factoring of account receivables. Factoring is a method offinancing through accounts receivable under which a business firm sells its accounts tofinancial institution, called the Factor.


SOURCES OF SHORT-TERM FINANCE

In choosing a source of short term financing, the finance manager is concerned with thefollowing five aspects of each financing arrangement.

(i) Cost: Generally the finance manager will seek to minimise the cost of financing,which usually can be expressed as an annual interest rate. Therefore, the financingsource with the lowest interest rate will be chosen. However, there are other factorswhich may be important in particular situations.

(ii) Impact on credit rating: Use of some sources may affect the firm’s credit ratingmore than use of others. A poor credit rating limits the availability, and increases thecost of additional financing.

(iii) Reliability: Some sources are more reliable than others in that funds are morelikely to be available when they are needed.

(iv) Restrictions: Some creditors are more apt to impose restrictions on the firm thanothers. Restrictions might include rupee limits on dividends, management salaries, andcapital expenditures.

(v) Flexibility: Some sources are more flexible than others in that the firm canincrease or decrease the amount of funds provided very easily. All these factors mustusually be considered before making the decision as to the sources of financing.

Trade Credit: Trade credit represents credit granted by manufacturers, wholesalers,etc., as an incident of sale. The usual duration of credit is 30 to 90 days. It is granted tothe company on ‘open account’, without any security except that of the goodwill andfinancial standing of purchaser. No interest is expressly charged for this, only the priceis a little higher than the cash price. The use of trade credit depends upon the buyer’sneed for it and the willingness of the supplier to extend it.

The willingness of a supplier to grant credit depends upon:

(i) the financial resources of the supplier;

(ii) his eagerness to dispose of his stock;

(iii) degree of competition in the market;

(iv) the credit worthiness of the firm;

(v) nature of the product;

(vi) size of discount offered;

(vii) the degree of risk associated with customers.

The length of the credit period depends upon:

(a) Customer’s marketing period;

(b) Nature of the product (long credit for new, seasonal goods and short credit onperishable goods and low-margin goods); and

(c) Customer location (long distance evidencing the amount that he owes to the seller)

Cost of Trade Credit

The trade credit as a source of financing is not without cost. The cost of trade credit isclearly determined by its terms. However, the terms of trade credit vary industry toindustry and from company to company. However, regardless of the industry, the twofactors that must be considered while analysing the terms and the cost of trade creditare:

(i) the length of time the purchaser of goods has before the bill must be paid, and

(ii) the discount, if any, that is offered for prompt payment. For instance, a companypurchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. It means ifthe payment is made within ten days the firm will be entitled for 2% cash rebate;otherwise the payment is to be made within 30 days in full. If the company wants to useRs.9,800 for 20 days at a cost of Rs.200, then its actual cost works to 2.049.

Advantages of Trade Credit

Trade credit as a form of short term financing has the following advantages:

(i) Ready availability: There is no need to arrange financing formally.

(ii) Flexible means of financing: Trade credit is a more flexible means of financing.The firm does not have to sign a Promissory Note, pledge collateral, or adhere to a strictpayment schedule on the Note.

(iii) Economic means of financing: Generally, during periods of tight money, largefirms obtain credit more easily than small firms do. However, trade credit as a source offinancing is still more easily accessible by small firms even during the periods of tightmoney.

Customers Advances: Depending upon the competitive condition of the market andcustoms of trade, a company can meet its short-term requirements at least partlythrough customer/dealers advances. Such advances represent part of the price and carryno interest. The period of such credit will depend upon the time taken to deliver thegoods. This type of finance is available only to those firms which can dictate terms totheir customers since their product is in great demand as compared to the products ofthe other competitive firms.

Commercial Bank: Bill Discounting and Cash Credit: Bank credit is the primaryinstitutional source for working capital finance. Banks offer both unsecured as well assecured loans to business firms. At one time banks confined their lending policies tosuch loans only. Banks, now, provide a variety of business loans, tailored to the specificneeds of the borrowers. Still, short term loans are an important source of businessfinancing such as seasonal build-ups in accounts receivable, and inventories. Thedifferent forms in which unsecured and secured short-term loans may be extended arediscounting of bills of exchange, overdraft, cash credit, loans and advances. Banksprovide credit on the basis of the security. A loan may either be secured by tangibleassets or by personal security. Tangible assets may be charged as security by any one ofthe following modes, viz., lien, pledge, hypothecation, mortgage, charge, etc.


Discounting and Purchase of Bills: Under the Bill Market scheme, the ReserveBank of India envisages the progressive use of bills as an instrument of credit as againstthe current practice of using the widely prevalent cash credit arrangement for financingworking capital. To popularise the scheme, the discount rates are fixed at lower ratesthan those of cash credit, the difference being about 1 to 1.5 per cent.

Cash Credits: Banks in India normally make loans and advances in three forms viz.,cash credits, overdrafts and loans. Cash credit is an arrangement by which a bankerallows the customer to borrow money up to a certain limit (called cash credit limit)against some tangible security or on the basis of a promissory-note signed and fixes thelimit annually or quarterly after taking into account several material levels, etc. Thebanker keeps adequate cash balances so as to meet the customer’s demand as and whendemand arises. Once the cash credit arrangement is made, the customer need not takethe whole advance at once but may draw out or utilise the bank credit at any timewithout keeping a credit balance. Further, the borrower can put back any surplusamount which he may find with him for the time being. The bank can also withdraw thecredit at any time in case the financial position of the borrower goes down. Generally theborrower is charged interest on the actual amount utilised by him and for the period ofactual utilisation only; interest is charged by the bank on daily debit balance.

Overdrafts: When a customer having a current account requires a temporary financialaccommodation, he is allowed to overdraw (to draw more than his credit balance) hiscurrent account up to an agreed limit. Overdraft accounts can either be secured orunsecured, usually, security is insisted upon for an overdraft arrangement. Thecustomer is allowed to withdraw the amount by cheques as and when he needs it andrepay it by means of deposits into his account as and when it is feasible for him. Interestis charged on the daily debit balance i.e.,the exact amount overdrawn by the customerand for the period of actual utilisation. This is more advantageous to the customer-borrower in the sense that the interest is charged only on the amount drawn by him. Butthe banker is comparatively at a disadvantage because he has to keep himself inreadiness with the full amount of the overdraft and he can charge interest on theamount actually drawn. An overdraft, is different from a cash credit in that the former issupposed to be for a comparatively short time where as the latter is not so.

Loans: When an advance to a customer is made in a lumpsum against security orotherwise, without liberty to him of repaying, with a view to making a subsequentwithdrawal, it is called a loan. The entire loan amount is paid to the borrower in cash oris credited to his current account and interest is charged on the full amount of the loanfrom quarterly rests from the date of sanction. Where the loan is repayable in

installments the interest is charged only on the reduced balance. A loan once repaid infull or in part cannot be withdrawn again by the borrower, unless the banker grants afresh loan which will be treated as a separate transaction. In this respect a loan accountdiffers from a cash credit or an overdraft account. A banker prefers to make an advancein the form of a loan because he can charge interest on it, rather than overdraft or cashcredit because in the latter case there is continuity and magnitude of operation.

Critical Evaluation of Bank Finance:

Bank credit offers the following advantages to the borrowing companies:

(1) Timely assistance: Banks assist the borrowing companies by providing timelyassistance to meet the working capital requirements. A company can usually rely uponthe bank for amounts of loan up to an agreed limit sanctioned by bank in advance.

(2) Flexibility: Bank assistance is flexible to the company. The accommodation caneasily be got extended and may be used when it is urgently needed. It helps the companyin maintaining goodwill in the market. Also, if the amount of loan or a part of it is nomore required it can be repaid and interest on it be saved.

(3) Economy: Bank assistance entails the payment of only interest and does notinvolve the kind of costs which are to be incurred in the issue of securities such ascommission on underwriting etc. Moreover, the rate of interest is not very high. Theinterest is payable only for the period the loan remains unpaid. Thus it reduces the costof borrowings.

(4) No permanent burden: The borrowings can be repaid if it is no more required.In this way, it is not a permanent burden to the concern.

(5) No interference with company management: The loan provided by the bankis simply a loan and no string is attached to it. Generally banks do not interfere with themanagement of the borrowing companies, till the bank is assured of the repayment ofloans.

(6) Secrecy: This is by far the greatest advantage of bank finance. Any informationsupplied to bank regarding financial position of the borrowing company is not madepublic in any way by the bank.

Drawbacks of Bank Finance: Bank accommodation and loans suffer from thefollowing drawbacks:

(1) Burden of mortgage or hypothecation: The stock of raw material, finished orsemi finished goods are to be kept in a godown under bank control and can be used onlywith the permission of bank or after paying the amount of loan.

(2) Short-duration of assistance: Banks provide only short-term assistancegenerally for the period less than a year and its renewal or extension is quite uncertaindepending upon the discretion of bank’s authorities.

(3) Cumbersome terms: Banks grant assistance generally, to the extent of 50 to 75%of the cost of security pledged or hypothecated, thus having a margin of 25% to 50%. Inaddition, banks press the borrowing companies to have the goods in their godowns.Minimum interest is paid on a certain specific amount whether it is drawn or not andrepayment of loan is strictly enforced as per the agreement entered into between thecompany and the bank. Thus, the terms of borrowings are too harsh. It also increasesthe cost of new borrowings and of the production.

REGULATION OF BANK CREDIT SINCE 1965Since 1965, the availability of bank credit to industry has been the subject matter ofregulation and control with a view to ensure equitable distribution of bank credit tovarious sectors of the economy as per planning priorities. The following are of specialsignificance in this respect:

(i) Credit Authorisation Scheme, 1965

(ii) Dehejia Committee, 1969

(iii) Tandon Committee Report, 1975

(iv) Chore Committee Report, 1979

(v) Marathe Committee 1,1992, and

(vi) Nayak Committee

Credit Authorisation Scheme, 1965

The Credit Authorisation Scheme (CAS) was introduced by the Reserve Bank of India inNovember 1965 as a measure to regulate bank credit in accordance with plan prioritiesi.e., purpose-oriented. Under this Scheme, the scheduled commercial banks are requiredto obtain Reserve Bank’s prior authorisation before granting fresh credit limits(including commercial bill discounts and term loans) of Rs. 1 crore or more to any singleparty or any limit that would take the total limits enjoyed by such party from thebanking system as a whole to Rs. 1 crore or more on secured or unsecured basis. If theexisting credit limits exceed Rs. 1 crore, such prior authorisation is also required forgrant of any further credit facilities.

New Procedures for Quicker Release of Funds under CAS, based onMarathe Committee 1982

The Reserve Bank of India (RBI) had issued guidelines under which banks can releasefunds to their borrowers up to 50 per cent of the additional limits under the modified

Credit Authorisation Scheme (CAS) which come into force from April 1, 1984 withoutwaiting for prior authorisation from the RBI subject to the five requirements. The fiverequirements under this "Fast Track Procedure" are:

1. Reasonableness of the estimates and projections of production, sales, currentassets, etc, given by the client

2. Proper classification of current assets and liabilities3. Maintenance of minimum current ratio of 1.33:14. Prompt submission of quarterly operating statements as also annual accounts by

borrowers, and5. Regular annual review of the credit facilities by the banks

The proposals should be certified by an authorised senior officer of the bank regardingthe fulfillment of these requirements.

All proposals seeking the benefit of the Fast Track Procedure simultaneously go throughthe normal process of scrutiny by the RBI. If it is found that the credit limits sanctionedby the commercial banks are not need-based or were excessive, corrective action will betaken. In such cases the RBI may stipulate that until further notice, credit proposalsfrom these borrowers should be referred to it for its prior authorisation. With effectfrom April 1, 1984, banks may grant facilities on an ad hoc basis for a period notexceeding three months to any of CAS borrowers under exceptional circumstances up to25 per cent of the existing packing credit limit or 10 per cent of the existing workingcapital limit subject to an overall ceiling of Rs.75 lakhs against Rs.50 lakhs now.

Prior authorisation from the RBI will not be necessary for letters of credit (L.C.)facilities subject to the following conditions.

Banks should not open letters of credit for amounts out of proportion to the borrower'sgenuine needs and without ensuring that the borrowers have made adequatearrangement for retiring the bills received under the letters of credit out of their ownresources or from the existing borrowing arrangements.Tandon Committee

The Reserve Bank of India constituted in July 1974 a study group to frame guidelines forfollow-up of bank credit under the chairmanship of P.L.Tandon. The report submittedby the committee in August 1975 is popularly referred to as the Tandon CommitteeReport.

Recommendations: The recommendations of this committee are given below:

1. Norms for Inventory and Receivables: The Committee has come out with a setof norms that represent the maximum levels for holding inventory and receivables ineach of 15 major industries, covering about 50 per cent of industrial advances of banks.As norms cannot be rigid, deviations from norms can be permitted under extenuatingcircumstances such as bunched receipt of raw materials including imports, power-cuts,strikes, transport bottlenecks etc., for usually short periods. Once normalcy is restored,

the norms should become applicable. The norms should be applied to all industrialborrowers with aggregate limits from the banking system in excess of Rs. 10 lakhs andextend to smaller borrowers progressively.

2. Approach to Lending: (i) As a lender the bank should only supplement theborrower’s resources in carrying a reasonable level of current assets in relation to hisproduction requirements.

(ii) The difference between total current assets and current liabilities other than bankborrowing is termed as working capital gap. The bank should finance a part of theworking capital gap and the balance should be financed through long-term sourcescomprising equity and long-term borrowings.

(iii) Three alternative methods have been suggested for calculating the maximumpermissible bank borrowing. The methods will progressively reduce the maximumpermissible bank borrowing. These three methods are explained by means of anumerical example which indicates the projected financial position as at the end of thenext year.

Method 1...

Under this method, 75% of the ‘working capital gap’ may be provided by banks andthe customer should provide the balance 25% from long-term funds like ownedfunds or term-loans.

Method 2...

According to this method, the borrower should be required to provide throughlong-term resources 25% the gross current assets while the balance could beprovided by trade creditors and current liabilities as also the banks.

Method 3...

This method is similar to Method 2, but it further requires that even out of thegross current assets, the ‘core current assets’ should be determined and separatelyfunded from long-term resources. The Committee did not lay down any mode forthe determination of the ‘core current assets’ and left it to the lending banks tofind out method for such determination.

The Committee recommended that if in any borrower’s case, the limit under theparticular method in its case had been exceeded, the excess should be converted into afunded debt and liquidated within an agreed period. It was also suggested that thechange over should be gradual, viz., a borrower may first be brought into the baseprovided under Method 1, and then he should be carried towards Method 2, andthereafter to Method 3. In fact, till now, Method 3 has not been applied.

Example:

Let us try to apply these methods to a company which has the following current assetsand current liabilities position.

The current assets have been worked out on the basis of suggested norms or pastpractices, whichever is lower.

3. Reporting System regarding Bank Credit: The Committee suggested that inorder that the lending bank could follow up the position of a borrower, certainperiodical statements (in addition to the audited Balance Sheet) should be submitted bythe borrower to the lending bank, e.g.

(i) Quarterly Profit & Loss Account

(ii) Quarterly Statement of Current Assets & Current Liabilities

(iii) Quarterly Funds Flow Statement

(iv) Half-yearly Proforma Balance Sheet and Profit & Loss Account

(v) Monthly Stock Statements in a revised form

The Committee suggested that the above information system should be introducedinitially with borrowers whose limits aggregated rupees one crore and above within aperiod of 6 months, and then progressively extended to borrowers with limits of rupeesfifty lakhs and above, and then to borrowers with credit limits of rupees ten lakhs andabove. According to the committee, the banker should be guided by the borrowers’ totaloperations and not merely by the value of the current assets. The credit that should beallowed must be entirely need-based and the borrower's requirement should be plannedin advance with the assistance of the banker. A financial analysis of the borrower'soperating results along with inter-firm comparison should be carried out by the bankerso that the efficiency and performance of the borrower can be judged, and a time-boundprogramme can be laid down as corrective measure.

4. Inter-firm Studies: To facilitate inter-firm and industry-wise comparisons forassessing efficiency, it would be of advantage if companies in the same industry could begrouped under three or four categories, say, according to size of sales and the group-wise financial ratios compiled by the RBI for furnishing to banks.

5. Classification of Borrowers: For the purpose of better control, there should be asystem of borrower classification in each bank. This will facilitate easy identification ofthe borrowers whose affairs require to be watched with more than ordinary care and willalso provide a rational base for the purposes of fixing rates of interest for the respectiveborrowers.

6. Bank credit for Trade: While financing trade, banks should keep in view, amongother things, the extent of owned funds of the borrower in relation to the credit limitsgranted, the annual turnover, possible diversion to other units or uses and how much isbeing ploughed back from profit into the business. They should avoid financing of goodswhich have already been obtained on credit.

7. Norms for Capital Structure: In discussing the norms for capital structure wehave to keep in mind both the relationships long-term debt to equity and total outsideliabilities to equity. Where a company's loan-term debt / networth and outsideliabilities, networth ratios are worse than the medians, the banker should try topersuade the borrower to strengthen his equity base as early as possible.

8. The committee favoured the retention of the basic elements of the existing systembecause

(i) it provides more flexibility to borrowers,

(ii) it is cheaper to borrowers, and

(iii) it leaves abundant discretion and judgment to the bankers operate in a realisticmanner given daily developments. Central to existing system is the cash creditarrangements with its three elements of annual credit limits, drawing accounts anddrawing power based on security stipulations.

9. The Committee also suggested that within the overall eligibility, a part of theborrower’s requirements should be met by the banker by way of a bills limit apart fromthe loan or other cash credit arrangements. This, however, should be only a sort ofinterim arrangement. In most cases, the bankers apply Method 1 advocated by theCommittee for determining the maximum limit of borrowings to be allowed to aborrower. In some cases only, Method 2 is applied, while Method 3 has not yet beenapplied in any case. The Committee’s Report has been subsequently modified to someextent by the Chore Committee Report of 1979.Chore Committee

The RBI constituted in April 1979 a six-member working group under the chairmanshipof K.B. Chore, Chief Officer, Department of Banking Operations and Developments, RBIto review mainly the system of cash credit and credit management policy by banks.

Recommendations

The highlights of the Chore Committee report as considered by the RBI are as follows:

1. Enhancement on borrower's contribution: The net surplus cash generation ofan established industrial unit should be utilised partly at least for reducing borrowingfor working capital purpose. In assessing the maximum permissible bank finance, banksshould adopt the second method of lending recommended by the Tandon Committee,according to which, the borrower’s contribution from owned funds and term finance tomeet the working capital requirement should be equal to at least 25 per cent of the totalcurrent assets. In cases where the borrowers may not be in a position to comply withthis requirement immediately, the excess borrowing should be segregated and treated asWorking Capital Term Loan (WCTL) which could be made repayable in half-yearlyinstallments within a definite period which should not exceed five years in any case. TheWCTL should carry a rate of interest which should, in no case, be less than the ratesanctioned for the relative cash credit limit and banks may in their discretion, with aview to encouraging an early liquidation of the WCTL, charge a higher rate of interest,not exceeding the ceiling. Provisions should be made for charging of penal rate ofinterest in the event of any default in the timely repayment of WCTL.

2. Lending System: The existing system of three types of lending (cash credit, loansand bills) should continue but wherever possible the use of cash credit should besupplemented by loans and bills. However, there should be scrutiny of the operations of

the Cash Credit Accounts by at least reviewing large working capital limits once in ayear. The discipline relating to the

submission of quarterly statements to be obtained from the borrowers under theinformation system is also-to be strictly enforced in respect of all borrowers havingworking capital limits of Rs.50 lakhs and over from the banking system.

3. Bifurcation of Cash Credit: The RBFs earlier instructions to banks to bifurcatethe cash credit accounts (as recommended by the Tandon Committee) in demand loanfor corporation and fluctuating cash credit component and to maintain a differentialinterest rate between these two components are withdrawn. In cases where the cashcredit accounts have already been bifurcated, steps should be taken to abolish thedifferential interest rates with immediate effect.

4. Separate limits for peak level and normal non-peak level period: Banksshould appraise and fix separate limits for the 'normal non-peak level' as also for the'peak level' credit requirements for all borrowers in excess of Rs. 10 lakhs indicating therelevant periods.

5. Drawals of fund to be regulated through Quarterly Statement: Within thesanctioned limits for peak and non-peak periods, the borrower should indicate inadvance his need for funds during the quarter. Excess of under-utilisation against thisoperative limit beyond tolerance of 10 per cent should be deemed to be an irregularityand appropriate corrective action should be taken.

6. Ad hoc or temporary limits: Borrowers should be discouraged from frequentlyseeking ad hoc or temporary limits in excess of sanctioned limits to meet unforeseencontingencies. Additional interest of 1 per cent per annum should normally be chargedfor such limits.

7. Encouragement for bill finance: Advances against book debts should beconverted to bills wherever possible and at least 50 per cent of the cash credit limitutilised for financing purchase of raw material inventory should also be changed to thisbill system. The RBI tentatively accepted a few major recommendations of ChoreCommittee on cash credit system for reshaping and reforming the existing system andasked the commercial banks to submit their opinion on the feasibility of implementingthe recommendations and their possible future impact. The Chore Committee'srecommendations will pre-empt all internal accruals towards augmenting workingcapital, leaving nothing for modernisation and expansion.

Commercial Papers: Commercial Papers (CPs) are short-term use promissory noteswith a fixed maturity period, issued mostly by the leading, reputed, well-established,large corporations who have a very high credit rating. It can be issued by bodycorporates whether financial companies or non-financial companies. Hence, it is alsoreferred to as Corporate Paper.

Features of a Commercial Paper

(i) They are unsecured and backed only by the credit standing of the issuing company.

(ii) They are negotiable by endorsement and delivery like pro-notes and hence are highlyflexible instruments.

(iii) Since Commercial Papers are issued by companies with good credit-rating, they areregarded as safe and liquid instruments. In India, as per the RBI guidelines, any privateor public sector company can issue Commercial Papers provided,

(a) its minimum tangible net worth (paid up share capital plus reserves andsurplus) is equal to Rs.4 crores and it has a minimum current ratio of 1.33:1 as perthe latest audited balance sheet;

(b) it enjoys a working capital limit of Rs. 4 crores or more;

(c) it is listed on one or more of the stock exchanges; and

(d) it obtains every 6 months an excellent credit rating (Pi or AI) from a ratingagency approved by RBI like CRISIL, ICRA, CARE, etc.

(iv) Commercial Papers are normally issued at a discount and are in largedenominations.

(v) Issues of Commercial Papers may be made through banks, merchant banks, dealers,brokers, open market, or through direct placement through lenders or investors.

(vi) Commercial Papers normally have a buy-back facility; the issuers or dealers can buyback Commercial Papers if needed.

(vii) The maturity period of Commercial Papers may vary from 3 to 6 months.

(viii) The minimum denomination of a Commercial Paper is to be Rs.5 lakhs and themaximum amount of Commercial Paper finance that a company can raise is limited to20% f the maximum permissible bank finance.

(ix) No prior approval of RBI is needed to make Commercial Paper issues andunderwriting of the issue is not mandatory.

(x) The minimum size of a commercial paper issue is Rs. 25 lakhs.

Commercial Papers are mostly used to finance current transactions of a company and tomeet its seasonal needs for funds. They are rarely used to finance the fixed assets or thepermanent portion of working capital. The rise and popularity of Commercial Papers inother countries like USA, UK, France, Canada and Australia, has been a matter ofspontaneous response by the large companies to the limitations and difficulties theyexperienced in obtaining fundsfrom banks.

Commercial Papers in India

The introduction of Commercial Papers in India is a result of the suggestions of theWorking Group (known as Vaghul Committee) on Money Market in 1987. Subsequently,in 1989, the RBI announced its decision to introduce a scheme by which certaincategories of borrowers could issue Commercial Papers in the Indian Money Market.This was followed by RBI Guidelines on issue of Commercial Papers in January 1990,further revised in April 1991. These guidelines apply to all Non-Banking Finance andNon-Finance Companies. Some recent issues of Commercial Papers by IndianCompanies and their CRISIL Ratings are shown below:

Note :

P1: Highest Safety - This rating indicates that the degree of safety regarding timelypayment on the instrument is very strong.

CRISIL may apply '+' (plus) or '-' (minus) signs for ratings to reflect comparativestandings within categories.

Inter-Corporate Deposits: A deposit made by one company with another, normallyfor a period up to six months, is referred to as an inter-corporate deposit. Such depositsare of three types:

i. Call Deposits

In theory, a call deposit is withdrawable by the lender on giving a day’s notice. Inpractice, however, the lender has to wait for at least three days. The interest rateon such deposits may be around 14 per cent per annum.

ii. Three months Deposits

More popular in practice, these deposits are taken by borrowers to tide over ashort-term cash inadequacy that may be caused by one or more of the followingfactors: disruption in production, excessive imports of raw material, tax payment,delay in collection, dividend payment, and unplanned capital expenditure. Theinterest rate on such deposits is around 16 per cent annum.

iii. Six months Deposits

Normally, lending companies do not extend deposits beyond this time-frame. Suchdeposits, usually made with first-class borrowers, carry an interest rate of around18 per cent per annum.

Growth of Inter-Corporate Deposit Market

Traditionally, some prosperous companies in the fold of big business houses such asBirlas and Goenkas carried substantial liquid funds meant primarily to exploitinvestment opportunities in the form of corporate acquisitions and takeovers. Until suchopportunities arose, the liquid funds were deposited with other companies with anunderstanding that they would be withdrawn at short notice.

From the early seventies (more particularly from 1973), the inter-corporate depositmarket grew significantly in the wake of the following development:

(i) Substantial excise duty provisions made by the companies ever since the BombayHigh Court made a ruling that excise duty was not payable on post-manufacturingexpenses.

(ii) Curbs on working capital financing imposed by the Reserve Bank of India after thefirst oil shock of 1973.

(iii) Imposition of restrictions on acceptance of public deposits (this was perhaps causedlargely by the failure of W.G. Forge and Company Limited).

(iv) Burgeoning liquidity of scooter companies (little Bajaj, Honda etc.) and, of late, ofcar companies (like Maruti Udhyog), which have received massive booking depositsfrom their customers.

Characteristics of the Inter-Corporate Deposit Market

- Lack of Regulation: While Section 58 A of the Companies Act, 1956, specifiesborrowing limits for inter-corporate loans of a long-term nature, inter-corporatedeposits of a short-term nature are virtually exempt from any legal regulation. The lackof legal hassles and bureaucratic red tape makes an inter-corporate deposit transactionvery convenient. In a business environment otherwise characterised by a plethora ofrules and regulations, the evolution of the inter-corporate deposit market is an exampleof the ability of the corporate sector to organise itself in a reasonably orderly manner.

- Secrecy: The inter-corporate deposit market is shrouded in secrecy. Brokers regardtheir lists of borrowers and lenders as guarded secrets. Tightlipped and circumspect,they are somewhat reluctant to talk about their business. Such disclosures, theyapprehend, would result in unwelcome competition and undercutting of rates.

- Importance of Personal Contacts: Brokers and lenders argue that they are guidedby a reasonably objective analysis of the financial situation of the borrowers. However,the truth is that lending decisions in the inter-corporate deposit markets are based onpersonal contacts and market information which may lack reliability.

Public Deposits: Public deposits constitute an important source of industrial financein some of the Indian industries, particularly in sugar, cotton textiles, engineering,chemicals, and electricity concerns. Although public deposits are principally a form ofshort-term finance, but have since long been utilised to provide long and medium term

finance by cotton mills of Bombay, Ahmedabad and Sholapur and tea gardens of Bengaland Assam. The system is a legacy from the old past when the banking system had notdeveloped adequately and the money was kept for safe custody with the mahajans. InBombay and Ahmedabad the men who established the mill companies were eithermerchants or shroffs in whom the public had confidence, and hence their savings wereentrusted to them. These deposits are received from (i) the public, (ii) the shareholdersand (iii) the employees of the mills.

Popularity of Public Deposits

Hardly a day passes with a big advertisement in the news papers issued by one companyor the other inviting deposits from the public. Their major selling point is the attractiverate of interest they offer. When the banks were giving just 12 per cent, some of thesecompanies were offering even up to 15 to 24 percent. Over a period of three years thisdifference in the rate of interest can mean a lot, especially when compounded.

Merits

Given below is a brief of plus points of fixed deposits with companies:

(1) Returns: The interest has to be paid irrespective of the level of profits of acompany. It has to be paid even if a company incurs loss in a particular year. This is insharp contrast with dividend on shares, which becomes payable only if there are profitsand even then only if the directors recommend such a payment.

(2) Frequent payments: Many companies offer interest payments on half-yearly,quarterly, or even on monthly basis. One can expect frequent returns, instead of justonce or twice in a year.

(3) Regularity: If the company’s management is honest and efficient, it is quite likelythat the interest payments will be regular, and that the principal sum will be returned onthe due date.

(4) No fluctuations: The principal sum is not subject to any fluctuations unlike themarket prices of shares. One can be sure of the value of one’s investments.

(5) Preference over shareholders: In case the company goes into liquidation, thefixed deposit holder enjoys preference over the shareholders, for both the principal andthe interest as unsecured creditor of the company.

(6) Tax deduction at source: Income tax will not be deducted at source up to aninterest income of Rs. 10,000 at one time, or during one year for one deposit holder (onsums exceeding Rs. 10,000 tax is deducted at source at the rate of 10%). So far, so good.Many brokers advertise and circulate literature enumerating the merits of fixeddeposits. But all these merits are subject to a major qualification provided the companyis financially sound.

Now, turn to the other side of the story. There are many risks associated with fixeddeposits with companies:

Risks

(1) Lack of security: Fixed deposits are absolutely unsecured. If a company becomesinsolvent there is no chance that a fixed deposit holder may get anything back. It is noconsolation that the shareholders is also going to lose in such a case. The CentralGovernment or the Reserve Bank of India does not come to the rescue of the deposit-holder. The broker who might have lured the innocent investors to invest in thatcompany will not even, perhaps, acknowledge his letters of complaints. The investor cando one thing to write off the investment as bad debt.

(2) No protection: There are many tales of woe even when a company does notbecome insolvent. Several companies neither pay interest nor return the principal.Therefore, for very understandable reasons, they do not even reply to registered letters.There is no statutory authority on earth to whom one, as a small investor, can go for anyeffective remedy. The Company Law Board or the Registrar of Companies cannot, anddo not, generally, come to one's rescue.

REVIEW QUESTIONS

1. What are the different sources of financing working capital requirements?

2. Explain the merits and demerits of trade credit as a source of working capital financeto industry.

3. Critically evaluate bank credit as a main source of working capital finance toindustrial undertakings.

4. In recent years the availability of bank credit to industry has been the subject matterof regulation and control - why and how?

5. Write a critical appraisal of the recommendations of Tandon Study Group or ChoreCommittee.

6. Write brief notes on the following:

(a) Credit Authorisation Scheme

(b) Marathe Committee

(c) Commercial Paper

(d) Inter Corporate Deposits

(e) Public Deposits

SUGGESTED READINGS

1. Kulkarni, P.V. : Corporate Finance, Bombay, Himalaye PublishingHouse.

2. Srivastava, R.M. : Financial Management, Meerut, Prakati Prakashan.

- End of Chapter -

LESSON - 6

CASH MANAGEMENT

Learning Objectives


· Understand the nature of cash· Identify issues in cash management· Appreciate the motives for holding cash.· Detail the factors influencing the level of cash balance to hold.· Examine the strength and weakness of cash surplus/deficit.· Explain and evaluate the techniques of expediting collections.

Lesson Outline

· Nature of Cash· Motives for Holding Cash· Cash Planning - Cash Budget· Factors Influencing the Level of Cash Balance· Advantages of Maintaining Ample Cash· Cash Deficit/Surplus· Techniques of Expediting Cash Collections· Evaluation of Cash Management· Illustrative Examples

Cash means and includes actual cash (in hand and at bank). Cash is like blood stream inthe human body gives vitality and strength to a business enterprise. The steady andhealthy circulation of cash throughout the entire business operation is the basis of

business solvency.

Nature of Cash

Cash is the common purchasing power or medium of exchange. Cash forms the methodof collecting revenues and paying various costs and expenses of the business. As such, itforms the most important component of working capital. Not only that, it largelyupholds, under given conditions, the quantum of other ingredients of working capitalviz., inventories and debtors, that may be, needed for a given scale and type ofoperation. Approximately 1.5 to 2 per cent of the average industrial firm's assets are heldin the form of cash. However, cash balances vary widely not only among industries butalso among the firms within a given industry, depending on the individual firm’s specificconditions and on their owner's and manager's aversion to risk.

Cash as a Liquid Asset

Cash is the most liquid asset that a business owns. Liquidity refers to commonlyaccepted medium for acquiring the things, discharging the liabilities, etc. The mainpreoccupation of a businessman should be cash, which is the starting point and thefinishing point. It is the sole asset at the commencement and the termination of abusiness. It should be remembered that a want of cash is more likely to cause the demiseof a business than any single factor. Credit standing of the firm with sufficient stock ascash is the strengthened. A strong credit position of the firm helps it to secure frombanks and other sources generous amount of loans on softer terms and to procure thesupplies on easy terms.

Cash as a Sterile Asset

Cash itself is a barren or sterile asset and in nature until and unless human beings applytheir head and hand. That is cash itself can not earn any profit or interest or yieldunless; it is invested in the form of near-cash or non-cash assets.

Cash as a Working Asset

While cash is a factor contributing to the liquidity position of the enterprise, fixed assetsare real producer of earnings; on planning it would be the objective of management tomaintain in each asset group the appropriate amount of resources to easy but onefficient production and to meet the requirements of the future. Should an excess cashbalance be is covered, it would be non-working asset and should be employed elsewhereto produce some income.

Cash as a Strange Asset

A firm seeks to receive it in the shortest possible time but to hold as little as possible. Itis more efficient to maintain good credit sources than to hold extra cash or low interestbearing market instruments against unexpected use. Clearly, it is preferable, whenever

possible to hold income-earning marketable investment in lieu of cash and to use short-term borrowing to meet peak seasonal needs.

Issues in Cash Management

In a business enterprise, ultimately, a transaction results in either an outflow or aninflow of cash. Its shortage may degenerate a firm into a state of technical insolvencyand even to liquidation. Though idle cash is sterile, its retention is not without cost.Holding of cash balance has an implicit cost in the firm of opportunity cost. It variesdirectly with the quantity of cash held. The higher the amount of idle cash, the greater isthe cost of holding it in the form of loss of interest which could have been earned eitherby investing it in some interest bearing securities or by reducing the burden of interestcharges by paying off the past loans, especially in the present era of ever increasing costof borrowing. Hence, a finance manager has to adhere to the five ‘R’s of financialmanagement, viz

(i) the right quality of finance for liquidity considerations;

(ii) the right quantity whether owned or borrowed;

(iii) the right time to preserve solvency;

(iv) the right source; and

(v) the right cost of capital the organisation can afford to pay.

In order to, resolve the uncertainty about cash flow prediction, lack of synchronisationbetween cash receipts and payments, the organisation should develop some strategiesfor cash management. The organisation should evolve strategies regarding the followingareas and facets of cash management:

(i) Determining the organisation's objective of keeping cash,

(ii) Cash planning and forecasting

(iii) Determination of optimum level of cash balance holding in the company.

(iv) Controlling flow of cash by maximising the availability of cash i.e., economising cashby accelerating cash inflows or decelerating cash outflows.

(v) Financing of cash shortage and cost of running out of cash.

(vi) Investing idle or surplus cash.

Motives for Holding Cash

According to John Maynard Keynes, the famous economist, there are three motives thatboth individuals and businessmen hold cash. They are:

(i) the Transaction motive.

(ii) the Precautionary motive.

(iii) the Speculative motive.

Yet another motive which has been added as the fourth one by the modern writers onfinancial management is Compensation motive Thus, there are altogether four primarymotives for maintaining cash balances.

1. Transactions Motive: This motive requires a firm to hold cash to conduct itsbusiness in the ordinary course. The firm needs cash primarily to make payments forpurchases, wages, operating expenses, taxes, dividends, etc. The need to hold cashwould not arise, if there were perfect synchronisation between cash receipts and cashpayments, i.e. enough cash is received when the payment has to be made. But cashreceipts and payments are not perfectly synchronised. Sometimes cash receipts exceedcash payments, while at other times cash payments are more than cash receipts; hence,the firm should maintain some cash balance to make the required payments. Fortransaction purposes, a firm may invest its cash in marketable securities. Usually, thefirm will purchase the securities whose maturity corresponds with some anticipatedpayments, such as dividend, taxes etc., in future. However, the transactions motivemainly refers to holding cash to meet anticipated payments whose timing is notperfectly matched with cash receipts.

2. Precautionary Motive: According to this motive, a firm should maintain sufficientcash to act as a cushion against unexpected events. Even though, by the use of budgets,the financial needs of a firm, can be estimated, yet inaccuracies are likely to occur inpredicting the cash flows which require the attention of the management. Theseinaccuracies may be caused by (a) floods, strikes and failure of an important customer topay in time, (b) bills may be presented for settlement earlier than expected, (c)unexpected slow down in collection amounts receivables, (d) cancelation of some orderfor goods as the customer is not satisfied,(e)sharp increase in cost of raw materials. Thatis why it is necessary to maintain higher cash balances. The size of the cash balance to bemaintained also depends upon the ability of the firm to borrow funds at short notice. Ifthe firm has the ability to borrow funds at short notice, it is not necessary to maintainhigher cash balances. If the management is not prepared to take the risk theprecautionary balances will be larger than it would be if the management is prepared totake the risk. To compensate the loss of return on these balances, the firm will invest alarge part of the balances in short-term (marketable) securities, so that they can beconverted into cash immediately. The amount of income that a firm is willing to foregoby holding precautionary balances will be criterion for the upper limit for investment incash.

3. Speculative Motive: It refers to the desire, of a firm to take advantage ofopportunities which present themselves at unexpected moments and which are typicallyoutside the normal course of business. While the precautionary motive is defensive innature, in that firm must make provisions to tide over unexpected contingencies, thespeculative motive represents a positive and aggressive approach. Firms aim to exploitprofitable opportunities and keep cash in reserve to do so.

4. Compensation Motive: Yet another motive to hold cash balance is to compensatebanks for providing certain services and loans. Banks provide a variety of services bankscharge a commission or fee, for others they seek indirect compensation. Usually clientsare required to maintain a minimum balance of cash at the bank. Since this balancecannot be utilised by the firms for transaction purposes, the banks themselves can usethe amount to earn a return. To be compensated for their services indirectly in thisform, they require the clients to always keep a bank balance sufficient to earn a returnequal to the cost of services. Such balances are compensating balances. Compensatingbalances are also required by some loan agreements between a bank and its customers.During periods when the supply of credit is restricted and interest rates are rising, banksrequire a borrower to maintain a minimum balance in his account as a conditionprecedent to the grant of loan. This is presumably to ‘compensate’ the bank for a rise inthe interest rate during the period when the loan will be pending.

Cash Planning

Cash Planning involves the formulation of cash policies resulting from normal andabnormal requirements. Normal cash requirements are those which are predictable andoccur as a result of routine operations and include cash of such items as raw materials,supplies, interest, wages and salaries, replacement of fixed assets which are worn-outthrough use, dividends, and taxes. Abnormal requirements, which cannot be anticipatedin the routine of the business process, include cash for fixed assets which are replacedfor reasons other than normal depreciation, purchases resulting from price declines, andinterruption of cash flow which reduce cash receipts without a corresponding reductionin cash disbursement. The main purpose of cash planning is low synchronise cashreceipts with cash outgo. In most firms perfect synchronisation is difficult to achievemainly because the inflow and outflow are affected by several factors.

Tools of Cash Planning

(i) Net Cash Forecast through Projected Cash flow Statements which give theestimated receipts and disbursements on a month by month basis.

(ii) Cash Budget as a tool of cash planning and control.

(iii) Statement of Working Capital Forecast

(iv) Cash Ratios like Acid Test Ratio, Turnover of cash etc.

(v) Cash Reports: A cash report showing the monthly position can supplement thecash budget in the task of controlling the cash. The management must try to maintain abalance between cash receipts and payments and cash reporting helps very much in thisdirection.


(vi) Proforma Statements: In addition to the above tools, Cash Planning requirestwo additional statements viz.,(a) Proforma Balance Sheet and (b) Proforma Profit andLoss Statement. The proforma balance sheet establishes a connection between planningfor the use of assets. The proforma profit and loss statement reveals the managementplanning regarding sales (revenue), expenses and net profit.

Cash Budget as a Tool of Cash Planning and Control: The cash budget may beused either as a simple forecasting device or as a means of aggressive strategy orplanning. When used as a forecasting device, operating projections are made; cashinflows and outflows are matched, deficiencies are provided for and surplus fundsinvested. Aggressive planning involves estimating different levels of operations andjudging the inflows and outflows to obtain the mix that makes the greatest contributionto the profitability of the enterprise without entailing too much risk.

Cash budget is a formalised structure for estimating cash in come and cash expenditureover some period of time. The net cash position of the enterprise as it moves from onebudgeting sub-period to another, is highlighted. The cash budget includes only cashflow, non-cash items such as depreciation, loss in sale of fixed assets etc., are excluded.The period of time covered by the cash budget may be a year, six months, three monthsor some other period. The sub-periods may be a day, a week, a month or a quarter,depending upon the needs of the enterprise. If the firm’s flow of funds is dependableand it has large cash balance, a cash budget covering a period of one year divided intothree-month intervals may be appropriate. Where substantial uncertainty is associatedwith the flow of funds a quarterly cash budget broken into monthly intervals may be themost suitable. The cash budget since, it shows the size of cash balance at the end of eachsub-period as well as the amount and term of financing required, is the key to arrangingfor needed funds at the most favourable terms available. Adequate time is available to

study the needs.

Factors Influencing the Level of Cash Balance to Hold

1. Credit Position : If a firm enjoys a sound credit position, it is not necessary for it tokeep heavy cash balances. If a firm wants to purchase its inventories on trade credit, itcan keep only small cash balances. It will not be possible in such a case for a firm tosynchronise the credit it allows and the credit it avails.

2. Position of Accounts Receivable : The amount of cash required is affected by thetime factor viz the time required for converting the accounts receivable into cash. If thecredit term of the firm is longer, the turnover also will be slow. Therefore when theoutflow and the turnover could not synchronise, it becomes necessary for a firm tomaintain larger cash balance required to meet its requirements.

3. Nature of the Product/Business : Nature of the business has also great iinfluence on the cash requirements. If one business was to carry larger inventory ascompared to that of similar business, it becomes necessary for the firm to investadditional funds in inventory. Further, cash requirement is influenced by the firm’sdemand. If the firm’s demand is volatile, larger cash will be required.

4. Sales in relation to Assets : Another factor affecting the cash requirement is thevolume of sales in relation to assets. In the case of firms with larger sales, as huge sumsare invested in inventories and accounts receivable they should carry heavy cashbalances. When sales increase cash requirements do not increase in the same proportionbut there is definite increase in cash.

5. Management's Attitude : Cash requirement of a firm is influenced by the attitudeof the management also. If the management is of conservative type it will hold largercash than that which is less conservative. The demands of such a firm will be more ofliquid nature. But a firm which plans its requirements effectively is less conservative. Byplanning, a firm will be able to predict its requirements accurately.

6. Distribution Channel : Distribution channel refers to the number of middlemen inthe process of distribution of service or product. If the distribution channel is long andthe credit policy is liberal the level of cash may be higher. If goods and services are soldthrough departmental stores or chain stores the cash holdings will differ substantially.

7. Size and Area of Operation : Area of operation refers to the geographical area inw hich the organisation is working. If the organisation working on large scale it ispossible that organisation must have to keep higher cash level.

8. Duration of Production Cycle : It refers to the time period taken by the rawmaterial to become finished product. In case of long production cycle the level of cashholding is likely to be high and vice-versa.

Advantages of Maintaining Ample Cash

(1) A shield for Technical Inefficiency: The provision of ample cash funds canprove to be a shield for technical inefficiency of a management.

(2) Maintenance of Goodwill: The goodwill and reputation of a business firmdepends to a large extent on this fact that the firm retires all the obligations and meetsthe payments as and when they mature. It can be possible only when the firm maintainsa good cash balance ascertained carefully for normal operations and adjustment forabnormal contingencies.

(3) Cash Discounts can be Availed: If a firm has sufficient cash, it can avail cashdiscounts offered by the suppliers. It will lower down the raw material cost and finallythe cost of production.

(4) Good Bank Relations: Commercial banks like to maintain good relations withsuch firms having high liquidity in funds. Large companies maintaining large liquidbalances of cash in excess of their immediate needs, need to borrow very little if at all,on current account.

(5) Exploitation of Business Opportunities: Firms having good cash position canexploit the business opportunities very well. They can take risk of entering into newventures.

(6) Encourage to new Investments: Firm having good cash position can maintain asound (cash) dividend policy. It encourages the new investment in the shares of suchfirm because shareholders like cash dividend more.

(7) Increase in Efficiency: Unless there is an adequate supply of cash to bridge thegap a stringency develops. Operations are slowed, if not paralysed. Creditors press fortheir payments. If payments can not be made in time, bankruptcy and failure follow.

(8) Overcoming Abnormal Situations: Such firms can overcome abnormalfinancial conditions also with cash and without causing loss to the interest of existingshareholders.

(9) Other Advantages: Cash is often the primary factor deciding the course ofbusiness destiny. The decision to expand the business, the decision to add any newproduct in the product line of the company, etc., are decided by the cash position of thefirm.

Utilisation of Cash Surplus

A cash surplus is obviously a more acceptable proposition for a firm than a cash deficit.However, a cash surplus is idle cash and, therefore, unproductive. This surplus may bedeployed for the greater benefit of the firm. If it is available permanently, it may beutilised for the purchase of additional equipment, for expansion, for the introduction of

a new product, etc. However, it should not be recklessly squandered on hare brainedloss-making schemes simply because it happens to be available.

Cash surplus should be utilised in the following ways:

(i) If it is available permanently, it should be deployed profitably in the business by aplanned phase of re-equipments, expansion, etc.

(ii) If it is available for a short period, it may be invested in several short-terminvestments like Certificates of Deposit, Commercial Papers, Money Market MutualFunds etc. However, short-term cash surpluses should not be used in speculativeinvestments.

(iii) Short-term surplus may be used to qualify for the benefit of discounts fromsuppliers by prompt payment or by negotiating concessional prices with the suppliers.

(iv) If the cash surplus is permanent, it may be utilised

(a) for the repayment of capital borrowed at exorbitant rates of interest;

(b) for the extension of loans to subsidiaries;

(c) for the investment of funds through mergers and acquisitions;

(d) for new plant facilities in order earn a higher rate of return;

(e) for the purchase of own securities to be used in acquisitions, stock option plansor other payments;

(f) for the investment in the development of a products or the improvement of theold ones, etc.

It is not always desirable for a company or group of companies to build up a reserve orsurplus cash funds in order to make a more effective use of money. The group mayalready have borrowed; it is therefore, far better and more cost effective to reduce suchborrowings than to place surplus cash funds in the money market.


Avoiding Cash Deficit or Cash Insolvency

Cash deficit, as stated earlier, presents a more difficult problem. A firm may reduce itscash deficit by a closer internal control rather than by resorting to external financing. Acash deficit may be dealt with in the following ways:

(i) The collections from customers and sundry debtors should be accelerated.

(ii) Liquidating marketable securities held by the firm.

(iii) Accounts receivable should be discounted with a bank.

(iv) Factoring the receivables.

(v) Redundant assets should be sold out.

(vi) Payments to suppliers may be deferred to the extent possible. The firm may alsotake advantage of liberal trade credit terms.

(vii) Expenditure on wages, salaries, etc., should be brought under control bymaintaining the activity at a constant level instead of encouraging cyclical fluctuations.The payment of corporate taxes cannot be avoided. However, a firm may pay on the lastday of payment so that early payment and late payment can both be avoided.

(viii) Capital investment decisions should be avoided or delayed in order that a firm maybe freed for the time being from commitment of funds.

(ix) Interest obligations are contractual. To avoid their payment, therefore, amounts tobe default. A firm, however, should ensure that the period of interest payment does notcoincide with the payment of inventory or other working capital items.

(x) Dividend payments may not be made in cash. It would be worthwhile to takestockholders into confidence to explain clearly the exigency of cash deficit. Non-payment of dividend might otherwise shatter their confidence.

(xi) The bank balance should be maintained in such a manner that cash deficitsituations do not get out of hand.

(xii) Utilising bank credit.

The ultimate hazard of running out of cash, however, and the one which lurks in thebackground of every debt decision, is the situation in which cash is so reduced - thatlegal contracts are defaulted, bankruptcy occurs and normal operations cease. Since no

private enterprise has a guaranteed cash inflow, there must always be some risk.However, this event may occur rarely. Consequently, any addition to mandatory cashoutflows resulting from new debt or any other act or event must increase that risk.

Costs of Being Short of Cash or 'Short Costs'

The 'Costs' of being short of cash come in the form of not being able to take advantage ofdiscounts, and short-lasting special buying opportunities, and that of cost associatedwith credit impairment are called ‘short costs’. Detailed explanation of these costs isgiven below:

1. Loss of Discount : Discounts for paying cash promptly are usually very generousand the effective return on capital employed is often well above that earned on any otherasset. To take advantage of discount, cash is required to be paid in very short period oftime. For instance, a concern purchases goods worth Rs. 10,000 on terms Rs.10,000/2/10, net 30 days. It means if the payment is made within ten days the firm willbe entitled for 2% cash rebate; otherwise the payment is to be made within 30 days infull. If the concern wants to use Rs.9,800 for 20 days at a cost of Rs.200 and then itsactual cost works to 2.04%. Further, taking the discount would mean a lower acquisitionprice for inventories. Thus, the impact of not being able to take advantage of a cashdiscount is therefore quite significant.

The quantity discount would require a higher purchase order. As a result, the highercarrying costs might outweigh the advantage of quantity discount. But this may not betrue in all cases.

2. Cost associated with credit impairment

(i) No credit given all dealings for cash; alternatively, the credit terms could be madeless generous;

(ii) Creditors could mark-up their prices up in order to compensate for poor payments;

(iii) Suppliers may refuse to deal at all;

(iv) Suppliers may give slow or unreliable delivery times, if there is an excess of demandfor supplies, then the poor paying firm may find that it is the last on the list of prioritycustomers;

(v) Short-term and long-term financing will not be easily obtainable reasonable terms;

(vi) Banks may charge

(a) higher (bank) charges on loans, overdrafts and cash credits

(b) penalty rates to meet a short fall in compensating balances

(vii) The attendant decline in sales and profits;

(viii) In some cases the shortage of cash may lead to creditors to petition for a windingup of the firm. This has very adverse publicity effects.

The quantification of credit impairment is difficult and will probably have to besubjectively estimated. Apart from the loss of creditors' confidence, a strained liquidityposition also places pressures on individual mangers. The amount of time spent bysenior executives to satisfy creditors when the cash balances are low is likely to be verycostly.

3. Transaction Costs : These costs are associated with raising cash to tide over theshortage of cash. This is usually the brokerage incurred in relation to the sale of someshort-term near-cash assets such as marketable securities. These represent the fixedcosts associated with the transaction. They consist of both explicit and implicit costs.

4. Borrowing Costs : Interest on loan, commitment charges, and other expensesrelating to the loan raised to cover the cash deficit are called borrowing costs. Theborrowing or financing costs are closely associated with the opportunity cost.

Techniques of Expediting Collections

Several techniques are employed to reduce the span between the time a customer makespayment and the time such funds are available for use by a firm. The following are thetechniques designed to accelerate the collection of accounts receivables:

(i) Concentration Banking

(ii) Lock-Box System

(iii) Playing on the float

(i) Concentration Banking: In this system, large firms which have a large number ofbranches at different places, selects some of these which are strategically located ascollection centres for receiving payment from customers. Instead of all the paymentsbeing collected at the head office of the firm, the cheques from a certain geographicalarea are collected at a specified local collection centre. Under this arrangement, thecustomers are required to send their payments (cheques) to the collection centrecovering the area in which they live and these are deposited in a local bank account ofthe concerned collection centre, after meeting local expenses, if any. Funds beyond apredetermined minimum balance are automatically transferred daily by wire transfer ortelex, to a central or concentration banks account. A Concentration bank is theCompany’s head office bank i.e., one with which the firm has a major account usually adisbursement account. Hence this arrangement is referred to as Concentration Banking.On the basis of their daily report of collected funds, the finance manager can use themaccording to need.

However, the Company will have to incur additional cost to man these collectioncentres. Compensating balances to cover the cost of service are usually maintained withthe local or regional banks. An in-depth cost-benefit analysis of each region, where thecollection centre is to be set up, should be undertaken by the company. Normally, theestablishment of collection centres depends upon the volume of business in the area.

Concentration Banking, as a system of decentralised billing and multiple collectionpoints, is a useful technique to expedite the collection of accounts receivable...

- First of all it reduces the time needed in the collection process by reducing the mailingtime. Since the collection centres are near the customers, the time involved in thesending the bill to the customer is reduced. Thus, mailing time is saved both in respectof sending the bill to the customers as well as in the receipt of payment.

- Secondly, the decentralised system hastens the collection of cheques because most ofthe cheques deposited in the company ;s regional bank are drawn on banks located inthat area. Thus, a company can reduce the time a cheque takes to collect.

- Lastly, concentration banking permits the company to ‘store’ its cash more efficiently.This is so mainly because by pooling funds for disbursement in a single account, theaggregate requirement for cash balances were maintained at each branch office.

(ii) Lock-Box System: Under this arrangement firms hire a post office box called the'lock box' at important collection centres. The customers are required to remit paymentsto the lock box. The local banks of the firm, at the respective places, are authorised toopen the box and pick up the remittances (cheques) received from the customers.Usually, the authorised banks pick up the cheques several times a day and deposit themin the firm's accounts. After crediting the account of the firm, the banks send a depositslip along with list of payments and other enclosures, if any, to the firm by way of proofand record of collection. Thereafter, depending upon the arrangements made with eachregional lock-box bank, funds in excess of balances maintained to cover costs aretransferred automatically to company head quarters.

Concentration Banking vs. Lock-Box System

The lock-box system is like concentration banking in that the collection is decentralisedand is done at branch level. But the main difference between them is that underconcentration banking the customer sends the cheque to the collection centres or localbranches while he sends them to a post office box under the lock-box system. In case ofconcentration banking, cheques are received by a collection centre and after processing,they are deposited in the bank.

The lock-box arrangement is an improvement over the concentration banking systemsince the former eliminates the processing time the receipt and deposit of chequeswithin the firm. This system, reduces the exposure to credit losses by expediting thetime at which data can come to know of dishonoured cheques and weak credit situationssooner. The lock-box bank performs the clerical task of handling the remittances prior

to deposits, services which the bank may be able to perform at a lower cost andconsequently the overhead expenses are lowered. Further, it facilitates control bydivorcing remittances from the accounting department. However, the basic limitation ofthe lock-box system lies in additional cost which the company’s bank will charge in lieuof additional services rendered. Since the cost for these services is directly in proportionto the number of cheques handled by the bank, obviously the lock box arrangement willprove useful and economical too when average remittance is large.

Concentration banking is the most popular technique employed by business firms inIndia to intensify cash inflows. Over three fifth of the firms rely on this technique. Thereis, however, customers’ resistance to lock-box system and they insist on sending chequesdirectly to company head quarters, in spite of company’s insistence that remittanceshould be forwarded to the regional lock-box. The customer have been traditionally usedto 7-10 days float (previously involved in making a remittance)and often draw and mailcheques against funds that would not be in their bank accounts for one week. The use ofthe lock-box system meant that they had to have bank balances to cover suchremittances in the bank, not later than one day after the cheque had been mailed.

(iii) Playing on the Float: The term 'float' refers to the amount of money tied up incheques that have been written and issued, but have yet to be collected and encashed.Alternatively, float represents the difference between the bank balance and book balanceof cash of a firm. The difference between the balance as shown by the firm’s record andthe actual bank balance is due to transit and processing delays. If the financial manageraccurately estimates when the cheques issued will be deposited and collected, he caninvest the “float” during the float period to earn a return. Float used in this sense iscalled 'cheque kitting'.

There are three ways of doing it:

(a) paying from a distant bank,

(b) scientific cheque encashing involving the time-lag in the issue of cheques and theirencashment, and

(c) the issue of bank draft.

If a firm’s own collection and clearing process is more efficient than that of therecipients of its cheques and this is generally true of larger, more efficient firms then thefirm should show a negative balance on its own records and a positive balance on thebooks of its bank. Obviously, the firm must be able to forecast its positive and negativeclearing accurately in order to make use of float.

Cash Management Models

Baumol Patinkin, Archer, Miller and Orr, and Orgler have developed some interestingmodels for cash management and to determine the minimum level of cash balances tobe held by a business firm.

Baumol's mathematical model is based on the combination of inventory theory withmonetary theory. In his model, cash is taken as an inventory item which flows out at aconstant rate and is replenished instantaneously by borrowing or by selling securities. Itis assumed that the size and timing of cash inflows are fully controllable to which a fixedcost per order(cost of converting the securities into cash) and a variable carrying costper rupee (in the form of opportunity cost of holding cash i.e., the return on marketablesecurities) are attached. Since the cash outflows are known the only cash managementdecision is to decide about the volume of cash and the frequently at which cash is to beprocured. Baumol has concluded that generally some cash should be kept even in a stateof no change and that the transaction demand for cash will vary approximately in aproportion with the money value of transactions with the object of minimising total cost.However, since the model is subject to unreal assumptions, it does not provide anapplicable tool for cash management.

Patinkin's model attempts to determine the optimum level of cash balance at thebeginning of each period with the object of minimising the probability of cash shortageduring the period.

This model also assumes that...

(i) net cash flows in each period are equal to zero;

(ii) cash flows cannot be controlled by a financial executive; and

(iii) all transactions between cash and other assets take place at the beginning of eachperiod.

Though this model takes into account both the cash inflows and outflows and is, unlikeBaumol’s model, deterministic in nature, the above assumptions limit the practicalapplication of the model.

Mehta observes that as an approach to cash management, the Economic OrderQuantity (EOQ) model is less than satisfactory. The assumptions about cash flows createproblems. Unlike the physical stock, the cash inflows, will be interspersed withpayments and at times receipts may exceed cash outflows. In fact, the cash balance canmove in either direction, whereas in the usual inventory model ‘demand' during anyperiod is assumed to be non-negative.

Archer's simple probabilistic model aims at determining optimum level of cash andmarketable securities together to be held by a business firm. About this model, it hasbeen commented that the model is largely based on a financial officer’s subjectivedecision.

Merlon H.Miller and Daniel Orr developed somewhat different probability model.In this model, unlike Baumol’s model, cash flows are assumed to fluctuate in acompletely stochastic manner. Transactions can increase as well as decrease cashbalance. Their main assumption about the model is that only two forms of assets exist:

cash and marketable securities. As regards the optimum level of cash balance, Millerand Orr suggest that there is not only one specific minimum level of ideal cash balancebut a range of ideal cash balances. Within this range cash balance be allowed to moveupwards as well as downwards and no action is needed. But when the balance reachesthe upper limit of the range, it is to be reduced to a predetermined level by purchasingmarketable securities and when the cash balance reaches the lower limit, it is to bereplenished by the sale of marketable securities. Orgler’s extensive linear programmingmodel deals with cash management of the firm as a whole. The objective functionincludes payments, short-term financing, and security transaction. The function ismaximised subject to managerial and institutional constraints including minimum cashbalance requirements. This model also points towards the value of operations researchtechniques in cash management.

Evaluation of Cash Management

In evaluating cash management, the finance manager has to

(i) check all receipts and payments against the projections.

(ii) compare the actual performance against predetermined plans and objectives.

(iii) find out discrepancy, if any, analysing these variations in order to pinpoint theunderlying causes, and finally

(iv) take remedial steps to correct the anomaly so that the performance conforms to theplans and goals of the economy. This means that there should be continuous budgetevaluation of the cash position so as to make continuous control through policydecisions.

The following ratios have been used to evaluate different aspects of cash managementperformance.

1. To test the adequacy of cash:

(a) Liquid ratio or Quick ratio;

(b) Net Cash flows to Current Liabilities ratio;

(c) Cash in terms of number of days of current obligations.

2. To assess the effective control of cash flows:

(a) Cash to Current Assets ratio;

(b) Cash Turnover in Sales ratio;

(c) Rate of Growth in Cash; and

(d) Absolute liquid funds to Current Liabilities.

3. For productive utilisation of surplus cash:

(a) Marketable securities to current assets ratio; and

(b) Marketable securities to absolute liquid funds.

To test a firm’s liquidity and solvency, current ratio and liquid ratio are calculated.

Traditionally 2:1 for Current Ratio and 1:1 Quick Ratio are taken as satisfactorystandards for these purposes. The computation of ‘cash in terms of number of days ofcurrent obligations’ is another measure to assess the sufficiency of cash. It is notpractical to suggest any standard ratio in this regard to determine the adequacy of cash.It is influenced by the firm’s cash flows pattern, maturity schedule of its currentobligations, and its ability to procure extra funds if develops.

The average Cash to Current Assets Ratio indicates the firm’s liquidity position. Theproportion of cash to total current assets directly affects the profitability of a firm. Adownward trend in this ratio over a period indicates tighter control whereas upwardtrend reveals a slack control over cash resources. Greater cash turnover in salesindicates the effective utilisation of cash resources. If a business can turnover its cashlarger number of times, it can finance greater volume of sales with relatively lesser cashresources. This will increase the profitability of a concern. Moreover, such a businesswould not require proportionate increase in cash resources with the increase in salesvolume. The proportion of marketable securities in current assets indicates the firm’sprudence to invest temporary surplus in such short term investments to augment itsoverall profitability.

Firms in India do not normally purchase marketable securities for the purpose ofinvesting idle cash for short durations for two reasons:

(i) Most of the firms consider it to be a speculative activity not meant for manufacturersand

(ii) Investment in securities has same element of risk on account of fluctuations in theirprices.

Illustration 1

The following information is available in respect of a firm:

(a) On an average accounts receivable are collected after 80 days; inventories have anaverage of 100 days and accounts payable are paid approximately 60 days after theyarise.

(b) The firm spends a total of Rs. 1,81,20,000 annually at a constant rate.

(c) It can earn 8% on investments.

Calculate:

(i) The firm’s cash cycle and cash turnover assuming 360 days in a year.

(ii) Minimum amounts of cash to be maintained to meet payments as they become due.

(iii) Savings by reducing the average age of inventories to 90 days.

Solution

(i)

Cash cycle = 80 + 100 - 60 = 120 days

Cash Turnover = 360 (assuming days in a year) divided by 120 days = 3 times

(ii)

Minimum operating cash = Annual expenses / Cash Turnover = Rs. 1,81,20,000 / 3 =Rs. 60,40,000

(iii)

New cash cycle = 80 + 90 - 60 (or old cash cycle of 120 days minus 10 days) = 110 days

New Cash Turnover = 360 / 110 = 3.2727 times

New Minimum operating cash = Rs.1,81,20,000 / 3.2727 = Rs. 55,36,713

Reduction in investments = Rs. 60,40,000 - Rs. 55,36,713 = Rs. 5,03,287

Savings = 8% of Rs. 5,03,287 = Rs. 40,263.

Illustration 2

A firm uses a continuous billing system that results in an average daily receipt ofRs.40,00,000. It is contemplating the institution of Concentration Banking, instead ofthe current system of centralised billing and collection. It is estimated that such asystem would reduce the collection period of accounts receivables by 2 days.Concentration banking would cost Rs. 75,000 annually and 8% can be earned by thefirm on its investments. It is also found that a Lock-Box system could reduce its overallcollection time by 4 days and could cost annually Rs. 1,20,000.

(i) How much cash would be released with the Concentration Banking system?

(ii) How much money can be saved due to reduction in the collection period by 2 days?Should the firm institute the concentration banking system?

(iii) How much cash would be freed by lock-box system?

(iv) How much can be saved with lock-box?

(v) Between Concentration Banking and lock-box system which is better?

Solution

(i) Cash released by the concentration banking system = Rs. 40,00,000 x 2 days = Rs.80,00,000

(ii) Savings = 8% x Rs.80,00,000 = Rs. 6,40,000. The firm should institute theconcentration banking system. It costs only Rs. 75,000 while the savings expected areRs. 6,40,000. Net savings = 6,40,000 - 75,000 = Rs. 5,65,000.

(iii) Cash released by the lock-box system = Rs. 40,00,000 x 4 days = Rs. 1,60,00,000.

(iv) Savings in lock-box system = 8% on Rs.1,60,00,000 = Rs. 12,80,000.

(v) Net savings = 12,80,000 - 1,20,000 = Rs. 11,60,000

Difference net saving = 11,60,000 - 5,65,000 = 5,95,000

Thus, the lock-box system is better. Its net savings Rs. 11,60,000 are higher than thatfrom concentration banking.

Additional savings of Rs. 5,95,000 if lock box system is introduced. Hence it is better togo for lock box system than Concentration Banking.

REVIEW QUESTIONS

1. Explain the nature of cash and state the scope and objectives of cash management.

2. Since cash does not earn, can we still call it a working asset? Why? What are theprincipal motives for holding cash? How do they relate to cash as a working asset?

3. Enumerate the factors that influence the size of cash holdings of company. Discussthe inventory approach to cash management.

4. Discuss the methods accelerating cash inflows and decelerating cash inflows of acompany.

5. Describe how a lock-box arrangement may be used to accelerate cash flow. What costsare involved with the use of a lock-box?

6. Discuss the management problems involved in planning and control of cash. Explainthe main tools of cash planning and control.

7. What is a firm’s ‘cash cycle’? How are the each cycle and cash turnover of a firmrelated? What should a firm’s objectives with respect to its cash cycle and cash turnoverbe?

8. Explain the following:

(a) Compensating balance

(b) Deposit float

(c) Lock-box system

(d) Cash forecast

(e) Cash Budget

(f) Cash ratios

(g) Cash reports

(h) Cash flow statement

(i) Payment float

(j) Cash losses

PRACTICAL PROBLEMS

1. A firm purchases raw-materials on credit of 30 days. All the sales of the firm are madeon credit basis and the credit term allowed to its customers is 60 days. However inactual practice the average age of the firm’s Accounts Payables is 35 days and that ofAccounts Receivables is -70 days. The average age of the firm’s inventory (that is thetime-lag between the purchase of raw-materials and the sale of finished goods) is 40days.

From the above data calculate

(i) The firm’s cash-cycle and

(ii) The firm’s cash turnover

2. A group of new customers with 10% risk of non-payment desires to establish businessconnections with you. This group would require one and a half month of credit and is

likely to increase your sales by Rs.60,000 p.a. Production, administrative and sellingexpenses amount to 80% of sales. You are required to pay income tax @ 50%. Should

you accept the offer if the required rate of return is 40% (after tax)?

[Ans.: Return works out to 50%. This is higher than desired rate of return of 40%, hencethe offer should be accepted]

3. A company’s present credit sales amount of Rs.50 lakhs. Its variable cost ratio is 60%of sales and fixed costs amount to Rs.10 lakhs per annum. The company proposes torelax its present credit policy of 1 month to either 2 months or 3 months, as the case maybe.

The following information is also available:

Present policy Policy1 Policy 2

Average age of debtors 1 months 2 months 3months

Increase in sales -- 20% 30%

Percentage of baddebts 1.0 2.5 5.0

If the company requires a return on investment of 20% before tax, evaluate theproposals.

[Ans.: Policy 1 is more profitable as it gives surplus of Rs.2,13,333 after meeting therequired return on investment at 20% before tax]

SUGGESTED READINGS

1. Bhabatosh Banerjee : Cash Management Calcutta, The World Press (P) Ltd.,

2. Khan, M.Y. and Jain, P.K. : Financial Management, New Delhi, Tata McGraw Hill Co.

3. Pandey, I.M : Financial Management, New Delhi, Vikas Publishing House

4. Van Home, James C. : Financial Management and Policy, New Delhi, Prentice Hall ofIndia.

- End of Chapter -

LESSON - 7

INVESTMENT MANAGEMENT

Learning Objectives


· Understand the concept of investment· Recognize the reasons for holding marketable securities· Detail the process of investment management· Explain the investment criteria· Suggest suitable basis for valuation of securities

Lesson Outline

· Portfolio of Marketable Securities· Investment Department/Adviser· Process of Investment Management· Classification of Securities· Investment Criteria· Valuation of Marketable Securities

There are basically three concepts of investment...

(i) economic investment i.e., an economist's definition of investment;

(ii) investment in a more general or extended sense, which is used by "the man on thestreet"; and

(iii) the sense in which a finance manager is very much interested, namely, financialinvestment.

Financial Investment is a form of this general or extended sense of the term. It means anexchange of financial claims like stocks, bonds, etc., collectively called securities. Theterm financial investment is often used by investors to differentiate between the pseudo-investment concept of the consumer and the real investment of the businessman.

Portfolio of Marketable Securities/Temporary Investments

There are two basic reasons for holding (temporary) investments in the corporateportfolio of marketable securities:

(i) they serve as a substitute for cash balances and

(ii) they are used as temporary investment for surplus cash-flows arising either duringseasonal operations or out of sale of long term securities.

Some firms hold portfolios of marketable securities in lieu of larger cash balances,liquidating part of the portfolio to increase the cash account when cash outflows exceedinflows. In such situations, the marketable securities could be a substitute fortransaction balances, precautionary balances, or speculative balances, or all three. Inmost cases, the securities are held primarily for precautionary purposes most firmsprefer to rely on bank credit to meet temporary transactions or speculative needs, but tohold some liquid assets to guard against a possible shortage of bank credit. Thus suchtemporary investments occur for one of three reasons: (a) seasonal or cyclicaloperations, (b) to meet known financial requirements, and (c) immediately following thesale of term-securities.

The cash forecast may indicate whether excess cash available is temporary or not. If it isfound that excess liquidity will be only temporary, then the cash could be invested forshort term. If a substantial part of idle cash is invested even though for a short period,the interest earned thereon is significant. Failure on the part of the management toinvest idle cash not only deprives the firm of a reasonable income but also be aninjustice and failure in serving the interest of the shareholders. On the other hand, if thecash forecast indicates that the excess cash is not temporary and not caused by onlyseasonal variation and the same need not be used in the business, then it should beinvested in productive assets.

Investment Department/Advisor : For effective management of securities a firmshould have investment department or investment advisor. The size of the investmentdepartment will depend upon many factors, including the size of the investmentportfolio or the type securities purchased and held in the investment portfolio. As inother operations, the degree of specialisation depends upon the magnitude of theinvestment, portfolio and the resources available. The firm having a large securityportfolio may employ a separate staff with people skilled in various phases ofinvestment programme and with funds for research and analysis. The firm with smallinvestment portfolio may not afford a separate investment organisation. The investmentfunction in such firm may be performed by a single individual on a part-time basis.

Process of Investment Management : Investment management is the process bywhich money is managed. The process involves

(a) collection of information with regard to the proposed investments,

(b) analysis of that information,

(c) establishment of the investment policy that is to be followed,

(d) decision making process as to investments,

(e) appropriate back-up for administrative arrangements, and

(f) measurement of the investment performance achieved.

The first objective of an investment team is to collect as much relevant information aspossible about potential investments with regard to fixed interest securities. This tendsto be a relatively simple exercise in that the basic facts are set out in the initialprospectus. Of more immediate relevance are up-to-date market prices, current yields,and supply and demand reports. Economics play a major part in investment decisionmaking, and in particular in the area of Government Securities /Market. Consequently,Investment Managers must be aware of the latest economic developments andforecasts.

The collection of information in ‘equity’ type investments such as ordinaryshares and properties is a more difficult task, as the range of possible investments isimmense and not two are similar. Most of the larger investment management teamsemploy a number of security analysis, but even if they do, the vast majority of teams relyon the analysis work carried out by stock-brokers, with the investment manageranalysing the competing stock-brokers’ output.

The second relates to analysis of the information which has been collected.Generally speaking the investment analyst's duty is to assimilate the information and toproduce recommendations for consideration. Obviously there is a reliance on theinformation supplied by stockbrokers and statistical services, and in addition there isthe analyst's own output.

The establishment of the correct investment policy for a fund is perhaps the mostimportant aspect of investment management. The investment policy to be followed mustbe laid down by the proprietors of the fund, but quite often the investment manager bythe nature of his training is well placed to assist in the formation of such policy. In factthe quality of an investment management team can often be judged by their grasp of thefundamentals in this area. The point here is that the objectives of investors vary, anddifferent investors require different investments with different attributes.

The investment policy of a fund must be such that the liabilities of the fund must be metas they arise. Furthermore, they must be met at the minimum cost. In order to achievethis, investment managers must maximise the return on the investments, but the riskfactor must not be exceeded. Thus the investment policy must recognise the risk factorand establish the appropriate level of risk to be accorded to the fund.

Having collected the information, analysed it and produced recommendations,established policy and risk levels, one arrives at the decision making process. While thisis clearly seen to be the point on which the fate of the fund will depend, it will beappreciated that, if the earlier foundation parts of the investments management processare carried out correctly, the actual decision on buying and selling is relatively easyto make. Consider the process under which, for example, investment policy hasindicated that the fund needs more ordinary shares to meet its long-term liabilities, that

an analysis of the portfolio reveals that no oil shares are held, that this is considered toohigh risk from a lack of industrial diversification point of view, and that the analyst isrecommending an investment in Bharat Petroleum. Under such circumstances, themanagement decision is straightforward.

One then comes to the administrative arrangement - contract notes, valuations,meetings, dividend collection, tax reclamation, safe-keeping of securities and nomineecompany services. Generally speaking, these arrangements present little difficulty to theinvestment manager, who is probably backed up by sophisticated computerprogrammes to handle the investment function. Clients will usually find that thesearrangements can be tailored to his individual needs.

In one sense the measurement of investment performance is the last stage of theinvestment management process. An investor who pays someone to manage a portfolioin the hope of achieving superior performance has every right to insist on knowing whatsort of performance is actually achieved. Such performance can be used to alter theconstraints placed on the manger, the objective stated for the account or the amount ofmoney allocated to the manager. Perhaps more important by measuring performance aclient can forcefully communicate his interests to an investment manager and perhapsinfluence the way in which the portfolio is managed.

Classification of Securities : Securities which are included in the official list of aStock Exchange forth purpose of trading, are known as Listed Securities. The ListedSecurities may be

(i) Public debts,

(ii) Semi Government Securities,

(iii) Securities of Public utility companies, and

(iv) Industrial securities.

Public debts are those securities which an issued by the Governments (both theCentral as well as the States) under various loan programmes e.g. Savings Bonds,Defence bonds, Developments Bonds, etc. Securing issued by Semi-Government bodiessuch as Port Trust, Municipalities and Corporations are known as Semi-GovernmentSecurities. Public debt securities and Semi-Government securities are in general,called "gilt-edged securities". They are so called because their edges have a gold lining.Trustee securities include promissory notes, debenture stock or other securities of anyState Government or of Central Government. Trustee securities are preferred becausethey are considered safe and trustees are allowed to invest trust funds. (Section 4 of theIndian Trust Act, 1882). Securities issued by the various State Electricity Boards,tramways, gas, telephone and hydro-electric power companies are called the Securitiesof the Public Utility Companies. Industrial securities include shares, stocks,stock warrants and debentures of various manufacturing, trading, extracting andshipping companies The word "Blue chip" is used to describe ordinary shares of

progressive, soundly run public limited companies which are not likely to be seriouslyaffected by temporary trade recessions.

Listed Securities may be further classified into two categories:

(i) Cleared Securities, i.e. securities on forward list, and

(ii) Non-cleared Securities on cash list.

The following conditions should be fulfilled before securities are included in the clearedsecurities list:

(i) The securities must be fully paid up equity shares of a company, other than a bankingcompany;

(ii) They must have been admitted for dealing for at least three years on any stockexchange,

(iii) They must not be included in the cleared securities list of any other stock exchange,

(iv) The company must be of sufficient public importance and the subscribed capitalrepresented by securities must be least Rs.25 lakhs and their value at the market pricemust be at least one crore of rupees,

(v) Lastly, there must be adequate public interest in the company and at least 49 percentof the capital represented the securities must held by public and such holdings are to beevenly distributed among a large number of shareholders.

In general, securities are also classified, into (i) Primary (or direct) securities and (ii)Secondary (or indirect) securities. Primary Securities are claims against those unitswhose principal economic activity is to buy and sell productive factors and currentoutput. Secondary securities are those claims against financial institutions-whoseeconomic activity is the purchase and sale of financial assets.

Investment Criteria

A wide variety of securities, differing in terms of default risk, interest risk, liquidity risk,risk of marketability and expected rate of return, are available. The following criteria areapplied while selecting a security for investment.

(a) Safety (Default Risk): In the selection of marketable securities for investment,the most important aspect to be considered is that they should be free from default risk.There should be safety as regard principal or there should be the minimum risk ofdefault. The risk that an issuer will be unable to make interest payments, or to repay theprincipal amount on schedule, is known as default. If the issuer is the Treasury (eitherthe Central or the State), the default risk is negligible; thus treasury securities areregarded as being comparatively default-free. Generally, safety of the investment

depends upon the credit of the institution issuing it. Government (gilt-edged) securitiesare considered very safe when compared to corporate securities.

(b) Rate of Return or Profitability: The yield on the securities must be reasonableand stable. As already pointed out, the higher a security’s risk, the higher the return onthe security. Generally, securities which are of low marketability will have higher yield.The yield therefore depends upon the marketability of the securities. Thus the financemanagers, like other investors must make a trade-off between risks and return whenchoosing investments for their marketable securities portfolios.

(c) Interest Rate Risk: Securities prices vary with changes in interest rates. Further,the prices of long term bonds are much more sensitive to shifts in interest rates ratherthan prices of short term securities.

(d) Marketability or Liquidity Risk: A security that can be sold on the short noticefor close to its quoted market price is defined as being highly liquid. Marketability of asecurity relates to the ability of the owner to convert it in to cash without appreciablereduction in their price. For financial instruments marketability is judged in relation tothe ability to sell at a significant price concession. The more marketable the security, thegreater the ability to execute a large transaction near the quoted price. In general, thelower the marketability of a security, the greater the yield necessary to attract investors.Thus, the yield differential between securities of the same maturity is caused not only bydifferences in default risk but also by differences in marketability.

Considering the motives for holding securities, it is advisable to hold short termsecurities as far as possible. The question of holding long term securities arises onlywhen the securities are needed for a longer period not for the purpose of disposing themoff in the near future. Government and quasi-government securities meet the test ofmarketability as they can be disposed off in fairly big lot without reducing their price.Industrial securities except blue-chips in general are not easily marketable,consequently, when it is desired to sell particularly in cash, a large block of such sharesat a time of pressure it proves difficult to do so without considerable price reduction.

(e) Maturity: Maturity period is yet another important factor to be considered. Ingeneral, the longer the maturity, the greater the risk of fluctuation in the market value ofthe security. Consequently, investors need to be offered a risk premium to induce themto invest long-term securities. Only when interest rate are expected to fall significantlythey are willing to invest in long term securities yielding less than short andintermediate term securities.

Preference to short dated securities is due to the presence of possibility of money raterisk in the long-dated securities. Money rate risk arises from change in market priceconsequent upon interest rate fluctuations. If the market rate of interest tends to shootup and the security holders want to dispose of their investments the price of the securitywill go down because the securities carry the rate lesser than the prevailing rate ofinterest. Thus, money rate is intimately related with maturity of securities. It shouldhowever, be noted here that money rate risk arises only when securities are disposed off

before their maturity period. Therefore, it is advisable to a firm to invest its funds insecurities of difference maturity pattern. That is, the firm should stagger its investmentportfolio in such a way that a certain amount of securities mature at regular intervals. Asecurity which conforms to the above criteria is considered a good and the same to be anideal investment it must further satisfy the following requirements also.

(f) Purchasing Power Risk: Another type of risk that is to be considered ispurchasing risk that inflation will reduce the purchasing power of a given sum of money.Purchasing power risk, which is important to both firms and individual investors duringtimes of inflation, is generally regarded to be lower on assets whose returns can beexpected to rise during inflation than on assets whose returns are fixed. Thus, real estateand equity investments are thought of as being better “hedges against inflation” than aredebentures and other fixed income securities.

(g) Stability of Price: The market price of several securities is subject to heavyfluctuations and a firm should not invest its surplus funds in such securities to makespeculative gains or losses. The prices of government and quasi-government securitiesare generally stable unlike the industrial securities.

(h) Acceptable denominations (Divisibility): The (face) value of the securityshould not be too high; it should be of acceptable denomination so as to be easilymarketable even outside the stock exchange.

(i) Absence of contingent liability: A security which carries with it an onerousliability cannot be considered good.

(j) Callability: Callability also affects the yield to maturity. Because the marketablesecurities position of most firms is confined to short-term securities, is not an importantfactor. Callability risk is caused by the chance that the security may be legally called forsale.

(k) Convertibility: Convertibility risk arises out of conversion of one type of securityin to another. Exchange rates may become unfavourable, as a result of which acorporation may suffer losses in foreign exchange transactions. This is known asForward Exchange Risk.

(l) Ascertainment of Title and Value: The easy ascertainment of value of securityoffered is also an important point for consideration. The value of debentures, shares,Government Bonds, etc. can be ascertained with the help of stock brokers and stockmarket quotations.

(m) Chance of Capital Appreciation: Investor normally aims not only to get areasonable and stable return on his investment but also to the chances for capitalappreciation. Capital appreciation is possible in the case of companies getting superprofit on account of their monopoly character or favourable operating performance.

(n) Taxability: The last but not the least factor which requires the attention of theinvestor is impact of taxes. The income from the investment should enjoy tax exemptionor tax concession because market yield of securities is very much affected by tax factor.There are certain categories of securities which are exempted either partially or fullyfrom levy of income tax, wealth tax, etc. In view of the differential tax treatment yield ofdifferent securities differ. Tax exempted securities are sold in the market at lower ratethan other securities of the same maturity. Hence, tax factor should be considered whilechoosing securities for investment as secondary reserve or near-cash items.


Valuation of Marketable Securities

The marketable securities may be valued under the following three bases:

(a) Valuation at Cost: Investment in securities have traditionally been carried at cost,and no gain or loss recognised until the securities were sold. One of the basic concepts offinancial accounting is that the gains shall not be recognised until they are realised andthe usual test of realisation is the sale of asset in question. In current practice the marketvalue of marketable securities is disclosed a separate note in the balance sheet.

(b) Valuation at the Lower of Cost or Market Price: Though valuation ofsecurities at cost is generally accepted, the accounting theory also treats as acceptablethe lower of cost or market price method. The objective of this method of valuation is togive effect to market declines without recognising market increases, and the result is amore conservative valuation of investments in the balance sheet.

(c) Valuation at Market Price: An increasing number of financial accountants alsoargue that investments in marketable securities should be valued at current marketprice regardless of whether this price is above or below cost. However, it is not a currentpractice to value security investments at market value.

Disclosing the Basis of Valuation in the Balance Sheet

Because of the variety of methods possible for valuation of fixed as well as currentassets, it is necessary that the balance sheet should contain a notation as to the valuationmethod being used. It is also important that the method selected be used consistentlyfrom year to year.

REVIEW QUESTIONS

1. What are the different motives for holding marketable securities in investmentportfolio?

2. What are the functions of an Investment Department in a large undertaking?

3. State and explain the different steps involved in the process of investmentmanagement.

4. How will you measure the investment performance?

5. Briefly explain the different categories of marketable securities available forinvestment in India.

6. Explain:

(a) Default risk

(b) Liquidity risk

(c) Blue chips

(d) Trust securities

(e) Listed securities

(f) Growth Stock

SUGGESTED READINGS

1. Bhalla. V.K. : Investment Management, New Delhi, S. Chand & Co., Ltd.

2. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi,Prentice Hall of India.

3. Hampton. J.J. : Financial Decision Making, New Delhi, Prentice Hall of India.

4. Preeti Singh : Investment Management, Bombay, Himalaya PublishingHouse.

- End of Chapter -

LESSON - 8

RECEIVABLES MANAGEMENT

Learning Objectives


· Know the objectives of Credit (Receivables) Management.· Identify the decision areas in Credit Management.· Detail the relevant costs associated with Receivables Management.· Evaluate the Credit Policy, Credit Standard and Credit Terms and Collection

Policy.· Explain the concept of Credit Scoring Credit Factoring.

Lesson Outline

· Objectives of Credit Management· Decision Areas in Credit Management· Credit Control Department· Credit Policy - Credit Standard - Credit Scoring - Credit Terms· Collection Policy - Credit Insurance - Factoring of Receivables· Evaluation of Credit Management· Illustrative Examples

The whole spectrum of a business can not entirely based on cash transactions. The sale(purchase) of goods or services is an essential part of the modern competitive economicsystem. In fact credit sales and therefore, receivables are treated as marketing tool toboost the sale of goods/services. The credit sales are generally made on open accountand the expansion of the business depends on the expansion of credit available which inturn depends on credit worthiness of the firm.

Credit allowed i.e., deferred terms of payment to a purchaser (customer) helps him

(i) to produce goods by buying input materials for which spot payment is not required,

(ii) to have greater volume of sales through credit terms of payment and

(iii) to deploy productive resources more economically.

Greater volume of sales necessitate greater volume of production resulting in lower unitcost may lead to the possibility of lowering the selling price. Granting of credit involvesuse of financial resources i.e., a firm should be able to sell its goods on credit. At thesame time the seller must be in a position to pay his creditors in time for the purchase ofgoods and services.

Objectives of Credit Management

The main objective of credit management can be enumerated as follows:

(a) Increase the volume of credit sales to the optimum level in relation to the creditperiod.

(b) To determine what extent the debtors volume is to be in relation to the overallfinancial soundness of the firm.

(c) To have business volume to optimal level so that the point of overtrading andundertrading will not occur.

(d) Balancing of liquidity versus profitability in the context of trade off between creditvolume of sales and the time span for realisation from credit customers.

(e) Control over cost of investment in sundry debtors and the cost of collection.

(f) At what level the price fixation to be done taking into account the cash discount,trade discount etc.

(g) To decide the price factor and the credit factor in relation to the competitorsbusiness.

(h) To take into account the external factors such as mercantile business conventions,effect of inflation, seasonal factors, government regulations and general economiccondition.

(i) The proper lines of communication and co-ordination between finance, production,sales, marketing and credit control department.

Crucial Decision Areas in Credit Management

Trade credit management involves a study on

(i) costs associated with the extension of credit and accounts receivables,

(ii) credit policies involving credit standard, credit terms, collection policies, creditinsurance,

(iii) determination of size of receivables, and

(iv) forecasting of receivables.


Costs Associated with the extension of Credit

The major categories of costs associated with the extension of credit and accountsreceivables are (i) capital cost, (ii) administration cost, (iii) collection cost (iv)delinquency (overdue) cost and (v) default risk.

(i) Capital Cost: The increased level of accounts receivable is an investment in currentassets and it involves the tying up of capital. There is a time-lag between the sale ofgoods to and payments by, the customers. Meanwhile, the firm has to pay employeesand suppliers of raw materials thereby implying that the firm should arrange foradditional funds to meet its own obligations, while awaiting for payment from its

customers. The cost on the use of additional capital to support credit sales whichalternatively could be profitably employed elsewhere, is therefore, a part of the cost ofextending credit or receivables.

(ii) Administrative Cost: The maintenance of receivables calls for the use of anadministrative machinery in different ways. A firm may have to create and maintain acredit department with staff, accounting records, and even to conduct investigations tofind out the credit worthiness or otherwise of its customers. Administrative expenses aretherefore incurred on the maintenance of receivables.

(iii) Collection Cost: An effective maintenance of receivables depend ultimately uponthe effective collection of receivables. The cost of collection includes the expensesregarding engaging collection agencies or bill collectors, sending collection letters, costof discounting bills of exchanges, collection of bills of exchange and other bank charges.A number of collection letters and reminders usually follow, which eventually increasesthe cost of collection.

(iv) Delinquency Cost: The cost which arises out of the failure of the customers tomeet their obligations when payment on credit sales become due after the expiry of theperiod at credit is called delinquency cost. The important components of this cost are (a)blocking up of funds for an extended period, (b) cost associated with steps that have tobe initiated to collect the overdues e.g. legal charges.

(v) Default Risk i.e., bankruptcy: This refers to the cost of writing off bad debts inthe event of debtors being adjudged as insolvent.

Credit Control Department

Where the firm is a sizable one, it is desirable that a person, called Credit Manager, beplaced in-charge of Credit Control Department. The Credit Controller or Managershould try to keep the bad debts down to the minimum and he may advocate therestriction of the sales to customers who would pay quickly. However, the SalesDepartment may be inclined to increase the sales by all possible means, and may not becareful in selecting credit customers by keeping in mind the question of recoverability ofdues. These two interests conflict each other, though on the whole, both are beneficial tothe organisation. It may be theoretically proper to segregate the functions of CreditControl Department and the Sales Department or even the Accounts Department.Usually most firms keep the task of credit control in the same department as is in chargeof the Sales Ledger. This method provides an advantage of showing the limit of thecredit and the actual amount outstanding in one single record, viz., the Sales LedgerCard.

Functions of a Credit Manager

The following are the functional details of a credit manager:

(i) Maintaining credit card;

(ii) Involvement in credit decision;

(iii) Reporting credit position;

(iv) Institution of credit procedures;

(v) Involvement in customer’s complaints;

(vi) Review of credit control system and procedures:

(vii) Attending or initiating legal formalities or actions;

(viii) Decisions on bad debts/doubtful debts;

(ix) Training the credit department personnel;

(x) Liaisoning with other departments.

Administration of Credit Control

The following are the important aspects involved in administration of credit control.

(i) The sales invoice should indicate the due date of payment,

(ii) The customers ledger should be recorded with the following among others, namely,the credit period allowed and the credit in terms of value.

(iii) Customer must signify his acceptance of credit terms in writing.

(iv) Close follow-up of realisation.

(v) Month-end statement of account to be sent for customer’s confirmation.

(vi) Personal call by salesman and /or personnel from credit control department forcollection of dues.

(vii) Credit assessment and review to be made to reassess the credit worthiness of thecustomers. A fresh decision on credit terms will depend on such an exercise.

(viii) There may be the necessity that persons to be entrusted for credit control shouldhave adequate-knowledge of administering credit control.

CREDIT POLICY

The term "Credit Policy" refers to those decision variables that influence the amount oftrade credit i.e., the investment in receivables. A firm’s credit policy provides the

guidelines for determining whether to extend credit to customer (and to the customersas a whole) and how much credit to extend and to how long the credit period is to beallowed/fixed. The credit policy includes (i) credit standards, (ii) credit period, (iii)credit terms, (iv) collection policy of the firm, and (v) provision of credit insurance.

Credit Standard

The credit manager has the responsibility for administering policy. However, because ofthe pervasive importance of credit, the credit itself is established by the executivecommittee, which normally consists of the President/Director in-charge of finance,production and marketing.

The 'easy' credit policy involves

(a) extending credit to a more risky class of customers,

(b) extending the allowable payment period,

(c) raising the cash discount allowed for prompt payments, and

(d) reducing the 'pressure' of the collection procedure on overdue accounts. The newterms will be 3/15 and 45 instead of the current 2/10, net 30.

These changes are expected to increase sales, but they will also increase the losses onbad debts and the investment in accounts receivables.

The 'tough' credit policy involves

(a) tightening credit standards,

(b) reducing credit terms to 1/10, net 20 and

(c) increasing the collection of efforts on overdue accounts.

lt will result not only in lower sales but also in lower bad debt losses and a smallerinvestment in accounts receivable.

The credit standard followed by a firm has an impact on sales and receivables. The salesand receivable are likely to be high, if the credit standards of the firm are relativelyloose. In contrast, if the firm has relatively tight credit standards, the sales andreceivable levels are expected to be relatively low.

Relaxing credit standards involves two costs:

(i) additional establishment expenses i.e., enlarged credit department and the clericalexpenses involved in maintaining additional accounts and servicing the added volume ofreceivables, and

(ii) bad debt losses which increase with increased sales and a slower average collectionperiod.

If new customers are attracted by the relaxed credit standards, collecting from thesecustomers is likely to be slower than collecting from existing customers. In addition, amore liberal expansion of credit may cause certain existing customers to be lessconscientious in paying their bills on lime. Those who decide credit policy must considerthis possibility.

The extent to which credit standards can be realised should depend upon the matchingbetween the profits arising due to increased sales and costs to be incurred on theincreased sales. Determining the optimal credit standards involves equating themarginal costs of credit to the marginal profits on the increased sales. Marginal costsinclude bad debt losses, investigation and collection costs and higher costs tied-up toaccounts receivables if the customers delay payment longer than the usual period.

Since credit costs and credit quality are closely related, it is important to be able to judgethe quality of an account. A good credit manager can make reasonably accuratejudgments of the probability of default by different classes of customers. To evaluatecredit risk, credit managers consider the five C’ s of credit- Character, Capacity, Capital,Conditions and Collateral.

Character is a customer’s own desire to pay off debts. This factor is of considerableimportance, because every credit transaction implies a promise to pay. Experiencedcredit managers frequently insist that the moral factor is the most important issue in acredit evaluation.

Capacity is a subjective judgment of customer’s ability to pay debts as reflected in thecash flows of the individuals or firm. It is also gauged by their past records,supplemented by physical observation of customer’s plants or stores, and their businessmethods.

Capital refers to the financial strength of the customer, which depends primarily onthe customer’s net worth relative to outstanding debt obligations.

Conditions refer to the impact of general economic trends or to special developmentsin certain areas of the economy that may affect customers’ ability to meet theirobligations.

Collateral is any asset that customers may offer as a pledge to secure credit. Collateral,thus, serves as a cushion or shock absorber if one or several of the first four C’s areinsufficient to give reasonable assurance of repayment on maturity.

Information on these items is obtained from the firm’s previous experience withcustomers, supplemented by a well developed system of information gathering groups.The credit worthiness of a customer can be assessed by any one of the following:

(a) Past records about the business

(b) Opinions of salesmen who have acquired information by interviewing thecustomer

(c) Valuation by professionals on the customers business and assets

(d) Analysts of the financial statement of business

Credit information can be gathered by employing the following indirect methods:

Bazar Reports or Trade Reference: Reports about the credit applicant can beobtained from the various markets particularly from businessmen carrying on the sametrade.

Bank Reference or Reports from banks: Information about the customer can beobtained from different banks with which the customers deal. Most commercial banksmaintain credit department of their own to perform credit investigation for theircustomers.

Other Sources: Credit information on business firms, especially the large ones, mightbe available from credit rating agencies, trade journals, newspapers, magazines, tradedirectories, public records such as tax returns/statements, municipal records, etc.

Credit-Scoring Systems

Many firms have used sophisticated statistical techniques in conducting their creditanalysis. Multiple discriminant analysis employs a series of variables to categorisepeople or objects into two or more distinct groups. A credit-scoring system utilisesmultiple discriminant analysis to categorise potential credit customers into two groups:good credit risk and bad credit risk. An important advantage of a credit-scoringsystem is that all of the variables are considered simultaneously, rather thanindividually as in the traditional analysis of five Cs. The plastic credit cards used bymillions of citizens are the result of credit-scoring systems. In addition to widespreadusage in consumer credit, credit-scoring systems are increasingly used in commercialcredit.

Suppose that a large retail firm had historical information on 200 customers who paidpromptly and 200 customers who did not. Using data from those 400 creditapplications, multiple discriminant analysis were made to determine the particular setof credit variables that best distinguishes the prompt group from the non-prompt group.The following profiles of eight variables were identified:

Multiple discriminant analyses also determine the numerical weightings which each ofthe variables should be given in calculating a total weighted credit score for each credit

applicant. The relative weights of the right variables are shown in parentheses(brackets). The discriminant procedure also provides information to management onhow credit-score levels are related to likely payment patterns by customers. Suppose thefollowing guidelines were developed:

Notice that for credit scores between 60 and 80, the guidelines call for additional creditinvestigation.

The model of Credit-Scoring System given below shows how the credit score would becalculated for a hypothetical applicant. The middle column includes the particularvalues for the applicant. When combined with the relative weights, a total credit score of104.1 is obtained. Since this easily exceeds the critical level of 80, the customer would begranted credit without further analysis.

One advantage of credit scoring, already mentioned, is that several variables areconsidered collectively. This captures interrelationships between variables that may beoverlooked in a traditional credit analysis. Another advantage is that credit-scoringsystems can be used to routinely accept or reject credit applications for which the finaldecision is relatively clear. This frees time for credit analyst to focus in greater detail onmarginal applications. In so doing, credit scoring does not substitute for sound humanjudgment, but rather serves to direct that judgment to more difficult credit decisions. Adisadvantage of credit scoring is that expenses are incurred by the firm in developing aworkable system. Care must be taken in constructing samples of good and badcustomers. Managerial judgment is needed in selecting the best profile of creditvariables. Management must also experiment with the resulting guidelines to ensurethat the costs of wrong decisions are minimised.

Model of Credit-scoring System

Variable Mesurement Value Weight Weightedvalue

Age In years as reported 36 0.4 14.4MaritalStatus Coded 1 (yes) or 0 (no) 1 20.0 20.0

Occupation Coded 1 to 5 fordifferent professions 4 4.3 17.2

Time on lastjob In years as reported 6 0.9 5.4

AnnualIncome

In thousands of rupeesas reported 22.5 0.6 13.5

Residence Coded 1 to 5 fordifferent postal zones 3 4.6 13.8

Home No. of years owned as 4 1.2 4.8

ownership reportedTelephone Coded 1 (yes) or 0 (no) 1 15.0 15.0

Total Credit Score 104.1

Credit Terms : The stipulations under which the firm sells on credit to its customersare called credit terms. Credit terms have four components - the cash discount, the cashdiscount period, the credit period and the credit limit. Changes in each of thesecomponents affect the firm’s sales, profits, average collection period and bad debtexpenses. Each trade has its customary terms of credit which frequently dictate thenature of credit terms to be offered by a firm. New firms normally offer liberal creditterms so as to attract customers. Sometime, even an established firm may offer stillmore favorable terms in order to retain old customers and to attract new ones.

Cash Discount : Many firms offer to grant cash discounts to their customers in orderto induce them to pay their bills early. The cash discount terms indicate the rate ofdiscount and the period for which discount has been offered. If a customer does notavail this offer, he is expected to make the full payment by the net date. For example,credit terms expressed as "2/10, net 30'. This implies that a 2 per cent discount will begranted if the payment is made on or before the 10th day; if the offer is not availed, thefull payment has to be made by the 30th day. When a firm initiates or increases the rateof cash discount, the following changes and effects on profits can be expected:

Advantages of Cash Discount: The seller gives this discount because

(i) he receives his sale proceeds quickly (promptly) and can use it to buy more goodswithout having to borrow from his bank,

(ii) he saves time and expenses in the collection of bills. This leads to less clerical work,less postage, less stationery etc., usually, delay leads to default or payment once delayedmeans payment denied. Hence remember the old saying, a rupee saved is a rupeeearned;

(iii) he has less trouble over bad debts; and

(iv) he avoids litigation or unnecessary legal expenses.

Credit Period : The time duration for which credit is extended to the customers isreferred to as credit period. It is generally stated in terms of net date. Normally, thecredit period of the firm is governed by the industry norms, but firms can extend creditfor longer duration to stimulate sales. Changes in the credit period also affects the firm'sprofitability. Increasing the credit period should increase the sales both the averagecollection period and bad debt expenses are likely to increase as well. Thus the net effecton profit may be negative. If the firm’s bad debts build up, it may tighten up its creditpolicy as against the industry norms.

Cash Discount Period : In addition to the size of the cash discount offered, the lengthof the discount period also may affect the average collection period and profit. When thecash discount period is increased there is a positive effect on profits because manycustomers who did not take the cash discount in the past, may now be tempted to availit, thereby reducing the average collection period. However, there is also a negativeeffect on profit when discount period is extended because people who already weretaking the cash discount will be able to still take it and pay later, thereby lengthening theaverage collection period For all practical purposes, the discount period is variablewithin only a narrow range. The minimum period for mailing invoice and receipt ofcheques is about ten days. To increase it significantly beyond ten days defeats itspurpose. In reality, then the discount period is not an important decision variable.

Credit Limit : The firm has not only to determine the duration of credit but also theamount of credit. The decision on the magnitude of credit. will depend on the amount ofcontemplated sales and customer's financial strength. In case of the customer who is afrequent buyer of the firm’s goods, a line of credit can be established. For example, if acustomer normally buys goods of Rs. 25,000 per month on the average, for him the lineof credit can be fixed at this level. The credit line must be reviewed periodically in orderto know the development in the account. If the tendencies of slow paying are found, thecredit line can be revised downward. At times, a customer may ask for the amount ofcredit in excess of his credit line. The firm may grant excess credit to him, if the producthas a high margin or if the additional sales help to use the unutilized capacity of thefirm.

Collection Policy : Collection policy refers to the procedures the firm follows to obtainpayment of past-due accounts. Prompt collection of accounts tends to reduceinvestment required to carry receivables and the costs associated with it A firm withlong over-due accounts will be exposed to greater amount of risk of non-payment. It isalso possible that customers who have not cleared the payment long due may be hesitantto place order on the firm for further supplies causing loss of some sale to the firm.

The overall collection policy of the firm is determined by the combination of thecollection procedures it undertakes. These procedures include such things as reminderletters sent, phone calls, personal calls and legal action. Monthly statements should besent to the customers of overdue accounts. Some of the customers may not pay until

they are reminded. It should be ensured that statement of accounts are sent promptly atthe end of each month.

The most important variable of credit policy is the amount expended on collection ofaccounts. Other things remaining same, the greater the amount spent on collectionefforts, the lower the percentage of bad debt losses and the shorter is the averagecollection period and vice-versa.

Some of the common impediments in debts collection visible in many companies are (i)inadequate invoicing producers, (ii) incomplete documents, (iii) non-compliance withthe terms of dispatch, (iv) absence of debtors information such as list of outstandings,age schedule, etc.

Some of the effective steps in debt collection drive are:

1. Organizing and maintaining an efficient credit (collection) department.

2. Setting credit standards and terms and defining clearly the collection policies andprocedures.

3. Preparing periodically, the customers accounts by age, sales regions, territories, etc.,and sending them to respective sales offices staff for follow up.

4. Assigning specific responsibility for collection.

5. Offering incentives like cash discounts for prompt payments.

6. Organizing a machinery for settlement in case of disputes.

7. Reviewing the customers accounts periodically, to identify frequent default andirregular accounts in order to tighten the credit terms and avoid bad debts. It is only theeffective follow-up which can produce quick liquidity and as such there is no substitutefor close and systematic review of customers accounts.

Financing of Debtors : Some of the financial policies used to finance debtors andensure efficient credit management to vogue especially in industrialized countries are,factoring of debtor, borrowing against purchasing of debtors, etc. In India, however,though borrowings against debtors (i.e. working finance facilities against pledge ofbooks debts) is not uncommon, factoring and purchasing of debtors are hot verypopular. There is need for separate agencies to undertake debt collection. For non-banking finance companies this would be a new avenue of business.

Credit Insurance : This is a method by which insurance cover is obtained for possiblebad debts. There are several types of which, the following are the most important:

(a) The Whole Turnover Policy: This covers the total turnover for the period of 12months and premium of a specified percentage is payable on the turnover. The turnover

relating to associate companies, Government department, nationalized industry andlocal authority are considered free of risk and not included,

(b) The Specific Account Policy: It provides insurance cover to any account whichinvolves a large sum of debt.

Valuation of Sundry Debtors

The basis of valuation is the amount, which it is estimated, will be realised by collectionin the ordinary course of business. This will involve a reduction in the book value fromthe sale price figure to the estimated collectable value and this is affected by means ofprovisions for doubtful debts and discounts allowable. Books debts should be classifiedas under:

(a) according to age;

(b) according to security reliability; and

(c) showing separately, debts due by persons connected with the management andothers.

According to age, sundry debtors should be classified into:

(i) debts outstanding for a period exceeding six months;

(ii) other debts.

According to security and reliability, sundry debtors should be classified as under:

(i) debts fully secured and in respect of which the company is fully secured;

(ii) debts considered good for which company holds no security other than thedebtor’s personal security; and

(iii) debts considered doubtful or bad.

The debts due from persons connected with the management and others shouldbe classified as under:

(i) debts due by directors or other officers of the company or any of them either severallyor jointly with any other person;

(ii) debts due by firms in which any director is a partner.

(iii) debts due by private companies in which any director is a director or a member;

(iv) debts due from other companies under the same management. By way of a note inthe balance sheet, the maximum amount due by directors or other officers of thecompany at any time during the year should be stated.

The provision in respect of bad and doubtful debts should be shown by way ofdeduction. Such a provision should not exceed the amount of debts stated forconsidered doubtful or bad.

FACTORING of RECEIVABLES

Receivables may be pledged as collateral which is called discounting of receivables orsold to a financing agency, which is called 'factoring'. Commercial, banks and financecompanies are the primary institutions that lend against a pledge of receivables. Factorpurchases accounts receivables outright.

The pledging of accounts receivable is characterized by the fact that the lender not onlyhas a claim against the receivables but also has recourse to the borrower (seller). If theperson or the firm that bought the goods does not pay the selling firm must take theloss. In other words, the risk of default on the accounts receivables pledged remainswith the borrowers. Also, the buyer of the goods is not ordinarily notified about thepledging of the receivables.

Factor or Factoring Company is a firm that, by arrangement, purchases the trade debtsof its clients and collects them on its own behalf. The factor has the right to select thedebts he will service and may not be prepared to make advances against debts that heconsiders doubtful. Factoring is common method of financing receivables in UnitedStates but developed more recently (since 1960) in the United Kingdom.

In India, factoring of receivables has been introduced based on the recommendations ofKalyanasundaram Committee, 1986. Four factoring concerns have been permitted bythe Reserve Bank of India.

Southern Zone : Canbank Factor Ltd., Sponsored by Canara Bank.

Western Zone : SBI Factor & Commercial Services Ltd., Sponsored by StateBank of India.

Eastern Zone : All bank Factor Ltd., Sponsored by Allahabad Bank.

Northern Zone : PNB Factor Ltd., Sponsored by Punjab National Bank.

Functions of Factors

The factor performs three functions in carrying the normal procedure for factoring ofdebts are

(i) Financing (lending)

(ii) Risk bearing

(iii) Credit checking

(i) Financing: The factor's function is to help to provide the trade with workingcapital. Once the client sends a batch of invoice to the factor, he can draw a highpercentage of the amount in invoices. The client may have to pay about 2% over thebank rate for a period only from the date of advance to the date of payment by thecustomer. This finance strictly speaking is not borrowing and will not appear in thebalance sheet as such the company’s ability to raise further finance is not affected. Afirm employing a factoring organisation will thus have more capital at its disposal, animportant consideration in a time of credit restriction.

(ii) Risk bearing: Factors by making finance available to their clients are taking creditrisk instead of providing of finance. The degree of service provided and willingness tobear risk of bad debts and other terms vary from company to company. Forbearing riskand servicing the receivables, the factor receives a fee of 1 to 3 per cent of the face valueof the receivables sold. The fee will vary according to typical size of individual accounts,the volume of receivables sold and the quality of accounts.

(iii) Credit checking: Credit checking about the buyer's credit worthiness andacceptability may be done either by the credit department of the seller or by the factor.Where factoring is available a small and a medium sized firm can avoid establishing acredit department. The factor maintains a credit department and makes credit check onaccounts. The factor’s service might well be less costly than a department that may haveexcess capacity for the firm’s credit volume. At the same time, if the firm uses part of thetime of anon-credit specialist to perform credit checking, lack of education, training andexperience may result in excessive losses.

Procedure for Factoring Accounts Receivable

When a seller receives an order from a buyer, a credit approval slip is written andimmediately sent to the factoring company for a credit check up. If the factor does notapprove the sale, the seller generally refuses to execute the order. This procedureinforms the seller, prior to the sale, about the credit worthiness and acceptability to thefactor. If the sale is approved, shipment is made and the invoice is stamped to notify thebuyer to make payment directly to the factoring company. Factoring is normally acontinuous process instead of the single cycle.

Kinds of Factoring

There are different kinds of factoring done by factors:

(i) Notification and Non-notification factoring and

(ii) Recourse and Non-recourse factoring.

There are some factors who buy clients invoices by advancing heavy percentage ofinvoice value and the balance will be paid after the debt is collected. In this case,although the firms buy invoices the supplier is responsible for collecting the debt and toguarantee the payment. This kind of facility offered is called "Non-notificationfactoring" whereby the customers is not notified the sale of the invoice. It should benoted that the facility offered, by which cash is advanced, is based upon the creditworthiness of the customers and the credit control procedures of the firm.

When a firm factors its receivables, it may be either with or without recourse dependingupon the type of arrangement negotiated. If the factoring arrangement involves fullrecourse, the firm will want to maintain same sort of credit department, in order to limitits risk exposure. On the others hand, if the receivables are sold without recourse thefactor bears both the risk of bad debt losses and of the expenses associated with thecollection of accounts.

Advantages:

For the seller of the goods and also the exporter factoring arrangement has a number ofadvantages...

(i) It gives him all the advantages of a cash trade while allowing him to offer credit to hiscustomers (either local or overseas or both).

(ii) It relieves overall the work involved in sales accounting and debt collecting.

(iii) It eliminates the uncertainty and risk of bad debts should buyers become insolvent.

(iv) Consequently, the cash flows of the firm are more predictable.

Its principal shortcoming is that it can be expensive. For a small firm, the savings maybe quite significant. Second, the firm is using a highly liquid asset as security and suchfinancing may be regarded as a confession of a firm’s unsound financial position.

Evaluation of Receivables Management

The possible measures of appraising performance of the credit department are asfollows:

(a) Percentage of orders rejected to credit sales,

(b) Percentage of monthly collections on past dues accounts to the accounts due at thebeginning of each month, and

(c) Percentage of bad debts to credit sales.

When taken together, these measures may present a picture of undesirable strictness orleniency. Thus an unusually low turnover of receivables in relation to the characteristic

ratio of the industry, a negligible reduction rate, a high proportion of past due accountswould require tightening of credit standards and collection procedures. The problemwould have to be analyzed on the basis of historical and horizontal standards in order tofind out whether or not percentage and ratios are unusually high or low.

Turnover of Debtors (Debtor's Velocity) Ratio:

This ratio explains the relationship of net (credit) sales of a firm to its books debtsindicating the rate at which cash is generated by turnover of receivables or debtors. Thepurpose of this ratio is to measure the liquidity of the receivables or to find out theperiod over which receivables remain uncollected i.e. ageing of receivables.

Net (Credit) sales

Turnover of Debtors Ratio (number of times in a year) = ------------------------------------

Average or year-endDebtors

If the annual turnover rate is say 6 times, this means that, on an average receivables arecollected in 2 months, i.e., average collection period is 2 months time. Alternatively,average collection period is calculated thus,

Accounts receivables

Average Collection Period (Number of days in a year) = ------------------------- x 365

Annual Creditsales

Trade debtors include bills receivables along with book debts. Bills arising not fromregular sales e.g., a bill receivable from the buyer of fixed assets, should be excluded.Bad and doubtful debts and their provisions are not deducted from the total debtors inorder to avoid the impression that a large amount of receivables have been collected. Ifthe breakup of sales into cash and credit sales is not available, the analyst has to use thetotal sales for computation of the ratio. As to the calculation of daily sales, the number ofworking days of the firm enduring the year is customarily taken as 360 days rather than365 days exact; Average collection period is analysed with reference to the (billing)terms of sales and then, overdue are counted after the expiry of credit period allowed.

Creditor's (Creditor's Velocity) Ratio:

This ratio shows the velocity of the debt discharged by matching annual credit purchasesto the outstanding payables (both trade creditors and bills payables) at the accountingdate.

Net (Credit) Purchase

Creditors or Payables Ratio (Number of times in a year) = ---------------------------------

Average (or yearend)payables

Smaller the payable ratio, greater the credit period enjoyed and consequently larger thebenefit reaped from credit suppliers.

Payables

Average Payment Period (Number of days in a year) = -------------------- X 365

Credit Purchases

Ageing of Accounts Receivables:

Ageing of Accounts is yet another method of analyzing the liquidity of receivables. Thisinvolves classifying the amounts due in each account according to the period that it isoutstanding or categorizing the receivables at a point of time according to theproportions billed in previous months. For instance, such a classification as on 31December of any year may reveal that 60% of the amounts outstanding are not morethan a month old, 20% may be more than a month but less than 2 months old, 12% maybe outstanding for more than 60 days (2 months) but less than 90 days (3 months) and8% of the amount may be more than 3 months old. If the terms of sale require paymentwithin 30 days, the information as regards ageing of accounts shows that 40% of theamount of receivables are overdue, 20% are upto one month overdue, 12% upto 2months overdue and 8% are more than 2 months overdue. Evidently, the accounts withoutstanding dues which are long overdue need to be investigated and written off, if theyare uncollectable. With the information on ageing of accounts, the analyst can get anaccurate picture of the investment in receivables and changes in the basic compositionof the investment over time.

The Ageing Schedule breaks down debtors according to length of time for which theyhave been outstanding and gives a detailed idea of the quality of debtors. The averagecollection period measures the quality of debtors in an aggregative way while ageingschedule very clearly spots out the slow paying debtors.

Illustration 1

A firm sells goods of Rs. 10,000 on '2/10, Net 30' days basis. The customer has twooptions (i) either to avail of cash discount by making payment on or before 10th day; or(ii) to keep the credit open and pay full amount by the 30th day. Assuming that bankfinance is available to customers on 18 per cent per annum, suggest which option wouldbe more beneficial to the customer to exercise.

Solution

In case the first option is exercised, the customer saves Rs. 200 and has to pay only Rs.9,800.

If the customer does not avail of the facility of 2% cash discount and pays Rs. 10,000 onthe 30th day, then it would imply that he is paying interest of Rs. 200 on Rs. 9,800(10,000-200) for getting the facility of keeping Rs. 9,800 for duration of 20 days. Thisby implication would mean that Rs. 200 is the interest on Rs. 9,800 for 20 days. On thisbasis the interest for 12 months can be calculated as follows:

Interest for 12 months = (200 x 30 days x 12 months) / 20 days = Rs.3,600

Annual Rate of Interest = (3,600 / 9,800 ) x 100 = 36.74% (approx)

As the rate of bank credit is only 18%, there is no point in exercising the second optionand paying 36.74% interest. Therefore the customer must make the payment by the 10thday and take advantage of 2% cash discount. In case cash is not readily available thenresorting to borrowing from bank (@ 18%) and making the payment by the 10th day (toget a discount Rs. 200) will be beneficial to the customer.

Illustration 2

A firm is considering pushing up its sales by extending credit facilities to the followingcategories of customers:

(a) Customers with a 10% risk of non-payment, and

(b) Customers with a 30% risk of non-payment.

The incremental sales expected in case of category (a) are Rs. 40,000 while in case ofcategory (b) they are Rs.50,000. The cost of production and selling costs are 60% ofsales while the collection costs amount to 5% of sales in case of category (a) and 10% ofsales in case of category (b). Advise the firm about extending credit facilities to each ofthe above categories of customers.

Solution

(a) Extending Credit Facilities with 10% Risk of Non-payment

Incremental Sales Rs.

Less: Loss in collection (10%) 40,000

4,000

------------

Net sales realized 36,000

Less: Production and selling costs (60% of sales) 24,000

Collection costs (5%) 2,000 26,000

-------------

Incremental Income 10,000

-------------

Thus, the firm can have extra income of Rs.10,000 by accepting the 10% risk group. Itmay, therefore, lower its credit standards in favour of this category of customers.

(b) Extending Credit Facilities with 30% Risk of Non-payment

Sales by accepting 30% risk group Rs.

Less: Loss in collection (30%) 50,000

15,000

------------

Net sales realized 35,000

Less: Production and selling costs (60% of sales) 30,000

Collection costs (10%) 5,000 35,000

-------------

Incremental Income Nil

-------------

Thus, the firm does not stand to gain or lose on account of extending credit to customerswith 30% risk of non-payment. The firm should not, therefore, extend credit to suchcustomers unless it is beneficial for the firm in the long-term because of having a widermarket for its products.

Illustration 3

The following are the details regarding the operations of a firm during a period of 12months.

Sales Rs 12 Lakhs

Selling Price per unit Rs 10

Variable cost price per unit Rs 7

Total cost per unit Rs 9

Credit period allowed to customers One month

The firm is considering a proposal for a more liberal extension of credit which will resultin increasing the average collection period from one month to two months. Thisrelaxation is expected to increase the sales by 25% from its existing level.

You are required to advise the firm regarding adoption to the new credit policy,presuming that the firm’s required return on investment is 25%.

Solution

Computation of New Sales

Present Sales 1.2 Lakh units x Rs 10 = Rs 12 Lakhs

Additional Sales 30 K units x Rs 10 = Rs 3 Lakhs

Total sales = Rs 15 Lakhs

Computation of New Total Cost

Present cost of sales 1.2 Lakh units x Rs 9 = Rs 10.8 Lakhs

Cost of additional sales 30 K units x Rs 7* = Rs 2.1 Lakhs

Total cost of sales = Rs 12.9 Lakhs

* Only variable costs to be considered.

Existing investment in receivables = Rs. 10.8 Lakhs x 1 month /12 months (since creditperiod is 1 month)

= Rs 90K

New average cost per unit = New total costs / New total output

= Rs 12.9 Lakhs / 1.5 Lakh units = Rs 8.60

Average Investment in Receivables under new sales pattern

Total annual sales = 1.5 Lakh units

Cost of sales (1.5 Lakh units x Rs 8.6) = Rs. 12.9 Lakhs

Average collection period = 2 Months

Amount invested in receivables = (Rs 12.9 Lakhs x 2 months) / 12 months = Rs 2.15Lakhs

Additional investment in receivables = New investment - Existing investment

= Rs 2.15 Lakhs - Rs 90 K = Rs 1.25 K

Profitability on additional sales = Additional units sold x Contribution per unit

= 30 K x Rs 3 = Rs 90,000

Return on additional investment in receivables = (Rs 90,000 / Rs 1.25 K) x 100 = 72%

The required return on investment is only 25% where the actual return on additionalinvestment in receivables comes

to 72%. The proposal should, therefore, be accepted.

Illustration 4

XYZ Corporation is considering relaxing its present credit policy and is in the process ofevaluating two proposed policies. Currently, the firm has annual credit sales of Rs 50lakhs and accounts receivable turnover ratio of 4 times a year. The current level of lossdue to bad debts is Rs 1.5 Lakhs. The firm is required to give a return of 25% on theinvestment in new accounts receivables. The company’s variable costs are 70% of theselling price. Given the following information which is the better option?

Present Policy Policy Option I PolicyOption II

Annual Credit sales Rs 50 Lakhs Rs 60 Lakhs Rs 67.5Lakhs

Accounts receivables turnover ratio 4 times 3 times 2.4times

Bad debt losses Rs 1.5 Lakhs Rs 3 Lakhs Rs 4.5Lakhs

Solution

XYZ Corporation Evaluation of Credit Policies

Present Policy Policy Option I Policy Option IIAnnual Credit Sales Rs 50,00,000 Rs 60,00,000 Rs 67,50,000Accounts receivable turnover 4 times 3 times 2.4 timesAverage collection period (12months / Accounts 3 months 4 months 5 months

receivables turnover)Average level of accountsreceivables (Annual creditsales /Receivabls turnover)

50,00,000/4 =Rs 12,50,000

60,00,000/3 =Rs 20,00,000

67,50,000/2.4 =Rs 28,12,500

Marginal increase ininvestment in receivables lessprofit margin (i.e. 70% ofincrease in Receivables)

- 5,25,000 5,68,750

Marginal increase in sales - 10,00,000 7,50,000Profit on marginal increase insales (30%) - 3,00,000 2,25,000

Marginal increase in baddebts losses - 1,50,000 1,50,000

Profit on marginal increase(sales less marginal bad debtlosses)

- 1,50,000 75,000

Required return on marginalinvestment at 25% - 1,31,250 1,42,188

Surplus (loss) after requiredrate of return - 18,750 (67,188)

The above analysis shows that the Policy Option I gives a surplus of Rs 18,750, whereasPolicy Option II shows a deficit of Rs. 67,188 on the basis of 25% return. Thus, PolicyOption I is better.

Notes:

1. (5,52,000 x 25) /100 = Rs 1,31,250

2. (5,68,750 x 25) /100 = Rs 1,42,188

Illustration 5

A firm has annual sales of Rs. 15,00,OOO. It grants 2 months credit to its customerswith no cash discount facility. It intends to offer a discount of “2/10, net 60”. It isexpected that this will reduce the average collection period to one month and 50% of thecustomers (in value) will take advantage of this benefit. The selling price is Rs. 10 perunit, while the average cost per units comes to Rs. 8.60.

You are required to advise the firm regarding this new scheme presuming that therequired return on investment is 25% and one month is of 30 days.

Solution

Rs.

Annual credit sales 15,00,000

Cash discount allowed (15,00,000 x 50/100 x 2/100) 15,000

Present investment in receivables (15,00,000 x 2/12 x 8.6/10) 2,15,000

Expected investment in receivables (15,00,000 x 1/12 x 8.6/10) 1,07,500

Decrease in investment in receivables 1,07,500

Savings in capital costs (1,07,500 x 25/100) 26,875

Net savings (Rs. 26,875 - Rs. 15,000) 11,875

Since the new credit terms will result in a net savings of Rs. 11,875, hence the firm mayadopt them.

REVIEW QUESTIONS

1. Explain the objectives of receivables management.

2. What are the determinants on the size of investment in receivables?

3. What system of control would you suggest to keep the investment in receivableswithin reasonable limits?

4. What benefits and cost are associated with the extension of credit? How should theybe combined to obtain an appropriate credit policy?

5. What are a firm’s credit standards? On what basis are they normally established?

6. What is meant by a firm’s credit terms? What do they determine?

7. What are collection policies? How can they be evaluated?

8. Explain briefly (i) Credit insurance (ii) Factoring (iii) Ageing of Receivables (iv)Delinquent debts (v) Credit scoring.

9. A company manufactures several products which are marketed all over India throughwholesalers. How would the company decide the credit control policy it should adopt?

10. What factors should be taken in to account in deciding upon the credit limits to beallowed to a new customers who is likely to have substantial transaction with the seller?

PRACTICAL PROBLEMS

1. Chidambaram & Co. Limited has currently annual credit sales of Rs.7,80,000. Itsaverage age of accounts receivable is 60 days. It is contemplating a change in its creditpolicy that is expected to increase sales to Rs. 10,00,000 and increase the average age ofaccounts receivable to 72 days. The firm’s sale price is Rs. 25 per unit, the variable costper unit is Rs. 12 and the average cost per unit at Rs.7,80,000, sales volume is Rs. 17.Assume 360 days in a year.

(i) What is the average accounts receivable with both the present and the proposedplans?

(ii) What is the average cost per unit with the proposed plan?

(iii) Calculate the marginal investments receivable resulting from the proposed change.

(iv) What is the cost of marginal investment if the assumed rate of return is 15%?

[Ans. (i) Rs. 1,28,000 (ii) Rs. 16 per unit (iii) Rs. 37,330 and (iv) Rs. 5,600]

2. A firm has credit sales amounting to Rs. 32,00,000. The sale price per unit is Rs. 40,the variable cost is Rs. 25 per unit while the average cost per unit is Rs. 32. The averageage of accounts receivable of the firm is 72 days. The firm is considering to tighten thecredit standards. It will result in a fall in the sales volume to Rs. 28,00,000 and theaverage age of accounts receivable to 45 days. Assume 20% rate of return. Is theproposal under consideration feasible?

[Ans. The firm should not adopt more strict credit collection policy as it will decreaseprofits by Rs. 1,05,350]

3. Ramasamy & Co. Limited is examining the question of relaxing its credit policy. Ifsells at present 20,000 units at a price of Rs. 100 per unit, the variable cost per unit isRs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales areon credit, the average collection period being 36 days. A relaxed policy is expected toincrease sales by 10% and the average age of receivables to 60 days. Assuming 15%return, should the firm relax its credit policy?

[Ans. The firm should relax its credit policy as it increases profit by Rs. 1,200]

SUGGESTED READINGS

1. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi,Tata McGraw Hill Co.

2. Hampton, J J. : Financial Decision Making, New Delhi, Prentice Hallof India.

3. Khan, M.Y. and Jain, P.K.: Financial Management, New Delhi, Tata McGraw HillCo.

4. Pandey, I.M. : Financial Management, New Delhi, Vikas PublishingHouse

- End of Chapter -

LESSON - 9

INVENTORY MANAGEMENT

Learning Objectives


· Know the motives for holding inventories· Understand the costs-risks involved in inventory decisions· Detail inventory control techniques· Explain and calculate EOQ and stock points· Examine the several methods of inventory valuation

Lesson Outline

· Motives for Holding Inventories· Objectives for Inventory Management· Costs for Inventory Policies and Decisions· Inventory Control Techniques - EOQ - Stock levels - ABC Analysis etc.· Inventory Valuation - LIFO - FIFO - HIFO - NIFO etc.· Illustrative Examples

The success of a business concern largely depends upon efficient purchasing, storage,consumption and accounting. The uncontrolled inventories e dangerous and at times itis called as graveyard of business. Hence, inventory control system should be designedto ensure the provision of the required quantity of material at the required time to meetthe needs of production and sales, while at the same time keeping the investment inthem at a minimum.

Motives For Holding Inventories

Generally three motives are involved in holding inventories.

(i) The transaction motive which emphasizes the need to maintain inventories tofacilitate smooth production and sales operations (called transaction inventory).

(ii) The precautionary motive which necessitates holding of inventories to guardagainst the risk of unpredictable changes in demand and supply force (calledprecautionary inventory).

(iii) The speculative motive which influences the decision to increase or reduceinventory levels to take advantage of price fluctuations (called speculative inventory).

Objectives of Inventory Management

Broadly, the objectives of inventory management can also be classified into operativeobjectives and financial objectives. Operative objectives aims at avoiding productionbottlenecks by providing continuous supply of all types of materials, avoidance ofwastage like theft, pilferage, leakage, spoilage etc., promotion of manufacturingefficiency and prompt execution of their orders to ensure better service to customers.The financial objectives of inventory management include effecting economy inpurchasing through economic order quantity and taking advantage of favourablemarkets, maintaining optimum level of investment in inventories, etc.

Management information on stocks is required by the production department so thatthey can schedule workloads, shift work and machine usage. Information on finishedgoods is required by the marketing department so that they can estimate whethercustomer's requirements can be met or not.

Cost for Inventory Policies and Decisions

There are four cost factors involved in general inventory policies:

(i) Acquisition or Ordering Cost: The cost associated with the placement of apurchase order i.e. expenses of the firm in acquiring or processing inventory. The costassociated with ordering consists of:

(a) Salaries of the staff in administration and purchase department,

(b) Rent for the space used by the purchase department,

(c) The postage, telegram and telephone bills,

(d) The stationery and other consumable required by the purchasing department,

(e) Entertainment charges on vendors,

(f) Travelling expenses,

(g) Lawyers and court fees due to legal matters arising out of purchase, etc.

All these costs usually come to 15 to 20% as ordering cost. The expenditure on orderingof material is directly proportional to the number of orders placed.

(ii) Material Cost: It is the cost of materials itself.

(iii) Carrying or Holding Cost: It is the cost associated with keeping the materials instock. The following costs are incurred in keeping materials in store, and the longer thematerials are stored, the greater these costs become:

(a) Capital costs i.e. the loss of return that could be obtained if the capital tied upin stock was employed elsewhere,

(b) Space costs such as rent, heating, lighting etc.,

(c) equipment costs like bins, racks, etc.,

(d) personal costs involved in storing, stock taking, security etc.,

(e) insurance costs i.e. protection against fire, theft, etc.,

(f) property taxes,

(g) cost of handling the material,

(h) stationery and other consumables used by the stores,

(i) cost of wastage and material losses in the store,

(j) obsolescence and deterioration costs. The higher the stock levels, the longer thetime materials in stock, and so the greater is the risk, and therefore ultimate costof obsolescence,

(k) depreciation and repair cost for the stores facilities and handling equipment.These costs come nearly 20 to 25%. These costs are arbitrary and vary fromindustry to industry and from time to time and also from item to item in the sameindustry.

(iv) Overstock and understock costs: Carrying inventory which results where thereis stock left on hand after the demand for the item has terminated. This cost is called theoverstock cost. Understock cost refers to the cost of running out of goods or costassociated with shortages i.e., lost sales or profits.

S.No. Inventory with cost Inventory without cost

(i) Return on Investment Stock out costs

(ii) Storage cost Lost sale, Loss of future sale (demand x futureprofitability)

(iii) Handling cost Loss of customers/goodwill

(iv) Handling equipment Down time cost

(v) Obsolescence Idle labour, idle production

(vi) Spoilage and shelf life Capacity and other cost


INVENTORY CONTROL TECHNIQUES

In most manufacturing concerns inventories are controlled through the followingtechniques:

(i) Economic Order Quantity,

(ii) Determination of Stock Levels,

(iii) Inventory Turnover Ratio,

(iv) Input-Output Ratio Analysis,

(v) A B C Analysis,

(vi) Perpetual inventory or Continuous stock taking,

(vii) Value Analysis.

Economic Order Quantity (E.O.Q.)

The Economic Order Quantity (E.O.Q.) is the optimum or the most favourable quantitywhich should be ordered for purchase each time when the purchases are to be made.The Economic Order Quantity is one where the cost of carrying is equal to, or almostequal to the cost of not carrying. The E.O.Q is also known as "Reorder Quantity" or"Standard Order Quantity" and it depends upon two factors viz, cost of carrying and costof ordering and receiving per order. The cost of carrying or holding costs can beestimated by the management on the basis of sales of past years but costs of not carryingenough are only estimated.

EOQ = √ (2CO / I)

where, I = interest payment including variable cost of storage per unit per year,

C = Consumption of materials concerned in units,

O = Cost of ordering and receiving per order

Assumptions

· Inventory is consumed at a constant rate· Costs do not vary over the period of time· Lead time is known and constant· Ordering cost, carrying cost and unit price are constant· Holding or carrying costs are proportional to the value of stocks held· Ordering cost varies proportionately with price

For example, a unit of material V costs Rs. 50 and the annual consumption is 2,00,000units. The cost of placing an order and receiving the material is Rs. 200 and the interestincluding variable cost of storage per unit per year is 10% per annum.

EOQ = √ (2CO / I) = √(2 x 2,00,000 x 200/10% of Rs.50) = √(800,00,000/5) =√16000000 = 4000 units

The E.O.Q. approach can be extended to production runs to determine the optimum sizemanufacture. Two factors deciding the economic production size are set-up costs andcarrying costs. Set-up cost is roughly equivalent to the ordering cost per order. Itincludes,

(a) engineering cost of setting up the production line or machine,

(b) paper-work, cost of processing the work order and authorising production, and

(c) ordering cost to provide raw materials for the batch or order.

The set-up cost will reduce with bulk production runs, but the carrying costs willincrease as large stocks of manufactured inventories will be held. Thus, the economicproduction lot size is one where the total of set-up cost and carrying cost is minimum.

Illustration 1

A manufacturer buys certain equipment from supplier at Rs. 30 per unit. Total annualneeds are 800 units. The following further data are available:

Annual return on investment 10%

Rent, insurance, taxes per unit per year Re. 1.

Cost of placing an order Rs. 100

Determine the economic order quantity.

Solution

Cost of carrying inventory per unit = 30 x 10% + 1 = Rs. 4

E.O.Q = Square Root of (2 x 100 x 800) / 4 = √160000 / 4 = 400/4 = 200 units

Determination of Stock Levels

The demand and supply method of stock control technique determines different stocklevels viz; Maximum level, Minimum level, Reorder level, Average level, Danger level,etc.

• Maximum Stock Level : It represents the quantity of inventory above which shouldnot be allowed to be kept. This quantity is fixed keeping in view the disadvantages ofover stocking. The disadvantages of over stocking are:

(i) working capital is blocked up unnecessarily in stores and interest may have to be paidthereon;

(ii) more storage space is required so more rent, insurance charges and other costs ofcarrying inventory have to be incurred;

(iii) there is risk of deterioration in quality, depreciation in quantity due to evaporation,rusting etc., and risks of obsolescence besides the risk of loss due to breakage, theft,excessive consumption also, and

(iv) there is a possibility of financial loss on account of subsequent fall in prices.

The following are the factors helpful in deciding the limits of inventory to be stored:

(a) amount of capital available and required for purchases,

(b) storage facilities and storage costs,

(c) rate of consumption of the material,

(d) possibilities of price fluctuations,

(e) seasonal nature of supply of materials, (possibility of loss due to evaporation,moisture, deterioration in quality, etc.,

(g) insurance costs,

(h) possibility of change in fashion and habit which will outdate the productsmanufactured from that material,

(i) restrictions imposed by government or local authority or Trade association inregard to materials in which there are inherent risks e.g. we and explosion or as toimports or procurement,

(j) economic order quantity, and

(k) lead time.

Lead Time: From the time the requisition for an item is raised; it may take | severalweeks or months before the supplies are received, inspected, and taken in stock. Thistime is called as “Lead time” or "Procurement Time" and involves the time for thecompletion of all or some of the following activities:

(i) Raising of a purchase requisition,

(ii) Inquiries, tenders, quotations,

(iii) Receiving quotations, tenders, their scrutiny and approval,

(iv) Placement of order on a supplier/suppliers,

(v) Suppliers time to make the goods ready (may have to be manufactured orsupplied ex-stock),

(vi) Transportation and clearing,

(vii) Receipt of materials at the company,

(viii) Inspection and verification of the materials,

(ix) Taking into stock, and

(x) Issuing items and carrying them to the place of work.

This lead time required to procure any item can be divided into two parts namelyinternal lead time (also known as Administrative Lead Time) required fororganizational formalities to be completed and external lead time (also known asDelivery Lead Time) as shown below:

Total Lead Time

Internal Lead Time + External Lead Time + Internal Lead Time

(Requisition order) (Placement of order (Taking unit stock)

and receipt of goods)

It is a common belief that external lead time should be controlled and reduced, but ithas been found in actual practice that internal lead time constitutes a considerable partof total lead time and offers ample scope for reduction. The management must make adetermined and deliberate effort to reduce lead time by selectively delegating powers,better paper work procedures, and fixing targets individually for all activities. Obviously,in order to receive supplies before the stock reaches zero level, it is necessary to orderthe materials much in advance i.e., when the stock available is sufficient to last duringthe lead time.

• Minimum Stock Level : This represents the quantity below which stock should notbe allowed to fall. This is known as 'safety' or 'buffer stock'. The main purpose of thislevel is to ensure that production is not held up due to shortage of any material. Thislevel is fixed after considering: (i) average rate of consumption of materials, and (ii) leadtime.

• Reorder Level (or Order level) : It is the point at which if stock of the material instore reaches the store-keeper should initiate the purchase requisition for fresh supplies

of the materials. This level is fixed between maximum and minimum-stock levels insuch a way that the difference of quantity of the materials between the reorder level andthe minimum level will be sufficient to meet the requirement of production up to thetime the fresh supply to the material is received.

• Danger Level : This is a point at which issues of the material are stopped and issuesare made only under specific instructions. This level is generally fixed below ‘heminimum stock level. When stock of materials reaches the danger level the purchaseofficer should take special arrangements to get the materials at any cost.

Just-in-time Inventory Control: The just-in-time inventory control system,originally developed by Taiichi Okno of Japan, simply implies that the firm shouldmaintain a minimal level of inventory and rely on suppliers to provide parts andcomponents “just-in-time” to meet its assembly requirements. This may be contrastedwith the traditional inventory management system which calls for maintaining a healthylevel of safety stock to provide a reasonable protection against uncertainties ofconsumption and supply-the traditional system may be referred to as a “just-in-case”system.

The just-in-time inventory system, while conceptually very appealing, is difficult toimplement because it involves a significant change in the total production andmanagement system. It requires inter alia

(i) a strong and dependable relationship with suppliers who are geographically notvery remote from the manufacturing facility,

(ii) a reliable transportation system, and

(iii) an easy physical access in the form of enough doors and conveniently locateddocks and storage areas to dovetail incoming supplies to the needs of assemblyline.

Formulae for Determination of Stock Levels

Maximum Stock Level = Reorder level + Reorder Quantity - (Minimum consumption xMinimum Reorder period)

Reorder Level = Maximum consumption x Maximum Reorder period

Minimum Stock Level = Reorder level - (Normal consumption x Normal reorderperiod)

Average Stock Level = Minimum level + ½ of Reorder Quantity

= ½ (Minimum stock + Maximum stock)

Danger Level = Maximum delivery time x Maximum rate of consumption

= Minimum rate of consumption x Emergency delivery time

Illustration 2

From the following information calculate the Maximum stock level, Minimum stocklevel, Reordering level, Average stock level and Danger level.

- Normal consumption 300 units per day

- Maximum consumption 420 units per day

- Minimum consumption 240 units per day

- Reorder quantity 3,600 units

- Reorder period 10 to 15 days

- Normal reorder period 12 days

- Time required to emergency purchase 4 days

Solution

Reorder Level = Maximum consumption x Maximum Reorder period

= 420 units per day x 15 days = 6,300 units

Minimum Stock Level = Reorder level - (Normal consumption x Normal reorderperiod)

= 6,300 units - (300 units per day x 12 days) = 6,300 - 3,600= 2,700 units

Maximum Stock Level = Reorder level + Reorder quantity - (Minimum consumptionx Minimum reorder period)

= 6,300 units + 3,600 units - (240 units per day x 10 days)

= 9,900 - 2,400 = 7,500 units

Average Stock Level = ½ (Minimum stock level + Maximum stock level)

= ½ (2,700 units + 7,500 units) = 5,100 units

Danger Level = Minimum rate of consumption x Emergency delivery time

= 240 units per day x 4 days = 960 units

Control through ABC Analysis - Selective Control

Different types of analyses, each having its own specific advantages and purpose, help inbringing a practical solution to the control of inventory. The most important of all suchanalysis is ABC analysis. The others are:

FSN (Fast, Slow, Non-moving items) Analysis

GOLF (Government controlled, Ordinarily available, Locally available and Foreignitems) Analysis

HML (High, Medium, Low cost) Analysis

SDE (Scarce, Difficult, Easily Available) Analysis

SOS (Seasonal and Off-seasonal) Analysis

VED (Vital, Essential, Desirable) Analysis

An effective inventory control system should classify inventories according to values sothat the most valuable items may be paid greater and due attention regarding theirsafety and care, as compared to others. Hence, it is desirable to classify the productionand supply items, both purchased and manufactured, depending upon their importanceand subject each class of group of items to control commensurate with importance. Thisis the principle of "control by importance and exception" (CIE) or selectivecontrol as applied to inventories and the technique of grouping is termed as ABCanalysis or classification which it said to be "Always Better Control". As the itemsare classified in the importance of their relative value, this approach is also known asProportional (parts) Value Analysis (PVA) or Annual Usage Value (AUV)analysis.

The general procedure for implementing the ABC technique is as follows:

(i) Classify the items of inventories;

(ii) Determine the expected use in units over a given period of time;

(iii) Determine the total cost of each item by multiplying the expected units by itsunit price;

(iv) Rank the items in accordance with total cost, giving first rank that the itemhighest total cost and so on;

(v) Calculate percentage (ratio) of number of units of each item to total units of allitems and the percentage of total cost of each item to total cost of all items;

(vi) Combine items on the basis of their relative value to form three categories - A,B and C e.g., classify the inventory as A,B, or C based on the top 20%, the next30% and the last 50% valuation respectively;

(vii) Decide cut-off points and methods of control;

(viii) Tag the inventory with A, B, C classification and record these classificationsin the item inventory master record.

Illustration 3

The following information is known about a group of items. Classify the material in A, B,C classification.

___________________________________________________________________________________

Model Number Annual consumption in Unit price in Rs.

pieces

__________________________________________________________

501 30,000 10

502 2,80,000 15

503 3,000 10

504 1,10,000 5

505 4,000 5

506 2,20,000 10

507 15,000 5

508 80,000 5

509 60,000 15

510 8,000 10

____________________________________________________________________________________

Solution

__________________________________________________________________________________________

Model Number Annual Unit price Annual Rank

consumption Rs. consumption (According

in pieces value (Rs.) to value)

__________________________________________________________________________________________

501 30,000 10 3,00,000 6

502 2,80,000 15 42,00,000 1

503 3,000 10 30,000 9

504 1,10,000 05 5,50,000 4

505 4,000 05 20,000 10

506 2,20,000 10 22,00,000 2

507 15,000 05 75,000 8

508 80,000 05 4,00,000 5

509 60,000 15 9,00,000 3

510 8,000 10 80,000 7

_____________ _________________

Total 8,10,000 87,55,000

____________________________________________________________________________________________

_________________________________________________________________

Model No. %items Annual % Rank

consumption

value Rs.

_________________________________________________________________

A Category 502 10% 42,00,000 48% 1

506 10% 22,00,000 25% 2

____________________________________

Total 20% 64,00,000 73%

____________________________________

B Category 509 10% 9,00,000 10% 3

504 10% 5,50,000 6% 4

508 10% 4,00,000 5% 5

____________________________________

Total 30% 18,50,000 21%

____________________________________

C Category 501 10% 3,00,000 3½% 6

510 10% 80,000 1% 7

507 10% 75,000 1% 8

503 10% 30,000 ¼% 9

505 10% 20,000 ¼% 10

____________________________________

Total 50% 5,05,000 6%

____________________________________

Grand Total 100% 87,55,000 100%

________________________________________________________________

Control Through Perpetual Inventory System

The Institute of Costs and Management Accountants, England defines the perpetualinventory system as “a system of records maintained by the controlling department,which reflects the physical movements of stocks and their current balance”. Thus, this isa method of ascertaining balance after every receipt and issue of materials through stockrecords, to facilitate regular checking and to avoid closing down for stock-taking. Inorder to ensure accuracy of perpetual inventory record, it is desirable to check thephysical stocks by a programme of continuous stock-taking. Any discrepancy notedbetween physical stocks and the stock records can be investigated and rectified, thenand there.

INVENTORY VALUATION

Materials are issued to different jobs or work orders from the stores. These jobs or workorders are charged with the value of materials issued to them. Following are theimportant methods of valuing material issues:

A. Based on Cost Price or Actual Cost

(i) The First in First Out (FIFO) Method

(ii) The Last in First Out (LIFO) Method

(iii) The Highest in First Out (HIFO) Method

(iv) The Next in First Out (NIFO) Method

(v) The Base Stock Method

(vi) The Specific (or Actual) Fixed Price Method

(vii) The Inflated Price Method

(viii) Fixed Cost Method

(ix) Average Cost Method

(a) Simple average price method

(b) Periodic simple average price method

(c) Weighted average price method

(d) Periodic weighted average price method

(e) Moving simple average price method

(f) Moving weighted average price method

B. Based on Market Price Method

(x) Realizable Value Method

(xi) Replacement Value Method

C. Based on Standard Price Method

(xii) Current Standard Price

(xiii) Basic Standard Price

Methods Based on Actual Cost

First In First Out (FIFO) Method

This method operates under the assumption that the materials which are received firstare issued first and, therefore, the flow of cost of materials should also be in the same

order. Issues are priced at the same basis until the first batch received is used up, afterwhich the price of the next batch received becomes the issue price. Upon this batchbeing fully used, the price, of the still next batch is used for pricing and so on. In otherwords, the materials issued are priced at the oldest cost price listed in the stores ledgeraccount and consequently the materials in hand are valued at the price of the latestpurchases.

Example:

Receipts

2nd Jan (first consignment) 500 kilos @ Rs. 8 per kilo

5th Jan (second consignment) 300 kilos @ Rs. 8.20 per kilo

Issues

7th Jan 600 kilos

500 kilos @ Rs. 8 per kilo = Rs. 4,000

100 kilos @ Rs. 8.20 per kilo = Rs. 820

_________

Total issue value = Rs. 4,820

-------------

Advantages

1. This method is realistic in so far as it assumes that materials are issued to productionin the order of their receipts.

2. The valuation of closing stock tends to be nearer current market prices as well as atcost.

3. Being based on cost, no unrealized profits enter into the financial result.

4. The method is easy to operate if the prices do not fluctuate very frequently.

Disadvantages

1. The issue prices may not reflect current market prices and, therefore, when priceincreases the cost of production is unduly low.

2. The cost of consecutive similar jobs may differ simply because the prior job exhaustedthe supply of lower priced stock. This renders comparison between different jobs isdifficult.

3. The method may involve cumbersome calculations if the prices fluctuate quitefrequently.

The FIFO method is most successfully used when

(a) the size and the cost of raw material units are large,

(b) materials are easily identified as belonging to a particular purchased lot, and

(c) not more than two or three different receipts are on a materials card at one time.

Last In First Out (LIFO) Method

This method operates on the assumption that the latest receipts of materials are issuedfirst for production and the earlier receipts are issued last, i.e., in the reverse order toFIFO. It uses the price of the last batch received for all the issues until all units from thisbatch have been issued after which the price of the previous batch received becomes theissue price. Usually, a new delivery is received before the first batch is fully used, inwhich case the new delivery price becomes the 'last-in' price and is used for pricingissues until either the batch is exhausted or a new delivery is received.

Example:

Take the same data as given in earlier example:

Receipts

2nd Jan (first consignment) 500 kilos @ Rs. 8 per kilo

5th Jan (second consignment) 300 kilos @ Rs. 8.20 per kilo

Issues

7th Jan 600 kilos

300 kilos @ Rs. 8.20 per kilo = Rs. 2,460

300 kilos @ Rs. 8 per kilo = Rs. 2,400

_________

Total issue value = Rs. 4,860

-------------

Advantages

1. The method keeps the value of issues close to the current market prices.

2. No unrealized profit or loss is usually made by using this method.

3. In periods of raising prices, the high prices of the most recent purchases are chargedto operations, thus reducing profit figure and resulting in a tax saving.

Disadvantages

1. The value of the closing stock may be quite different from the current market valueand hence may not be acceptable for income tax purposes.

2. Comparison among similar jobs is very difficult because different jobs may beardifferent charges for materials consumed.

3. This method does not conform to the physical flow of materials.

4. The number of calculation complicates the stores accounts and increases thepossibility of clerical errors when rates of receipt are highly fluctuating.

Under condition of rising market prices, LIFO method is generally considered better.This is so because under LIFO method reasonably correct effect of current prices isreflected in the cost and the cost is not understated. The quotation of prices for theproducts also becomes more safe than FIFO.

Highest In First Out (HIFO) Method

The method is based on the assumption that stock of materials should be always valuedat the lowest possible price. Materials purchased at the highest price are treated as beingfirst issued irrespective of the date of purchase. The method is very suitable when themarket is constantly fluctuating because cost of highly priced materials is recoveredfrom the production at the earliest. But it involves too many calculations as in the casewith the LIFO and FIFO methods. The method has not been adopted widely.

Next In First Out (NIFO) Method

The method attempts to value material issr.es at an actual price which is as near aspossible to the market price. Under this method the issues are made at the next pricei.e., the price of materials which has been ordered but not yet received. In other words,issues are at the latest price at which the company has been committed even thoughmaterials have not yet been physically received. This method is better than market pricemethod under which every time when materials are issued, their market price will haveto be ascertained. In case of this method materials will be issued at the price at which a

new order has been placed and this price will hold good for all future issues till a nextorder is placed.

Base Stock Method

The method is based on the contention that each enterprise maintains at all times aminimum quantity of materials in its stock. This quantity is termed as base stock. Thebase stock is deemed to have been created out of the first lot purchased and therefore, itis always valued at this price and is carried forward as a fixed asset. Any quantity overand above the base stock is valued in accordance with any other appropriate method. Asthis method aims at matching current costs to current sales the LIFO method will bemost suitable for valuing stock of materials other than the base stock. The base stockmethod has the advantage of charging out materials at actual cost. Its other merits ordemerits will depend on the method which is used for valuing materials other than thebase stock.

Specific Price Method

Where materials are purchased for a particular job, they should be charged to thatparticular job at their actual cost. This method can always be used where materials arepurchased and set aside for a particular job until required for production. This methodis best suited for job order industries which carry out individual jobs or contractsagainst specific orders. From the point of view of costing, the method is desirablebecause it ensures that the cost of materials issued is actual and that neither profit norloss arises out of pricing. This method however, is difficult to use if purchases and issuesare numerous and the materials issued cannot be identified.

Inflated Price Method

In case of certain materials wastage is unavoidable on account of their inherent nature,e.g., if a log of timber is issued to various departments in pieces or if it is kept forseasoning, there will be some loss in its quantity. In such a case the production shouldbe charged at an inflated price so as to recover the total cost of materials over thedifferent issues.

Average Cost Method

(a) Simple Average Price: Simple average price is the average of the prices withoutany regard to quantities. The calculation of simple average price involves adding ofdifferent prices dividing by the number of different pieces. The method operates underthe principle that when materials are purchased in lots and are put in store, theiridentity is lost and, therefore, issues should be valued at the average price of all the lotsin store. Though this method is very easy to operate, but it is crude and usually producesunsatisfactory results. The value of closing stock may be quite absurd. Moreover,materials are not charged at actual cost and, therefore, a profit or loss will usually ariseout of pricing.

(b) Weighted Average Price: Weighted average price is calculated by dividing thetotal cost of material in stock by the total quantity of material in stock. This methodaverages prices after weighing (i.e., multiplying) by their quantities. The average price atany time is simply the balance value divided by the balance units. Issue prices need to becomputed on the receipt of new deliveries and not at the time of each issue as in the caseof FIFO and LIFO.

Thus as soon as a fresh lot is received, a new issue price is calculated and all issues arethen taken at this price until the receipt of the next lot of materials. This methodoperates under the assumption that the identity of the materials, when put in stores, islost and therefore their cost should reflect the average of the total supply.

Advantages

1. Since the receipts are much less frequent than issues, the method is not socumbersome because the calculation of the new issue price arises only when freshlots are purchased. All subsequent issues are then charged at this price until thenext lot is received.

2. The method even out the effect of widely varying prices of differentconsignments comprising the stock.

3. A profit or loss may arise out of pricing.

4. Issue prices may run to a number of decimal points.

(c) Periodic Simple Average Price: This method is similar to the simple averageprice except that here the issue price is calculated at the end of each period (normally amonth) covering the prices at which purchases were made during the period and not atthe occasion of each issue of material.

(d) Periodic Weighted Average Price: The periodic weighted average price is theweighted average price of materials purchased during a period. It is calculated bydividing the total cost of materials purchased during a period by the total quantity ofmaterials purchased during that period. A new average price is calculated at the end ofeach period (normally a month).

(e) Moving Simple Average Price: This price is obtained by dividing the total of theperiodic simple average prices of a give number of periods, by the number of periods,the last of the period being that for which material issues are valued. The calculation ofmoving simple average price requires to decide upon the number of periods (months),i.e. 3, 5, 7, etc. If, for example, a 5-monthly simple average is to be calculated, theperiodic simple average prices of 5 periods have to be added and total of these pricesdivided by 5 would give simple moving average price.

(f) Moving Weighted Average Price: This is a derivation of the weighted averagemethod. To obtain the weighted average price, the weighted average price of a given

number of periods (including and preceding the period of accounting) have to be addedand divided by the number of periods.

Selection of a Suitable Method of Pricing Issues: No single method can beappropriate in all circumstances. The selection of a proper method of pricing issuesdepends on the following factors:

(a) the nature of the business and type of production, e.g., intermittent such as job orcontinuous such as process;

(b) the method of costing used, whether the cost accounts are maintained according tothe standard costing system, if so, method of issuing materials on standard cost shouldbe used;

(c) the nature of materials e.g., if materials are to be kept for some time for maturing orseasoning, an inflated price will have to be charged;

(d) the frequency of purchases and issues;

(e) the extent of price fluctuations;

(f) the policy of the management. If the management wants that the cost accountsshould represent the current position and correspond with estimates and besides thatthey should disclose efficiency in buying, pricing materials issues at market price may besuitable;

(g) relative value of material issued and relative size of batch of material issued;

(h) length of inventory turnover period and quantity of material to be handled; and

(i) the necessity for maintaining uniformity within an industry.

Illustration 4

XYZ Ltd, has purchased and issued the materials in the following order:

January 1 Purchases 300 units Rs. 3 per unit

Januray 4 Purchases 600 units Rs. 4 per unit

January 6 Issue 500 units --





Ascertain the quantity of closing stock as on 31st January and state what will be its value(in each case) if issues are made under the following methods

(a) Average cost (b) FIFO method, and (c) LIFO method

Solution

(a) Average Cost method



January 6 Issue 500 units Average cost = (300 x 3 + 600 x 4) /(300+600) = Rs. 3.67 per unit


January 15 Issue 800 units Average cost = [400 x 3.67 + 700 x 4]/(400+700) = Rs. 3.88 per unit


January 23 Issue 100 units Average cost = [300 x 3.88 + 300 x 5]/(300+300) = Rs. 4.44 per unit

January 31 Balance 500 units Average cost = Rs. 4.44 per unit

Value of Closing Stock = 500 x 4.44 = Rs. 2,220

(b) FIFO (First-in-first-out method)



January 6 Issue 500 units 300 units @ Rs.3 per unit + 200 units @Rs. 4 per unit


January 15 Issue 800 units 400 units @ Rs. 4 per unit + 400 units @Rs. 4 per unit


January 23 Issue 100 units 100 units @ Rs. 4 per unit

January 31 Balance 200 units @ Rs. 4 per unit + 300 units @ Rs. 5 per unit

Value of Closing Stock = 200 x 4 + 300 x 5 = Rs. 2,300

(c) Last-in-first-out method



January 6 Issue 500 units 500 units @ Rs.4 per unit


January 15 Issue 800 units 700 units @ Rs. 4 per unit + 100 units @Rs. 4 per unit


January 23 Issue 100 units 100 units @ Rs. 5 per unit

January 31 Balance 300 units @ Rs. 3 per unit + 200 units @ Rs. 5 per unit

Value of Closing Stock = 300 x 3 + 200 x 5 = Rs. 1900

Illustration 5

The following information is obtained from the records of ABC Ltd.:

January 1 Opening stock 00 units Rs. 200

January 10 Purchases 40 units Rs. 100

January 25 Purchases 100 units Rs. 300

January 31 Sales 140 units Rs.700

On January 31st, the replacement cost was Rs. 3.5 per unit. Determine the closing stock,cost of goods sold and profit for the month using LIFO, FIFO and Replacement cost (usethe format of a trading account).

Solution:

Using LIFO Method

Trading A/C

------------------------------------------------------------------------------------------------

Date Particulars Units Amount | Date Particulars Units Amount

------------------------------------------------------------------------------------------------

Jan 1 Opening Stock 100 200 | Jan31 Sales 140 700

Jan 10 Purchases 40 100 | Jan 31 ClosingStock 100 200

Jan 25 Purchases 100 300 |

Jan 31 Profit 300 |

----------------------| ----------------

240 900 | 240 900

------------------------------------------------------------------------------------------------

Opening Stock value + Purchases value - Closing Stock value = Cost of goods sold

= 200 + 400 - 200 = Rs. 400

Using FIFO Method

Trading A/C

------------------------------------------------------------------------------------------------


------------------------------------------------------------------------------------------------




Jan 31 Profit 400 |

----------------------| ----------------

240 1000 | 240 1000

------------------------------------------------------------------------------------------------


= 200 + 400 - 300 = Rs. 300

Using Replacement Cost Method

Trading A/C

------------------------------------------------------------------------------------------------


------------------------------------------------------------------------------------------------




Jan 31 Profit 425 |

----------------------| ----------------

240 1025 | 240 1025

------------------------------------------------------------------------------------------------


= 200 + 400 - 325 = Rs. 275

Conclusion:

LIFO FIFO RCM

Closing Stock Rs. 200 Rs. 300 Rs. 325

Cost of goods sold Rs. 400 Rs. 300 Rs. 275

Profit Rs. 300 Rs. 400 Rs. 425

REVIEW QUESTIONS

1. What are the objectives of inventory management?

2. What is the financial manager’s role in respect of the management of inventory?

3. What purpose does safety stock serve? What are the benefits and costs associatedwith safety stock?

4. What are inventory carrying charges? How are they calculated?

5. What are ordering costs? How are they calculated?

6. What are the costs of stock-outs? How should the costs of stock-out and the carryingcosts be balanced to obtain the safety stock?

7. What is lead time? What are the various activities occurring during the lead time?

8. How would you determine Economic Ordering Quantity?

9. What factors do you consider in fixing the maximum and the minimum stock levels?

10. What do you understand by A B C analysis? What are its advantages? Discuss theinventory policies for A, B and C items.

11. Explain the following: (a) LIFO Method (b) FIFO Method.

PRACTICAL PROBLEMS

1. 10,000 units of a component are required per year. Rs. 100 is ordering cost on anaverage per order. Rs. 2 is the average stock carrying cost p.a. per unit. What is theeconomic ordering size? How many times should the orders be placed and what will betotal cost of ordering and of carrying cost of inventory.

[Ans: E.O.Q. 1,000 units; 10 times; Rs. 2.000]

2. Two components, A and B are used as follows: Normal usage 50 units per week eachMinimum usage 25 units per week each Maximum usage 75 units per week eachReorder Quantity A : 300 units : B : 500 units Reorder Period A : 4 to 6 weeks: B : 2 to 4weeks. Calculate for each component (i) Reorder level, (ii) Minimum level, (iii)Maximum level, and (iv) Average Stock level.

[Ans. (i) A 450 units, B 300 units (ii) A 200 units, B 150 units (iii) A 650 units, B 750units (iv) A 350 units, B 400 units]

3. A manufacturing company uses Rs. 50,000 materials per year. The administrationcost per purchase is Rs. 50, and the carrying cost is 20% of the average inventory. TheCompany currently has an optimum purchasing policy but has been offered a 4 per centdiscount if they purchase five times per year. Should the offer be accepted? If not, whatcounter offer should be made?

[Ans. E.O.Q. = Rs, 5,000; the offer should not be accepted because the cost will increaseby Rs. 46; any counter offer of more than 5% discount should be made].

4. The following are taken from the records of M/s Balaji & Co Thirupathi for the year1994. The valuation of inventory is Re. 1 per kg or litre.

Opening stock Purchases Closing stock

Material A 700 kg 11,500 kg 200 kg

Material B 200 litres 11,000 litres 1,200 litres

Material C 1,000 kg 1,800 kg 1,200 kg

Calculate the material turnover ratio and express in number of days the averageinventory is held.

[Ans. Material A - 26.67 times; 14 days. Material B - 14.29 times; 26 days. Material C -1.46 times; 250 days.]

SUGGESTED READINGS

1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi-, TataMcGraw Hill Co.

2. Gopalakrishnan, P: Inventory and Working Capital Management, New Delhi,Macmillan India Ltd.

3. Menon, K.S.: Stores Management, Madras, Macmillan India Ltd.

- End of Chapter -

LESSON -10

COST OF CAPITAL

Learning Objectives


· Recognise the significance of cost of capital· Understand the concept of cost of capital

· Detail the controversial views regarding the cost of capital· Explain and calculate cost of debt, equity etc.

Lesson Outline

· Significance of Cost of Capital· Concept of Cost of Capital· Assumption of the Cost of Capital· Controversial Views - Traditional Approach - MM approach· Calculation of Specific Cost of Capital· Weighted average cost of capital· Illustrative Examples

It has been stated in the first lesson that a crucial aspect in investment decision (capitalbudgeting) is the cost of capital. It may be recalled that the cost of capital is usuallytaken to be the cut-off rate for determining whether an investment opportunity shouldbe rejected or accepted. This is so in the case of Return on Investment (ROI) method(i.e., the expected return is compared with the required return), Net Present Valuemethod. Profitability Index, Discounted Pay-back (i.e., the discount rate should be thecost of capital rate) and Internal Rate of Return (i.e., the rate should not be lower thancost of capital rate). Hence proper capital budgeting procedures require an estimate ofcost of capital. Secondly, many other decisions, including those related to leasing, bondrefunding, dividend policy, and to working capital policy require estimates of the cost ofcapital. Thirdly, the concept of cost of capital is significant in designing the concern’scapital structure. The cost of capital is influenced by the capital structure changes. Intrying to achieve its optimal capital structure over time, a firm should aim at minimisingthe cost of capital and maximising market value of the firm. Thus the knowledge of thecost of capital is also helpful in deciding about the capital-source-mix i.e., method offinancing. Finally, the cost of capital framework can be gainfully applied to evaluate thefinancial performance of top management. Such an evaluation will involve a comparisonof actual projected overall cost of capital, and an appraisal of the actual costs incurred inraising the required funds.

The principle of cost of capital is applicable equally to the public sector undertakingsalso. Unless the public sector earns a basic minimum of the cost of capital supplied to itby the society, it will impoverish the society in due course, because the society mighthave invested it elsewhere and got the returns. If certain companies in the public sectorcannot earn a profit for certain socially desirable reasons (e.g., Hindustan Latex Ltd.producing contraceptives) other companies in the public sector like HMT, BHEL, etc.,should earn more than their cost of capital in order to balance on the whole.

Concept of Cost of Capital

(i) Cut-off Rate: Cost of capital is the minimum required rate of return or earningsfrom any given project needed to justify the use of capital. In other words, it is the ratethat must be paid to obtain funds for the operation of the firm. It is the cut-off rate, (alsoknown as the target-rate or the hurdle-rate) for the allocation of capital to investment

projects; in theory, it should be the rate of return on a project that will leave unchangedthe market price of the firm’s equity shares.

(ii) Lending/Borrowing Rate: The phrase "cost of capital" is used in two senses inthe literature on capital budgeting viz., the borrowing rate and the lending rate. Theborrowing rate is the rate which a given firm will have to pay for obtaining capital in themarket, whether it is from shareholders or other lenders. As between these two rates,whichever rate is higher is to be used for discounting purpose while making investmentdecisions. That is, where the borrowing rate is above the lending rate, the formerbecomes the relevant rate of discount and vice versa.

(iii) Opportunity Cost: This is an alternative concept of cost of capital and is the rateof return foregone or sacrificed by using limited resources available in one investmentproject in preference to the next best alternative. For instance, if a person lending at arate of interest of 15% per annum finds that by lending on these terms he is foregoinginterest at 18 per cent per annum, which he could have easily earned by lendingelsewhere, then 18 per cent per annum is his opportunity cost (provided, of course, thathe cannot get a higher return than 18 per cent per annum on some other investmentbearing the same degree of risk). This is the opportunity cost because he has lost theopportunity of investing at 18 per cent. It is the sacrificed alternative return. The cost ofcapital in this sense is commonly known as ‘lending rate’, because his rate would beearned by the firm if it were to lend its excess funds outside. The ‘borrowing rate’ is saidto be outlay cost, involving financial expenditure and is, therefore, recorded in the booksof account.

(iv) Explicit cost and Implicit cost: The explicit cost of any source of capital may bedefined as “the discount rate that equates the present value of the cash inflows that areincremental to the taking of the financing opportunity with the present value of itsincremental cash outflows”. The cash outflows may be interest or dividend payments,repayment of principal, etc. Thus the explicit cost of capital is the internal rate of returnof the financial opportunity. The implicit cost is that rate of return associated with thebest investment opportunity for the firm and its shareholders that will be foregone ifthat project presently under consideration by the firm were accepted. The implicit costis the opportunity cost.

(v) Composite Cost, Average Cost, Specific Cost etc: A firm’s supply of capitalmay come from several sources, each source having a different cost. Therefore it isessential to calculate a weighted average cost of capital for all the funds used by thecompany. The capital structure of a company may include...

(i) Debt capital, carrying fixed interest rate (fixed cost of capital)

(ii) Preference share capital, carrying preference dividend rate (fixed cost of capital)

(iii) Equity capital, carrying no fixed rate of dividend (variable cost of capital)

(iv) Reserve funds, Trade credit etc., on which a company is not required to pay anyamount for their use. (No cost or variable cost of capital)

The cost of each source (i.e., specific source) is known as Specific Cost. The combinedaverage cost of shares, debt, reserves and retained earnings may be termed as overall orcomposite cost of capital and is generally calculated as weighted cost of capital. Specificcost of capital may be useful for short-run analysis but composite cost of capital shouldbe used for long-run analysis such as evaluation of capital expenditure decision, targetcapital structure etc.

(vi) Marginal Cost of Capital: It refers to weighted average or simply additional costof new capital raised by the concern. Marginal cost of capital is also considered as moreimportant for capital budgeting purposes and financing decisions.

Assumptions of the Cost of Capital : The cost of capital and its determination asdiscussed in this lesson are based on two assumptions given below:

(i) Business Risk is unaffected: It has been assumed that business risk complexionof the concern would remain the same by accepting a new investment proposal. Theterm ‘business risk’ refers to the variability in annual earnings due to change in sales. Ifa concern accepts a considerably more risky investment proposal than the average, thebusiness risk complexion is bound to change and investors are quite likely to expect anincrease in Cost of Capital. However, we assume no change in business risk and cost ofcapital determined ignoring the change in business risk is used as accept/rejectcriterion.

(ii) Financial Risk is also unaffected: It is also our assumption that financial riskcomplexion would also remain unchanged. Financial risk refers to the risk on account ofpattern of capital structure. Here also, there may be a chance of capital structure beingchanged due to acceptance of a particular investment proposal. This changed capitalstructure would give rise to financial risk and suppliers may be demanding higher ratethan the cost of capital, ascertained on the basis of original capital structure. However,one assumes that capital structure will remain constant, i.e., additional funds requiredto finance the new project can be raised in the same proportion as the concern’s existingfinancing.

Thus, the cost of capital discussed here does not consider the business risk and financialrisk. It is something like rate of return with zero-risk level.

Controversial Views Regarding the Cost of Capital

There are two important approaches in this regard: (a) Traditional Approach; (b)Modigliani and Miller (M.M.) Approach.

(a) Traditional Approach: According to this approach, a company’s cost of capitaldepends upon, the method and level of financing or its capital structure. It means that acompany can change its overall cost of capital by changing its capital structure, i.e.,

increasing or decreasing debt-equity ratio. Since the cost of debt is cheaper due to lowerbut fixed rate and also tax saving (interest on debenture is allowed as deductibleexpense) as compared to equity shares, the traditional theorists argue that the overallcost of capital (i.e., weighted average cost) will decrease with every increase in debtcomponent in the total capital structure. However, debt component in the total capitalemployed should be maintained at proper level because cost of debt is a fixed burden onprofit of the company. If the company has low profit, the increase in debt componentmight have adverse impact upon the company’s risk. The shareholders may raise theirexpected rate of return due to increased risk in the business. The followers of theapproach are Ezra Solomon, Barges, Alexander and others.

(b) Modigliani and Miller Approach (M.M.Approach): According to thisapproach, a change in capital structure (i.e., debt- equity ratio) does not affect the costof capital. In other words, the method and level of financing will not affect the cost ofcapital; this will remain constant. This approach is based on the reasoning that eachchange in debt-equity ratio offsets the change in one with the change in other due tochange in the shareholders’ expectations. For example, a change in capital structure infavour of debenture may bring down the overall cost of capital but at the same time theexpectation of shareholders will go up from the present dividend rate because they willfind the business more risky. This increased expectation of shareholders will offset thedownfall in overall cost of capital and thus, the overall cost will not be affected at all.

Calculation of Specific Cost of Capital

To obtain the weighted cost of capital it is therefore necessary to evaluate each of theseitems, which are discussed below:

A. Cost of Debt Capital - Debentures, Bonds, Public Deposits: In measuringcost of capital, the first thing to be considered is the cost of debt e.g., debentures, bonds.For calculating the cost of debt both contractual (explicit) as well as imputed costsshould be taken into consideration. The explicit costs are measured by interest rate dulyadjusted by tax rate. The yearly imputed interest can be calculated by the differencebetween the actual receipts of debentures/bonds and the amount to be paid at the end ofmaturity divided by the years of maturity.

Example:

Reliance Textiles issued 15% debentures worth Rs.1,000 maturing in 20 years. Thedebentures are sold for Rs.960.

The yearly imputed interest will be...

Rs. 1,000 — Rs. 960

---------------------- = Rs. 2

20 years

Ordinarily the yearly interest amount @ 15% will be Rs.150. Since debenture interest isan allowable item for income tax purposes, assuming the corporate income tax is 50%,the effective interest rate is only half of 15% i.e., 7.5% or Rs.75 and the 50% tax (half ofinterest is borne by the Government). Thus, the cost of debentures issued at a discountis calculated with the following formula:

Yearly interest amount + Yearly imputed interest

----------------------------------------------------- x Tax Rate

Average debenture receipts

Substituting the above figures in this formula,

Rs. 150 + Rs. 2

------------------------ x 50% = 7.76%

(Rs.960+ Rs. 1,000)/2

When it is possible for the borrower to issue debentures/bonds at full face value, beforetax cost of debt is simply the nominal (compound) rate of interest (which is also themarket yield).

Thus, the cost of debt finance can be defined in terms of required rate of return that thedebt financed investment must yield to prevent damage to the stock holders’ position.That is, to keep the earnings available to the common stockholders unchanged, the firmmust, at least, earn a return equal to the interest rate on the .borrowed funds. If the firmearns less than the interest rate, the earnings available to the common stockholderswould decrease and this may, in turn, affect the stock market price of the company’sshare adversely. Further, the lowered market price of outstanding shares will set theupper limit at which additional new shares can be issued. This is the implicit cost of theuse of debt finance, thus making the firm risky for future investment. However majorityof them favour the exclusion of such implicit costs in cost of capital consideration.

B. Cost of Preference Share Capital (Preferred Equity): Preference shares arethe fixed cost bearing securities. Their rate of dividend is fixed well in advance at thetime of their issue. Dividends on preference capital would be paid regularly except whenthe firm does not make profits or is in a very tight cash position. The cost of preferenceshare capital is a function of the dividend expected by investors. The cost of a preferenceshare can be determined in the same manner as the cost of debentures except with one

difference. That is, the cost of preference share capital is not adjusted for taxes, becausedividend on preference capital is paid after taxes as it is not tax deductable. Thus, thecost of preference share capital is substantially higher than the cost of debt.

Cost of Preference Share Capital = (P /C) x 100

Where, P = Dividend payments, C = Net proceeds from preference share issues

Normally, the stipulated rate of dividend is taken as ‘P’. For calculating the value of ‘C’necessary adjustments have to be made for the terms of issues - issued at Par,Discounter Premium. Thus,

(i) When preference shares are issued at Par,

C = Par value - Flotation expenses

(ii) When preference shares are issued at Discount,

C = Par value - (Discount + Flotation expenses)

(iii) When preference shares are issued at Premium,

C = Par value + Premium - Flotation expenses

C. Cost of Equity Capital: The cost of equity capital is the minimum rate of returnthat the company must earn on the equity financed portion of an investment project inorder to leave the market price of the stock unchanged. Ordinarily the cost of equityfunds should not be less than the return the shareholders expect to get by investing theirequity funds elsewhere. That is, cost of equity funds must be somewhat greater thanshareholder1 s opportunity rate of return. Unlike the interest rate on debt and the fixedrate of dividend on preference capital, the rate of dividend to the common stockholdersis not fixed. However the stockholders invest their money in common stocks with anexpectation of receiving dividends. But declaration of dividend depends upon themanagement policy which varies as circumstances warrant.

The cost of equity can be found out by four approaches as stated below:

(i) D/P Ratio Approach - This approach is based on the principle as to what aninvestor expects from the company when he puts his money in it. It means that theinvestor arrives at a market price for a stock by capitalising dividends at a normalrate torn. The glaring drawback of this approach is that it ignores earnings onretained earnings. Further, it neglects the fact that stock market price rise may bedue to retained earnings also and not on account of high dividends alone.

(ii) E/P Ratio Approach - The proponents of this approach establish arelationship between earnings and market price of the shares. Shareholderscapitalise a stream of unchanged earnings by the capitalisation rate of E/P in order

to evaluate their holdings. Some people use the current earnings in the currentmarket price for determining capitalisation rate while others recommend anaverage of earnings at average market price. The chief limitation of this ratioapproach is that all earnings are not distributed to the shareholders in the form ofdividends. In fact, share price and earnings per share are not constant over theyears.

(iii) D/P + g Approach (or Dividend Model) - Solomon Ezra, Myron J.Gordon, and Shapiro are the chief exponents of this approach. This approach takesinto consideration one important fact, namely, what the investor really gets afterhe has invested. He usually gets the dividend as well as rate of growth in thedividend, (g) which is assumed to be equal to the growth rate in earnings per shareand market price per share.

Expected Dividend per share

Cost of Equity capital = ------------------------------------------------------------ xGrowth rate

Market Price of a share less Discount and Floatationcosts

This approach too is criticised on the ground that it assumes that cost ;s equivalentto cash outlay. Further all earnings whether paid in the form of dividend or notbelongs to shareholders and as such affect the market price of the shares.

(iv) Realised Yield Approach (or Earnings Model): This approach is basedon the rate of return actually realised for a period of time by investors in acompany. The supporters of this approach suggest that it can fairly be assumedthat past behaviour will materialise in the future and historic realised rate ofreturn would be an appropriate indicator of prospective investors’ required futurerate of return.

Expected Earnings per share

Cost of Equity capital = ----------------------------------------------------------- xGrowth rate

Market Price of a share less Discount and Floatation costs

D. Cost of Retained Earnings: According to some financial experts these funds arecost-free or zero-cost. But this is not true for several reasons:

(a) If the entire earnings are distributed (and not retained) the company will have toissue new shares for future finance and such that shares will have cost.

(b) If the earnings are distributed fully as dividends to the shareholders, they could haveinvested these cash dividends in other stocks, bonds, real estate or in anything else andearn a return equal to the opportunity cost.

Thus if the management decides to retain earnings, there is an opportunity costinvolved. This opportunity cost is simply the dividend foregone by shareholders. Here,the firm must earn on the retained earnings at least as much as stockholders themselvescould earn in alternative investments of comparable risk. If the firm cannot investretained earnings and earn at least that rate of return, then it should pay these funds toits stockholders and let them invest directly in other assets that do provide this return.

Many authors contend that the cost of retained earnings must take into account thetaxes a stockholder has to pay on dividends he receives as well as brokerage commissionto invest in another stock. Thus, a stockholder will have the use not of the entiredistribution of earnings but only of the portion that remains after taxes and brokeragecommission.

The total return he is able to achieve by investing the dividend in the stock of a Companyif identical risk is:

R = Ke (1 –T) (1 - B)

where, T is his Marginal Tax Rate, and B is the brokerage / commission expressed as apercentage.

E. Cost of Depreciation Funds: Depreciation (reserve) constitutes a second majorsource of generated funds. Technically, depreciation itself is not a source of funds but itserves to retained earnings as by a charge to costs and a corresponding understatementof profit. As depreciation is simply an adjustment to the sources of retained earnings,the cost of capital for depreciation should really be treated same as the cost of retainedearnings. Hence, the cost consideration relating to the retained earnings should alsoapply to depreciation funds. The cost of depreciation funds should thus be equal to theiropportunity costs to the equity holders concerned. It should be noted that depreciationis an admissible item for income tax purposes, its net effective cost would be after tax-rate adjustment.

Alternative approach is to consider depreciation as a reduction of debt corresponding toan investment in the asset-notionally, giving cash back to shareholders either bypurchasing shares in the market (which is not permitted by law) or a formal reduction incapital. Therefore, the cost of capital of depreciation reserve can be taken at theminimum as the cost of debt.

F. Cost of (Short Term Credit) Operating Debt: A short term credit either in theform of bank credit or trade credit is also not cost-free to the firm. For instance, aconcern purchases goods worth Rs. 10,000 on terms Rs. 10,000/2/10, net 30 days. Itmeans if the payment is made within ten days the firm will be entitled for 2% cash

rebate; otherwise the payment is to be made within 30 days in full. If the concern wantsto use Rs. 9,800 for 20 days at a cost of Rs. 200 and then its actual cost works to 2.04%.

G. Weighted Average Cost of Capital: Once the cost factors for all the sources ofcapital have been ascertained, they can be used to calculate the weighted cost of theentire capital. Weighted average (also known as composite or overall cost of capital) isan average of the costs of each of the sources of funds employed by the concern, properlyweighted by the proportion they hold in the capital structure. The following steps arerequired to calculate the average cost of capital:

(a) ascertain the costs of individual components of the capital structure;

(b) multiply the cost of each source by its proportion in the capital structure;

(c) add the weighted costs of all sources of funds to get the weighted cost ofcapital.

It should be noted that the component costs to be used to calculate the weighted cost ofcapital should be the after-tax costs. The weighted average cost of new or incrementalcapital is known as the marginal cost of capital.

There are several limitations in computing weighted average cost of capital.

(i) Determining the Weights: The first limitation arises with reference toassigning proper weight to the specific components of financing on sound basis.Normally, there are two types of bases for assigning weights - book values versusmarket values. Book values are historical weights. When the market value of anycomponent method of financing differs from its book value the weighted averagecost of capital calculated will differ accordingly. This case is more frequent in caseof equity shares.

The cost of capital based on the market value approach is usually higher than itwould be if the book value is used. The market value weights are sometimespreferred to the book value weights, for the market value represents the trueexpectations of the investors. However the market value suffers from the followinglimitations: (a) market value undergoes frequent fluctuations and has to benormalised, (b) the use of market value tends to cause a shift towards largeramounts of equity funds, particularly when additional financing is undertaken.

In the light of these limitations of the market value approach, it is desirable to usethe book value weights. This method has the following advantages: (a) it is easyto know the book value, (b) the capital structure targets are usually fixed in termsof book value, (c) investors are interested in knowing the debt-equity ratio on thebasis of book values, (d) it is easier to evaluate the performance of a managementin procuring funds by comparing on the basis of book values.

(ii) Choice of Capital Structure: The choice of the capital structure to be usedfor determining the average is also not an easy task. Three types of capitalstructure are there: current capital structure, marginal capital structure oroptimum capital structure. Generally current capital structure is regarded as theoptimum capital structure but it is not always correct. In other words, a firm cannot measure its costs directly at the derived capital structure, there costs can onlybe estimated.

(iii) Untrue Assumptions: First of all, it is assumed that the firms existingcapital structure is optimal and the proposed increment capital is also optimal inthe existing structure. It does not come always true. Secondly it is also assumedthat the cost of raising funds is independent of the volume of funds raised. Thisassumption also does not hold good in actual life.

Average cost of capital cannot be used in the following circumstances:

-When the company is trying to bring about radical changes in its debt policy, and

- When the dividend policy of the company is being changed with the objective ofreadjustment of proportion of retained earnings.


Illustration 1

Tantex Limited has 10% irredeemable debentures of Rs. 1,00,000. Par value ofdebentures is Rs. 100. Find out the cost of capital, if debentures have been issued (i) atpar, (ii) at discount of 10% and (iii) at premium of 10%.

Solution

Case(i)... at par

P = 10, C=100,

Cost of capital = (10 / 100) x 100 = 10%

Case (ii)... at discount of 10%

P=10, C = 100 - 10 = 90,

Cost of capital = (10 / 90) x 100 = 11.11%

Case (iii)... at premium of 10%

P=10, C = 100 + 10 = 110,

Cost of capital = (10 / 110) x 100 = 9.09%

Illustration 2

DCM Limited has issued 9%, 10,000 Preference Shares of Rs. 100 each, and hasincurred the following expenses out the cost of capital: Underwriting commission 2%,brokerage 1%, other expenses Rs. 10,000. If the present company tax rate is 50%, whatwill be the cost of capital before tax and after tax?

Solution

P = 9,

Floatation charges (per Rs. 100)

Underwriting Commission = 2

Brokerage = 1

Other expenses (10,000/10,000) = 1

------

4

------

C = 100 - 4 = 96,

It = P/C x 100 = 9/96 x 100 = 9.375%

Id = It / (I - T) = 9.375 / (1 - 50%) = 9.375 / 0.5 = 18.75%

Illustration 3

From the facts given below, calculate the cost of retained earnings:

(i) The company has net earning amounting to Rs. 50,000.

(ii) It is expected that the retained earnings, if distributed to the shareholders, can beinvested by them in securities carrying return of 10% p.a.

(iii) The shareholders of the company are in 30% tax (marginal) brackets.

(iv) Shareholder will have to incur 2% brokerage cost for making new investments.

Solution

Profit before distribution 50,000

Less: Income tax 30% - 15,000

---------

Profit after tax 35,000

Less brokerage 2% - 700

---------

Retained earmings for investment 34,300

---------

AD = (34300/100) x 100 = 3430

I = AD/RE x 100 = 3430/50000 x 100 = 6.86%

where, RE = Cost of retained earnings

AD = Earnings from Alternative Investments of Retained Earnings

Alternatively, it can be calculated as under also:

Ir = Expected Rate (1 - Td) (1-B)

= 10 (1 - 0.3) (1 - 0.02) = 10 x 0.7 x 0.98 = 6.86%

Illustration 4

Compute the weighted average cost of capital from the following information:

Rs. Lakhs Before-tax costs

Equity Capital 3 15%

Preference Shares 2 13.5%

Retained Earnings 2 15%

Debentures 3 15%

-------------

10

-------------

Solution

Method offinancing (i)

Rs. Lakhs(ii)

Proportion(iii)

Cost beforetax (iv)

Cost aftertax (v)

Weighted Cost(vi)

[(iii) x (v)]

Equity capital 3 30% 15% 15% 4.50%Retained earnings 2 20% 15% 15% 3.00%Preference capital 2 20% 13.5% 13.5% 2.70%Debenture capital 3 30% 15% 7.5% 2.25%

10 100% 12.45%

Therefore, the weighted average cost of capital is 12.45%

REVIEW QUESTIONS

1. Define cost of capital. Explain its significance in financial decision-making.

2. How is the cost of debt computed? How does it differ from the cost of preferenceshare capital?

3. Explain the different approaches to the computation of cost of equity capital.

4. “The cost of retained earnings is less than the cost of new outside equity capital.Consequently, it is totally irrational for a firm to sell a new issue of stock and to paydividends during the same year”. Comment on this statement.

5. State briefly the assumptions on which the Gordon model for the cost of equity isbased. What does each component of the equation represent?

6. Discuss the various approaches to determine the cost of retained earnings. Whichapproach do you consider better and why? Also explain the rationale of treating retainedearnings as a fully subscribed issue of equity shares.

7. How is the weighted average cost of capital calculated? Explain with a numericalexample.

PRACTICAL PROBLEMS

3. A company issues 10,000 irredeemable debentures of Rs. 100 each @ 15 percent. The company has to incur the following floatation charges or issue expenses:Underwriting commission 1.5%, brokerage 0.5%, miscellaneous expenses (forprinting, advertising and counseling fees etc.) Rs. 10,000. Assuming that the taxrate for the company is 50%, compute the effective cost of debentures to thecompany if the debentures are issued:

(i) At par, (ii) At a discount of 10%, and (iii) At a premium of 10%.

[Ans.: (i) 15.464%, (ii) 8.64% and (iii) before tax 14.02%]

4. Determine the cost of equity shares of company X from the followingparticulars:

(i) Current market price of a share is Rs.140.

(ii) The underwriting cost per share on new shares is Rs. 5

(iii) The following are the dividends paid on the outstanding shares over the pastfive years:

Year Dividend per Share (Rs.)

1 10.50

2 11.00

2 12.50

3 12.60

4 13.40

(iv) The company has a fixed dividend payout ratio.

(v) Expected dividend on the new shares at the end of 1st year is Rs. 14.10 pershare.

[Ans: 15.44%.]

SUGGESTED READINGS

1. Chakraborthi, S.K. : Corporate Capital Structure and Cost of Capital, New Delhi,Vikas Publishing House.

2. Chandra, Prasanna : Fundamentals of Financial Management, New Delhi, TataMcGraw Hill Co.

3. Khan, M.Y. and Jain, P.K. : Financial Management, New Delhi, Tata McGraw HillCo.

4. Pandey, I.M, : Capital Structure and Cost of Capital, New Delhi, Vikas PublishingHouse

- End of Chapter -

LESSON-11

CAPITAL STRUCTURE PLANNING

Learning Objectives


· Understand the terms like Financial structure, Asset structure and Capitalstructure

· List out the advantages and disadvantages of equity and debentures· Identify the characteristics of sound capital structure· Explain capital-gearing

Lesson Outline

· Financial Structure and Capital Structure· Equity, Preference and Debentures· Characteristics of sound capital structure· Capital gearing concept· Illustrative Examples

The term 'Financial Structure' refers to total liabilities while 'Assets Structure' refers tototal assets. Having determined the finance required for a project to be undertaken, thequestion arises what shall be the sources of finance, i.e., what are the securities to beissued, and what shall be the proportion of various securities. Deciding the proportion ofsecurities is deciding capital structure. Thus, capital structure refers to the proportion ofequity capital, preference capital, reserves, debentures, and other long term debts to thetotal capitalisation. Capital structure decision is not taken only when starting anenterprise. In the beginning the entrepreneur may decide a 'target capital structure'. Butthe capital structure decisions are made whenever additional finances are to be raised.Capital structure planning is a very important part of the financial planning, as it playsan important role in minimising the cost of funds.

According to Gerestenberg, Capital structure of a company refers to the make-up of itscapitalisation and it includes all long term capital resources viz. shares, loans, reserves,and bonds. While drafting a capital structure, care must be taken to see that it is flexiblei.e., it should be able to incorporate any future changes, if necessary. It is oftensuggested that a capital structure should be such which can maximise the long run value

per ordinary share in the market; for an individual company, there is necessity forattaining a proper balance among debt and equity sources in its capital structure.

Forms of Capital Structure

(1) Equities only : Under this form, the entire capital is raised from shareholders andthere is only one class of share known as Equities.

Advantages

(a) There are no fixed charges, dividends, etc, on the borrowings.

(b) The management can deal with the earnings as per their wish.

(c) No compulsion for directors to return the equity capital.

(d) Better public response as equity shares are cheap.

(e) If additional capital is needed, it can be readily arranged for by issuingsome more shares.

Disadvantages

(a) Over-subscription and over-capitalisation may take place if only equityshares are issued.

(b) Too much increase in the value of shares may lead to speculation.

(2) Equities and Preference Shares : Under this form, the capital structure ofcompany consists of mixture of equity and preference shares.

Advantages

(a) The market for the company’s securities is widened.

(b) The capital structure no longer remains rigid, but instead it becomeselastic.

(c) Use of preference shares enables the company to arrange for additionalfunds more easily.

Disadvantages

(a) The company’s liability is increased since a fixed rate of preferencedividend has to be paid regularly to preference shareholders.

(b) It usually costs more to finance with preference shares than withdebentures.

(3) Equities, Preference Shares and Debentures

In this form, the capital structure of a company is made up of equity shares, preferenceshares and debentures.

Advantages

(a) Financing with debentures is usually cheaper than financing with shares.

(b) It is advantageous for tax purposes because interest on debenture istreated as an expenditure unlike payment of dividend.

(c) The company gains by trading on equity.

Disadvantages

(a) Payment of interest on debentures during depression may prove difficultfor the company.

(b) Trading on equity may give rise to more losses during depression.

Every finance manager aims at developing a sound and most appropriate capitalstructure for the company. But can there be an optimum capital structure? There isdiversity of opinion on this point. Generally speaking a sound or optimum capitalstructure is one, which:

(i) maximises the worth or value of the concern,

(ii) minimises the cost of funds,

(iii) maximises the benefits to the shareholders by giving best earning per share andmaximum market price of the shares in the long run, and

(iv) is fair to employees, creditors and others.

There is no hypothesis which can determine the precise optimum capital structure. Inpractice, an optimum capital structure can be determined only empirically.

It is better to determine a range of proportion of debt and equity, which could be termedas an appropriate capital structure rather than a precise ratio.


Characteristics of Sound Capital Structure

(1) Simplicity : A complicated capital structure may not be understood by all, on thecontrary it may raise suspicions and create confusion. A capital structure must be assimple as possible. At least in the beginning the concern shall resort to minimumnumber of securities as a source of finance, only then the investors will respond quickly.

(2) Profitability : As already emphasised a sound capital structure shall be able tomaximise the profit and minimise the cost of funds.

(3) Solvency : Creditors and bankers are usually fair-weather friends. They extendcredit during prosperity of business. In difficult financial position they tend to withdrawthe credit. Thus, the excessive use of credit, may threaten the solvency of the concern. Ina sound capital structure debt shall only be a reasonable proportion of the total capitalemployed in the business.

(4) Flexibility : A sound capital structure shall keep room for expansion or reductionof capital. Usually the increase in capital is not a problem but reduction of capital is verydifficult. Equity capital is considered to be something sacred which cannot be reducedexcept in accordance with the provisions of Companies Act, 1956. Flexibility can beintroduced into capital structure by opting for redeemable preference shares orredeemable debentures as one of the securities to be issued for raising finance.

(5) Intensive use of funds : A sound capital structure shall provide the concern withsufficient funds needed for operations. It shall not cause surplus or scarcity of capital, asboth have adverse effect on the profitably. Fair capitalisation shall be a naturalconsequence of capital structure.

(6) Conservation : The capital structure shall be conservative in the sense that thedebt raising capacity of the concern shall not be exceeded. Capital structure shallgenerate sufficient cash for future requirements but shall not lead to excessive cash withthe company.

(7) Provision for meeting future contingencies : A business is bound to have upsand downs. It is inevitable because of the trade cycles. In the period of depression, it willbe difficult to raise funds. Such future contingencies shall be anticipated and capital

structure shall make provision for such contingencies. Making provision forcontingencies does not mean raising excessive capital when the market is favourable butkeeping less risky securities reserved for future issues.

(8) Control : The sound capital structure ensures that the control over the companyremains in the hands of equity shareholders.

(9) Economy : Having raised the capital, it has to be maintained. The total cost ofmaintaining the different securities issued shall be kept to minimum. Subject to otherconstraints, the capital structure selected shall be the most economical.

CAPITAL GEARING

The term "capital gearin"” is used to describe the relationship between the equity sharecapital (including all reserves and undistributed profits) and fixed interest/ dividendbearing securities of company. Fixed interest/dividend bearing securities are preferenceshares, debentures, public deposits, term loans etc. Such sources are known as fixed costsecurities or senior securities.

Equity Capital

Capital Gearing = -------------------------

Fixed cost securities

Gearing is said to be high if capital carrying fixed rate of interest/dividend is more thanthe equity capital. Similarly, gearing is low if capital carrying fixed rate ofinterest/dividend is less than the equity capital. When both the capitals are equal it issaid to be evenly geared. Thus, the gearing is in inverse ratio to the equity share capital.That is to say,

High Gear = Low equity share capital; Low Gear = High equity share capital

The capital gearing also reveals the suitability, or otherwise of the company’scapitalisation, that is to say,

Equity capital > Loan capital = Over-capitalisation = Low gearing equity capital

Equity capital = Loan capital = Optimum capitalization = Even gear

Whether or not high gear ratio is good for the enterprise will depend upon itsprofitability trend. Thus if the company can foresee a trend of continuous increase,relatively more and more profit will be available to equity shareholders as compared topreference shareholders and debenture holders. In such a case high gearing would bebetter.

Capital gearing may be planned or may be historical, the latter describing a state ofaffairs where the capital structure has been evolved over a period of time, but notnecessarily in the most advantageous way. Capital gearing ratio is not only important toprospective investors but also to the company because it affects distribution policies, thebuilding up of reserves as well as a stable dividend policy Hence, it must be properlyplanned.

The significance of the gear-ratio lies in the marked effects of variations in profit onequity share dividends when capital is high-geared; the effects are much more markedthan when capital is low-geared, as the following table shows:

-----------------------------------------------------------------------------------------------

Distribution of Profits

------------------------------------------------------------

Capital Structure Rs 1,60,000 Rs 1,82,000 Rs 1,50,000

-----------------------------------------------------------------------------------------------

(A) High Geared

Rs 6,00,000 Debentures (13%) 78,000 78,000 78,000

Rs 5,00,000 Preference shares(12%) 60,000 60,000 60,000

Rs 2,00,000 Equity shares 22,000 44,000 12,000

(11%) (22%) (6%)

-----------------------------------------------------------------------------------------------

(B) Low Geared

Rs 1,20,000 Debentures (13%) 15,600 15,600 15,600

Rs 1,80,000 Preference shares (12%) 21,600 21,600 21,600

Rs 10,00,000 Equity shares 1,22,800 1,44,800 12,800

(12.3%) (14.5%) (11.3%)

-----------------------------------------------------------------------------------------------

The increase in distributable profits from Rs. 1,60,000 to Rs. 1,82,000 raises the rates ofpossible dividend on the equity shares. High geared capital, from 11 % to 22%, anincrease of 105%. Low geared capital, from 12.3% to 14.5%, an increase of just over 18%.

A decrease in profits, from Rs. 1,60,000 to Rs. 1,50,000 reduces the rate of dividend.High geared capital, from 11% to 6% - a decrease of 50%. Low geared capital, from 12.3%to 11.3% - a decrease of just over 8%

Movements in equity dividend rates are thus, much wider when the capital is high-geared than when it is low-geared; and the equity shares with high geared capital areinclined to be speculative in consequence. In times of prosperity the speculative investorwill naturally tend to look for shares in companies with high geared capital, and in timeof recession to companies whose capital is low geared. The policy of using fixed costsecurities (debt capital including preference share capital) in the capital structure issimply known as the policy of “Trading on Equity”. That is to ‘trade’ on the strength ofthe equity (shareholders).

Trading on equity may be of two types :

(i) Trading on thick equity meaning low-geared capital structure and

(ii) Trading on thin equity meaning high-geared capital structure.

Conditions for Trading on Equity

The following are the important requirements or conditions for the successful operationof this policy:

(1) Stable Earnings : The permanent or long term borrowing should be undertakenonly when a reasonable stability of income makes the required payment of interest tothe debenture holders fairly certain. A company whose earnings are reasonably stablemay be justified in trading on equity. But if the earnings are subjected to violentfluctuations borrowings should be resorted to a limited scale.

(2) Large Investment in Fixed Assets : Large amounts of fixed property constitutea valuable adjunct for borrowing money, since they give the lender a feeling of securityand an assurance that the company will not vanish overnight. Generally, stable earningand large fixed assets accompany each other. The public utility services provide suchunique combination; hence, they are in a position to benefit from this policy.

(3) Well Defined and Established Field of Enterprise : Third requirement forsatisfactory trading on the equity is that the field of enterprise be well defined andestablished. The new and untried ventures should be invariably financed with the equityshares.

(4) Cost of Borrowings : The next condition on this policy is the increasing cost ofborrowings. As the proportion of funds borrowed from debentures increases increased

investment risk tends to increase the rate of interest to be paid. But this check isoperative in a perfect money market only where tenders are thoroughly competent tomeasure the risks involved,

(5) Custom or Usage : The next important restriction on this policy is of a practicalcharacter. It is the custom or usage of the industry concerned which builds up thegeneral standard beyond which neither issuing company nor the purchasing institutionswould like to go. Although custom will neither gain universal observance nor guaranteecertain safety, it nevertheless plays an extremely useful part in the world of finance.

Factors Determining the Pattern of Capital Gearing (Capital Structure)

1. Trading on Equity : Classified into two broad categories viz. (i) Internal factors and(ii) External factors. Internal factors include 'trading on equity' which means takingadvantage of equity share capital to borrowed funds on reasonable basis. It refers to theadditional profits that equity shares earn because of issuing other forms of securities,viz., preference shares and debentures. It is based on the theory that if the rate ofinterest on borrowed capital and the rate of dividend on preference capital which arefixed, is lower than the general rate of the company’s earning, the equity shareholderswill get advantages in the form of additional profits as dividends.

2. Idea of Retaining Control : If the promoters want to retain effective control of thecompany, they may raise funds from the general public by the issue of debentures andpreference shares. Debenture holders and preference shareholders are usually not giventhe voting rights enjoyed by the equity shareholders.

3. Flexibility of the Capital Structure : Elasticity or flexibility is an essential sinequa non of an ideal capital plan. From this point of view the capital structure should bedesigned in such a way that both (i) expansion and (ii) contraction of capital may bepossible. It requires the fixed charges of the company should be kept well within itsearning capacity so that the new issues of capital may be issued in the initial stage andbe reserved for emergencies and for expansion of the company.

4. The Cost of Financing : The cost of raising finance by tapping various sources offinance should be estimated carefully to decide which of the alternatives is the cheapest.Interest, dividends, underwriting commission, brokerage, stamp duty, listing chargesetc., constitute the cost of financing. Those securities which involve minimum costsshould be preferred. The corporation incurs the lowest expense in selling debenturesand highest in raising equity capital. The financial structure, therefore, should bejudiciously diversified with suitable mix as to minimise the aggregate cost of financing.

5. The Purpose of Financing : The funds may be required either for bettermentexpenditure or for some productive purposes. The betterment expenditure may be doneout of funds raised by share issues or still better out of retained earnings. Fundsrequired for expansion, purchase of new fixed assets etc., may be raised throughdebentures, if assets contribute to the earning capacity of the company.

6. Requirements of the Potential Investors : An ideal capital plan is that whichsuits to the requirements of different types of investors. The investors who care more forthe security of principal and stability of income usually go in for debentures. Thepreference shares have got a good appeal for those investors who want a higher andstable income with enough safety of investment. Ordinary shares are meant for thosewho want to take risk and participate in the management in order to have higher incomeas well as capital appreciation. The nominal value of the share should also be adjustedso As to secure subscription from the middle and lower classes of society.

7. Capital Market Conditions : The conditions prevailing in the money market alsoinfluence the determination of the securities to be issued. During periods of inflation,when people have plethora of funds, investors are ready to take risk and invest in equityshares. But during depression or deflationary periods, people prefer debentures andpreference shares which carry fixed rate of return. If, therefore, a company wants toraise more funds it must carefully watch the market sentiments, otherwise it will notsucceed in its plans.

8. Legal Requirements : Legal provisions regarding the issue of different securitiesshould be followed. Not all types of business may be subject to these legal provisions butfor some these do apply. In India banking companies are not allowed by the BankingRegulation Act 1949 to issue any type of securities except the equity share capital.

9. Period of Finance : When funds are required for permanent investment in acompany equity shares should be issued. But when funds are required to financeexpansion programme and the management of the company feels that it will be able toredeem the funds within the life time of the company, it may issue redeemablepreference shares and debentures or obtain long-term loans.

10. Nature and Size of Business : Nature of business of the company also counts indetermining the capital structure. Public utilities having assured market and freedomfrom competition and stability of income may find debentures as suitable medium offinancing. Manufacturing enterprises do not always enjoy these advantages, andtherefore, they have to rely, to greater extent, on equity share capital. Service andmerchandising enterprise having fewer fixed assets cannot afford to raise funds by long-term debentures because of their inability to offer their assets in mortgage for the loans.

11. Asset Structure : Composition and liquidity of asset may also influence the capitalstructure decision of the firm. Firms with long-lived assets, especially when demand foroutput is relatively assured - public utilities, for example-use long-term debt,extensively. Similarly, greater the liquidity the more debt that generally can be used, allother factors remaining constant. The less liquid the assets of firm, the less flexible firmcan be in meeting the fixed charges obligations.

12. Provision for Future : Financial planners always think of keeping their bestsecurity to the last instead of issuing all types of securities at one stretch.

Illustration 1

There are three companies namely A, B and C whose owned capital in each company isRs. 1,00,000. They earn Rs. 10,000 Rs. 15,000 and Rs. 8,000 respectively. Eachcompany is in need of Rs. 1,00,000 as additional capital and it is hoped that thecompany will be able to maintain the same rate of earnings. If they issue 14% debentureswhat will be the impact on equity?

Solution

Comments: The analysis shows that company A and C should not obtain its additionalfunds through 14% debentures. They should issue equity shares for additional funds.

Illustration 2

If a company has 30% debt and 70% equity and earns 25% on total capital before taxes,what is the percentage on equity, assuming it pays 15% for debt capital and taxes are50%?

Illustration 3

Kothari Oriental Leasing & Finance Company is a new firm that wishes to determine anappropriate capital structure. It can issue 8% debt and 6% preferred and has a 50% taxrate. The initial capitalisation of the firm will be Rs. 50 lakhs composed of Rs. 100 each.The possible capital structure is:

90,000

Illustration 4

The Indo- American Co. Ltd. had the following capital structure on December 31,1994:

Rs.

7% Debentures 12,00,000

8% Bank Loan (Long-term) 2,00,000

9% Preference Shares of Rs. 10 each 14,00,000

38,000 Equity Shares of Rs. 100 each 19,00,000

Retainedearnings 13,00.000

_____________

60,00,000

_____________

The present earnings before interest and taxes are Rs. 18,00,000. The company iscontemplating an expansion programme requiring an additional investment of Rs.10,00,000. It is hoped that the company will be able to maintain the same rate ofearnings. The company has the following alternatives:

(i) To issue debentures at 8%

(ii) To issue preference shares at 10%

(iii) To issue equity shares at a premium of Rs.10 per share.

Examine these alternatives in all their bearings and advise the company, (assumeincome tax rate at 55%)

Solution

Comparative Statement of EPS in Different Alternatives

-----------------------------------------------------------------------------------------------------------

Earnings per share III Alternative - II Alternative -I Alternative - at present (Rs.) Issue of

equity Issue of preference Issueof shares (Rs) shares @10%(Rs) debentures (Rs)

-----------------------------------------------------------------------------------------------------------

Total earnings (EBIT)

on present capitalof 9,00,000 9,00,000 9,00,000 9,00,000

Rs. 60,00,000

Total earnings on new

capital of Rs. 10,00,000 -- 1,50,000 1,50,000 1,50,000

at present rate*

-----------------------------------------------------------------------------------------------------------

Totalearnings 9,00,000 10,50,000 10,50,000 10,50,000

Less: Interest on bank

loan @ 8% Rs.16,000

interest on debenture - 1,00,000 - 1,00,000 - 1,00,000 - 1,00,000

@ 7% Rs.84,000

Less: Interest on

proposed debenture -- -- -- 80,000

under I Alternative @8%

-----------------------------------------------------------------------------------------------------------

Profit before tax(PBT) 8,00,000 9,50,000 9,50,000 8,70,000

Less: Tax @55% 4,40,000 5,22,500 5,22,500 4,78,500

-----------------------------------------------------------------------------------------------------------

Profit after tax(PAT) 3,60,000 4,27,500 4,27,500 3,91,500

Less: Dividend onexisting 1,26,000 1,26,000 1,26,000 1,26,000

preference shares @ 10%

Less: Dividend on proposed -- -- -- --

preference share @ 10%

Earnings forequity 2,34,000 3,01,500 2,01,500 2,65,500

shareholders

No. of equityshares 38,000 38,000 38,000 38,000

+ 16,667

= 54,667

Earning pershare 234000/38000 301500/54667 201500/38000 265500/38000

= 6.16 = 5.52 =5.30 =6.99

-----------------------------------------------------------------------------------------------------------

* Earning on Rs.60,00,000 capital = Rs.9,00,000

Earnings on additional Rs.10,00,000 = (9,00,000/60,00,000) x 10,00,000 = Rs.1,50,000

Present equity shares = 38,000

Add: New equity shares @ Rs 60 per share = Rs.10,00,000 / 60 = 16,667

Comments:

The present rate of earnings per share is Rs. 6.16. It will be in the interest of thecompany and the equity shareholders to raise additional amount of capital by issuing8% debentures, because, the earning per equity share will increase to Rs. 6.99 under thisalternative. Hence, the other two alternatives should be rejected as because the earningper equity share will be reduced to Rs. 5.30 and Rs. 5.52 respectively as compared to thepresent earning per share of Rs. 6.16.

REVIEW QUESTIONS

1. What do you understand by balanced capital structure? State its the characteristics.

2. Explain the considerations involved in evolving a balanced capital structure of acorporation.

3. What is an optimal capital structure? Why should a company aim at an optimalcapital structure?

4. Discuss the factors which enter into designing an ideal capital structure of a company.

5. Illustrate the meaning and significance of ‘gearing ratio’. What are the effects of highand low gearing on the financial position of a company during the various phases oftrade cycles?

6. ‘Trading on equity magnifies both profits as well as losses’. Explain.

7. ‘Trading on equity’ is conditioned primarily by the stability and certainty of earnings1.Discuss fully the above statement and explain the considerations involved in evolving abalanced capital structure for a corporation.

8. What restrictions have been placed on debt-equity ratio of companies by thegovernment of India and why? Discuss the advisability of keeping proper balancebetween debt and equity.

PRACTICAL PROBLEMS

Compute the average rate of return (after taxes) on the long term capital invested inthese two companies.

3. You are called upon to make a comparative assessment of the following three possiblepositions for a certain firm:

Position I Position II Position III

(Rs) (Rs) (Rs)

Debt 1,00,000 2,50,000 4,00,000

Equity 4,00,000 2,50,000 1,00,000

Total capital 5,00,000 5,00,000 5,00,000

(i) Calculate the debt-equity ratio.

(ii) Presuming that the rate of interest required to be paid on debt is 15%. Calculate the(maximum) rate of dividend payable to equity shareholders when the rate of earning is:

(a) 12% (under position I, II, and III)

(b) 16% (under position I, II, and III)

(c) 24% (under position I, II, and III)

SUGGESTED READINGS

1. Chandra, Prasanna: Fundamentals of financial Management, New Delhi, TataMcGraw Hill Co.

2. Pandey, l.M.: Financial Management, New Delhi, Vikas Publishing House.

3. Paul, S.K.R: Financial Management, Calcutta, New Central Book Agency.

4. Kulshrestha, R.S.: Financial Management, Agra, Sahitya Bhawan.

- End of Chapter -

LESSON -12

LEVERAGE IN CAPITAL STRUCTURE

Learning Objectives


· Understand the concept of leverage· Identify 'business risk' and 'financial risk'.· Explain and calculate financial and operating leverages· Examine the impact of leverages on E.P.S.

Lesson Outline

· Meaning of Leverage· Classification of Leverage - Financial Leverage - Operating Leverage - Combined

Leverage· Financial Leverage and Trading on Equity - Limiting Factors· Characteristics of Operating Leverage· Illustrative Examples

Cost structure, capital structure and asset structure are very important factors inmaximising earnings per share (EPS) or return on equity (ROE) of a company. Coststructure in terms of fixed and variable costs, gives rise to 'operating leverage' and the(optimal) capital structure, in terms of fixed cost and variable cost securities, to financialleverage. The optimal capital structure is the one that strikes a balance between theserisks and returns and thus maximises the price of the stock. The capital structuredecision is significant managerial decision which influences the shareholders return andrisk and ultimately the value of firm. Before discussing operating and financial leverageslet us consider the concept of leverage first.

Meaning of Leverage

The term 'leverage' has been borrowed from physical science where it refers to a device(lever) by which heavy objects (weights) are lifted with a small force. In businessparlance, it refers to the relationship between percentage changes in fixed cost and inearnings before interest and taxes (EBIT) viz. operating profit. Thus, leverage may bedefined as the employment of assets out of funds for which the firm pays a fixed cost orfixed return. The fixed cost or fixed return may be thought of as the fulcrum of a lever.When the revenues less variable costs (or earnings before interest and taxes) exceed thefixed cost or fixed return, positive favourable leverage results. When the operatingincome is less than the fixed cost or fixed return, the result is negative or unfavourableleverage.

Leverage belongs to the category of capital-gearing. This is an American term which hasapproximately the same meaning as "gearing". It is one of the important tools in thehands of corporate financial managers. If used judiciously it can maximise the return toequity shareholders.

Classification of Leverages

Leverage may be of five kinds:

(i) Return on Investment Leverage

(ii) Asset Leverage

(iii) Financial Leverage

(iv) Operating Leverage and

(v) Combined or Composite Leverage

(i) Return on Investment Leverage: It is an index of operational efficiency.

Sales EBIT EBIT

ROI Leverage = ----------------- x ------------- = ----------------

Total Assets Sales Total Assets

(ii) Assets Leverage: Assets turnover is the ratio of sales to total assets. Sales dividedby total assets aspect of ROI leverage is often referred to as Assets Leverage.

(iii) Financial Leverage: Financial Leverage (also known as Capital Leverage orCapital Structure Leverage) refers to the use of funds obtained by fixed cost securitiessuch as debentures, bonds, preference shares etc., in the hope of increasing the return toequity shareholders. It simply indicates the changes that take place in taxable income asa result of changes in operating income. It signifies the existence of fixed cost securitiesin the capital structure of a company. Debentures, bonds, preference shares etc., whoserates of interest or dividend as the case may be are prefixed and do not change with thelevel of profit. When in the capital structure of a company fixed cost securities aregreater as compared to equities the leverage factor or degree of leverage is said to belarge. That is a favourable or positive financial leverage which arises when the companyearns more from assets purchased with the funds (raised through fixed cost securities)than return or costs payable for the use of the funds. An unfavourable or negativefinancial leverage arises when the earnings from such assets are less than the fixed costpayable on such funds.

Financial Leverage causes change in the earnings before interest and taxes (totalearnings before interest and taxes may remain the same). When there is change inoperating profit there will be a sharp change (i.e., at a greater rate) in the Earnings per(Equity) Share (EPS). Increasing EPS is one of the reasons for higher market price ofshares. Thus, a favourable financial leverage causes the EPS to rise faster if other thingsremain the same.

By using an indifference chart, one can study the relationship between earnings beforeinterest and taxes (EBIT) and earnings per share under various alternative methods offinancing. The degree of sensitivity of earnings per share to EBIT is dependent upon theexplicit cost of the method of financing, the number of common stocks to be issued, andthe nearness to the indifference point. Although an EBIT-EPS chart is useful inanalysing the explicit cost of various methods of financing, it does not take into accountany implicit costs inherent in the use of a specific method of financing.

Percentage of change in EPS

Degree of Financial Leverage = --------------------------------------

Percentage of change in EBIT

Alternatively,

Operating Profits EBIT

Degree of Capital Structure Leverage = ----------------------- = -----------

EBFT - Interest EBT

Financial Leverage and Trading on Equity

Quite often the terms financial leverage and trading-on-equity are used inter-changeably. Although the concepts try to explain the impact on Return on Equity (ROE)of the capital structure there is a subtle difference between the two. As pointed by oneauthority on financial management, financial leverage explains the impact on EPS(ROE) of changes in operating profit, given the capital structure proportions of debt,preference and equity. Trading-on-equity, on the other hand, explains the impact ofROE of change in capital structure proportions, given the level of operating profit.

Financial Breakeven

Financial Breakeven is defined as the value of EBIT that makes EPS equal to zero. Atfinancial breakeven, the firm’s EBIT is just sufficient to cover its fixed financing costs(Interest and Preference dividend) on a before tax basis, leaving no earnings forcommon shareholders. Above the financial breakeven the EBIT the firm produces apositive level of earnings available to common shareholders and a positive EPS. Belowthis level, profit available to common shareholders and EPS are both negative. It is thuspossible for a firm to earn a positive level of EBIT even though its EPS is negative. Thiswill happen when the firm’s EBIT is positive but less than its financial breakeven level.If financial leverage is calculated at financial breakeven, the resulting coefficient offinancial leverage has an undefined value i.e., zero value.

Significance of Financial Leverage

Financial leverage is employed to plan the ratio between debt and equity so that earningper share is improved. Following is the significance of financial leverage:

(1) Planning of Capital Structure : The capital structure is concerned with theraising of long-term funds, both from shareholders and long-term creditors. Afinancial manager has to decide about the ratio between fixed cost funds andequity share capital. The effects of borrowing on cost of capital and financial riskhave to be discussed before selecting a final capital structure.

(2) Profit Planning : The earnings per share is affected by the degree offinancial leverage. If the profitability of the concern is increasing then fixed costfunds will help in increasing the availability of profits for equity stockholders.Therefore, financial leverage is important for profit planning. The levels of salesand resultant profitability are helpful in profit planning. An important tool ofprofit planning is break-even analysis. The concept of break-even analysis is usedto understand financial leverage. So financial leverage is very important for profitplanning.


Limiting Factors

Increased debt has a psychological impact on investors who consider investment in thecompany more risky. This financial risk offsets the increasing market price and bringsdown the price-earnings ratio (P/E). What should be the premium for this financial risk(known as implicit cost)? It will depend on the nature of the industry and the image ofthe organisation.

Another checking factor for this increase in market price of shares is the cash outflowover a period of time and limits the debt capacity of the firm. A large amount, ofborrowed capital will require increased cash inflows to meet the fixed charges of interestand repayment of principal. The inability to generate sufficient cash flows to meet the

fixed obligations may cause cash insolvency in the firm and thus put it in a higher risk-class. Even a possibility of cash inadequacy will increase the explicit cost of debt andthus bring down the rising trend of EPS and P/E ratio. While introducing leverage to geta higher EPS, cash budgets should be prepared so that the probability of being out ofcash with the increment of debt is negligible.

Another limiting factor on increased EPS due to financial leverage is the scarcity ofloanable funds at the prevailing rate of interest. The firm moves to a higher risk classand, therefore, a higher interest rate will be demanded. The rate of gains from leveragewill certainly be checked but not stopped till the marginal rate of interest is equal to theaverage cost of capital. When debts are not available at a reasonable rate of interest, it isa point of caution for the firm. The investors view the concern more risky and ultimatelybring down the P/E ratio. Risk is a dynamic condition and the position can be improvedby paying off debts from the surplus earnings, thus improving the debt-equity position.The optimum leverage situation will be the point where the marginal cost of debt isequal to the company’s average cost of capital.

With the introduction of financial leverage, the cost of debt remains fixed over a periodof time and, therefore, the weighted average cost of capital falls, which encourages thefirm to take up such projects as were previously above the cut-off rate. Expansion ofbusiness due to low cost of capital offers the advantage of growing bigger and strongerin a competitive market. The cost of equity automatically goes up which means a highermarket price for the shares.

Need for caution: From the above discussion, a few conclusions can be drawn forsuccessfully introducing financial leverage in a firm to maximise the wealth ofshareholders. Introduction of cheaper fixed costs funds rapidly increases the earningsper share, thereby pushing up the market price of the shares and boosting the firm'simage. Leverage also brings down the overall cost of capital and thus induces the firm toexpand and become stronger. But this tool must be used cautiously so that the debt isnot increased to the extent where the firm is put in a very high risk class offsetting thegains of leverage with a decrease in the Price-Earnings ratio.

Financial leverage can be harmful in the hands of a novice as over-enthusiasm to boostthe market price of the shares can lead to insolvency in adverse times if long-term cashbudgets with justifiable probability distribution are not prepared. The rate of gains ischecked by the demand for higher rate of interest due to increased risk in the firm, butthis should not be treated as a halting point as the situation can be improved by payingoff debts from surplus earnings and by following a low payout policy.

Illustration 1

A company has a choice of the following three financial plans. You are required tocalculate the financial leverage in each case and interpret it.

X Y Z

(Rs) (Rs) (Rs)

Equity Capital 2,000 1,000 3,000

Debt 2,000 3,000 1,000

Operating profit (EBIT) 400 400 400

Interest @ 10% on debt in all cases

Solution

The financial leverage will be computed as follows in each of these financial plans:

X Y Z

(Rs) (Rs) (Rs)

Operating Profit 400 400 400

Interest (10% on debt) 200 300 100

----------------------------------

Profit before tax (PBT) 200 100 300

----------------------------------

Financial leverage (OP / PBT) 400/200 400/100 400/300

= 2 = 4 =1.33

Financial leverage as explained earlier indicates the change that will take place in thetaxable income as a result of change in the operating income. For example, takingFinancial Pan X as the basis, if the operating profit decreases to Rs.200, its impact ontaxable income will be as follows:

Operating profit (OP or EBIT) Rs.200

Less: Interest Rs.200

Profit before Tax (PBT) Rs. 0

Financial leverage in case of Plan X is 2. It means that every 1% change in operatingprofit will result in 2% change in taxable profit. In the above case, operating profit has

decreased from Rs.400 to Rs.200 (50% decrease). As a result the taxable profit hasdecreased from Rs.200 to zero (100% decrease).

Illustration 2

A company has the following capital structure: Rs.

Equity share capital 1,00,000

10%Wreference share capital 1,00,000

8% Debentures 1,25,000

The present EBIT is Rs. 50,000. Calculate the financial leverage assuming that companyis in 50% tax bracket.

Solution

Rs.

Operating Profit 50,000

Less: Interest on debentures 10,000

Pref. dividend (pre-tax basis) 20,000 30,000

----------------

Profit before tax 20,000

----------------

Financial leverage = OP / PBT = 50,000 / 20,000 = 2.5

Illustration 3

The capital structure of a company consists of the following securities.

Rs.

10% Preference share capital 1 ,00,000

Equity share capital (Rs. 10 per share) 1,00,000

The amount of operating profit is Rs. 60,000. His company is in 50% tax bracket. Youare required to calculate the financial leverage of the company.

What would be new financial leverage if the operating profit increase to Rs. 90,000 andinterpret your results.

Solution

Computation of the Present Financial Leverage

Rs.

Operating profit (OP or EBIT) 60,000

Less: Preference dividend (after grossing up) 20,000

----------------

PBT 40,000

----------------

Present Financial Leverage = OP / PBT = 60,000 / 40,000 = 1.5

Computation of New Financial Leverage

Rs.

New Operating profit 90,000

Less: Preference dividend (after grossing up) 20,000

----------------

PBT 70,000

----------------

Present Financial Leverage = OP / PBT = 90,000 / 70,000 = 1.286

The existing financial leverage is 1.5. It means 1% change in operating profit (OP orEBIT) will cause 1.5% change in taxable profit (PBT) in the same direction. For example,in the present case operating profit has increased by 50% (i.e., from Rs.60,000 to Rs.90,000). This has resulted in 75% increase in the taxable profit (i.e., from Rs. 40.000 toRs. 70,000).

Operating Leverage

The concept of operating leverage was in fact originally developed for use in makingcapital budgeting decisions. Operating leverage may be defined as the tendency of theoperating profit to vary disproportionately with sales. The firm is said to have a highdegree of operating leverage if it employees a greater amount of fixed costs and asmaller amount of variable costs and vice versa. Operating leverage occurs where a firmhas fixed cost that must be met regardless of volume or value of output or sales. Thedegree of leverage depends on the amount of fixed costs. If fixed costs are high, even asmall decline in sales can lead to a large decline in operating income. If it employs morefixed expenses/costs in its production process, greater will be the degree of operatingleverage. A high degree of operating leverage, other things held constant, implies that arelatively small change of sales results in large change in operating income.

Higher fixed costs are generally associated with more highly automated capital intensivefirms and industries, the relationship between the changes in sales and the changes inoperating income. Operating leverage may be studied with the help of a break-evenchart or Cost-Volume-Profit analysis.

Firm A has a relatively small amount of fixed costs. Its variable cost line has a relativelysteep slope, indicating that its variable cost per unit is higher than those of other firms.Firm B as considered to have a normal amount of fixed costs, in its operations and it hasa higher breakeven point than that of Firm A. Firm C has the highest fixed costs of alland its break-even point is higher than either Firm A or Firm B. Once Firm C reaches itsbreak-even point, however, its operating profits rise faster than those of the other firms.

Firm A

Fig.12.1 Selling Price Rs. 2 per unit; Total Fixed Costs Rs. 20,000; Variable CostRs.1.50 per unit.

Firm B

Revenue

Fig.12.2 Selling Price Rs. 2 per unit; Total Fixed Costs Rs. 40,000; Variable CostRs.1.20 per unit.

Fig.12.3 Selling price Rs.2 per unit; Total Fixed Costs Rs.60,000; Variable costs Re.1per unit

_____________________________________________________________

Units sold Sales Operating costs Operating profit

Rs. Rs. Rs.

_____________________________________________________________

20,000 40,000 80,000 -40,000

40,000 80,000 1,00,000 -20,000

60,000 1,20,000 1,20,000 0

80,000 1,60,000 1,40,000 20,000

1,00,000 2,00,000 1,60,000 40,000

1,10,000 2,20,000 1,70,000 50,000

1,20,000 2,40,000 1,80,000 60,000

_____________________________________________________________

In general, higher a firm's operating leverage, the higher its business risk. If sale price,cost and the like are held constant but output varies, then the higher the degree ofoperating leverage, the greater is the degree of business risk. For most part, operatingleverage is determined by technology. Electrical utility firms, telephones, airlines, steelmills, chemical companies, cement companies etc. have heavy investments in fixedassets. This produces high fixed costs and operating leverage. Grocery/trading stores, onthe other hand, generally have significantly lower fixed costs, hence lower operatingleverage.

The degree of operating leverage can be measured with the help of the followingformula:

Percentage of change in sales volume Contribution

= ---------------------------------------- = ------------------ = C / EBIT

Percentage of change in income Operating Profit

Characteristics of Operating Leverage

(a) The degree of operating leverage depends upon the amount of fixed elements thecost structure. Operating leverage is a function of three factors (i) the amount of fixedcost, (ii) the contribution, and (iii) volume of sales.

(b) The concept of operating leverage cannot be applied at the Breakeven level, becausethe denominator (i.e., operating profit) becomes zero.

(c) The operating leverage is a number (integer or fraction) and if the activity isincreased by a stated percentage the operating profit will be increased by the product ofthat percentage and the operating leverage.

(d) The operating leverage decreases as the level of production or activity increases,provided that other things remain the same. So, near about the break even volume ofproduction or sales, a small increase in the level of activity gives rise to a rapid increasein profits. Companies acting just above the break-even capacity find it greatly profitableto increase the activity.

(e) For levels of activity below the Break-even level, operating leverage is negative. Inthat case it has to be interpreted that a given percentage increase or decrease in activitywill give rise to operating leverage limes that much percentage reduction or increase inlosses correspondingly.

(f) The operating leverage is the reciprocal (inverse) of the Margin of Safety. In view ofthe reciprocal relationship, the inference is that the higher the operating leverage, thelower will be the margin of safety and higher risk to the company.

Illustration 4

The installed capacity of a factory is 600 units. Actual capacity used is 400 units. Sellingprice per unit is Rs. 10. Variable cost is Rs. 6 per unit. Calculate the operating leveragein each of the following three situations:

1. When fixed costs are Rs. 400

2. When fixed costs are Rs. 1,000.

3. When fixed costs are Rs. 1,200.

The above example shows that the degree of operating leverage increases with everyincrease in share of fixed cost in the total cost structure of the firm. It shows, forexample, in Situation 3 that if sales increase by rupee one, the profit should increase byRs. 4. This can be verified by taking Situation 3 when sales increase to Rs. 8,000. Theprofit in such an event will be as follows:

Thus, the sales have increased from Rs. 4,000 to 8,000, i.e., a hundred percent increase.The operating profits have increased from 400 to Rs. 2,000, i.e., by Rs.1,600 (giving anincrease of 400 per cent). The operating leverage is 4 in case of Situation 3, whichindicates that with every increase of one rupee in sales, the profit will increase fourtimes. This has been verified by the above example where a hundred per cent increase insales has resulted in 400 per cent increase in profits. The degree of operating leveragemay, therefore, be put as follows:

Percentage change in operating income

------------------------------------------- = 400/100 = 4

Percentage change in Sales

As a matter of fact, operating leverage exists only when the quotient in the aboveequation exceeds one.

Composite or Combined or Total Leverage

Operating and Financial leverage combined themselves in a multiplicative form to bringabout a more proportionate change in EPS (ROE) for a given percentage change inactivity. This is because the dispersion and risk of possible earnings per share areincreased. The two types of leverages may be combined in different ways to obtain thedesired degree of overall leverage and risks, i.e., a compromise between the total riskand the expected return.

EBIT C C

------ x ------ = ------

EBT EBIT EBT

Overall Breakeven: Overall Breakeven is defined as the level of output that makesEPS equal to zero. At this level of output the combined or composite leverage has anundefined value i.e., zero value.

For both operating and financial leverage one can determine the degree of leverage. Inthe first case related the change in profits that accompanies a change in output; secondlythe change in earnings per share that accompanies a change in timings before interestand taxes. By combining the two formulae, one can determine effect of a change inoutput upon earnings per share.

The operating leverage and financial leverage are the two quantitative tools usedmeasure the returns to the owners viz., earnings per share (EPS) and market price of theoperating shares; of the two tools, financial leverage is considered to be superiorbecause it focuses attention on the market price of the share.

Between operating and financial leverage, operating leverage is less amenable tomanagerial control. This is so because operating leverage for a company is influenced byto a greater extent by the magnitude of fixed costs. But fixed costs are very much linkedto the nature of industry, choice of technology and the asset structure employed. Thusmanufacturing (capital-intensive) industries like cement, steel and heavy engineeringare likely to have higher fixed costs and a high operating leverage when compared to atrading industry. The super imposition of a high financial leverage on an already highoperating leverage will result in a higher combined leverage which is likely to expose thecompany to a greater risk and putting the interests of shareholders in danger.

From the above discussion it is evident that there is less scope to exercise greater controlin respect of operating leverage, one can exercise control in regulating the degree offinancial leverage. To sum up, companies having a high operating leverage should planfor a capital structure having more equity and less debt to bring down the combined

leverage to a reasonable level. Similarly, companies with a low operating leverage canbring up combined leverage to a more reasonable level by planning for a high financialleverage, thereby the management can secure for the shareholders the benefits ofleverage without exposing them to great risk.

Illustration 5

Calculate the Operating and Financial leverages from the following information:

Contribution

Operating leverage = ------------------ = 25,000 / 10,000 = 2.5

Operating Profit

Operating profit or EBIT

Financial leverage = -------------------------- = 10,000 / 5,000 = 2

Profit before tax

Note: Combined leverage = Operating leverage x Financial leverage = 2.5 x 2 = 5

Alternatively,

Contribution(C)

Combined leverage = ------------------------ = 25,000 / 5,000 = 5

Profit before tax (PBT)

Illustration 6

A firm has sales of Rs. 10,00,000 variable cost of Rs. 7,00,000, fixed costs of Rs.2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,financial and combined leverages?

If the firm wants to double up its Earnings Before Interest and Tax (EBIT), how much ofa rise in sales would be needed on a percentage basis?

Solution

Statement of Present Profit

Operating leverage = C / OP = 3,00,000 / 1,00,000 = 3

Financial leverage = OP / PBT = 1,00,000 / 50,000 = 6

Combined leverage = Operating leverage x Financial leverage = 3 x 2 = 6

or

Combined leverage = Contribution / PBT = 3,00,000 / 50,000 = 6

Statement of Sales needed to double EBIT

Operating leverage is 3 times i.e.331/3% increase in sales volume causes a 100% increasein operating profit or EBIT. Thus at the sales of Rs. 13,33,333, the operating profit orEBIT will become Rs. 2,00,000 (i.e. double the existing one).

Illustration 7

(a) Calculate (i) degree of Operating leverage, (ii) degree of Financial leverage and (iii)Combined leverage from the following data:

Sales of 1,00,000 units @ Rs. 2 per unit = Rs. 2,00,000

Variable cost per unit @ Re. 0.70

Fixed costs = Rs.1,00,000

Interest charges = Rs. 3,668

(b) Which combinations of operating and financial leverages constitute: (i) riskysituation and (ii) an ideal situation.

Solution

(a) (i) Operating leverage = C / OP = 1,30,000 / 30,000 = 4.33

(ii) Financial leverage = OP / PBT = 30,000 / 26,332 = 1.14

(iii) Combined leverage = Operating leverage x Financial leverage or C / PBT

= 4.33 x 1.14 or 1,30,000 / 26,332 = 4.9

(b) (i) High operating leverage combined with high financial leverage will constituterisky situation.

(ii) Normal Situation: ‘One should be high and another should be low’ i.e. if companyhas a low operating leverage, financial leverage can be higher and vice versa.

(iii) Ideal situation: Both should be low.

Illustration 8

Calculate the degree of operating leverage (DOL), degree of financial leverage (DFL) andthe degree of combined leverage (DCL) for the following firms and interpret the results:

Solution

Interpretation: High operating leverage combined with high financial leverage willconstitute risky situation. One should be high and another should be low. Low operatingleverage combined with low financial leverage will constitute an ideal situation. Hence,firm 'C' is an ideal one because it has low fixed cost and no interest P/V ratio also ishighest i.e., 80%.

REVIEW QUESTIONS

1. What is meant by the term 'Leverage'? What are its types? With what type of risk iseach leverage generally associated?

2. Why is increasing leverage also indicative of increasing risk? State the situation whenthere is neither a financial risk nor business risk.

3. What is meant by the concept 'Finance Risk'? What is the relationship betweenleverage and the cost of capital? Explain.

4. Why must the financial manager keep in mind the firm’s degree of financial leveragein evaluating various financial plans? When does financial leverage become favorable?

5. How does break-even analysis help in profit planning and capital structure planning?Explain with suitable illustrations.

6. Explain the significance of operating and financial leverage analysis for a financialexecutive in corporate profit and financial structure planning.

7. What is combined leverage? What does it measure? What would be the change in thedegree of combined leverage, assuming other things being equal, in each of the followingsituation? (a) the fixed cost increases, (b) the firm’s EBT level increases (c) the firmssales price decreases, (d) the firm’s variable cost per unit decreases.

8. What is the "indifference Point" and why is it so called? What is the usefulness of it incapital structure planning?

PRACTICAL PROBLEMS

1. The following information is available from the records of a company: Selling Price =Rs. 28 per unit. Variable Cost = Rs. 18 per unit. Breakeven point = 4,000 units. You arerequired to find out the degree of operating leverage for (i) 5,000 units of output, (ii)6,000 units of output and (iii) 8,000 units of output.

[Ans.: (i) 5 times or 500% (ii) 3 times or 300% (iii) 2 times or 200%]

2. Below is given the profitability statement of Kamath & Company Ltd. for the yearending 31st December, 1994:

From the above data, you are required to compute (i) Degree of Operating Leverage, (ii)Degree of Financial leverage, and (iii) Degree of Combined Leverage.

[Ans.: (i) 2.5 or 250% (ii) 1.6 or 160% (iii) 4 or 400%]

SUGGESTED READINGS

Pandey, I.M.: Financial Management, New Delhi, Vikas Publishing House.

Rathnam, P.V.: Financial Advisor, Allahabad, Kitab Mahal

Sharma R.K. & Gupta S.K: Financial Management, Ludhiana, Kalyani Publishers

- End of Chapter -

LESSON - 13

THEORIES OF CAPITAL STRUCTURE

Learning Objectives


· Know the different approaches to the problem of capital structure· Detail contention of the traditional approach and its limitations· Explain the M.M. Theory and offer criticisms to it.

Lesson Outline

· Traditional (Financial Structure) Theory - Assumptions - Limitations· Modigliani-Miller Theory - Assumptions - Limitations· Criticisms of M.M. Approach - Empirical Evidences· Illustrative Examples

A great deal of controversy has developed recently over whether the capital structure ofa firm, as determined by its financing decision, affects its cost of capital, owner's wealth,and society's wealth,

Theories of Capital Structure

Different theories have been propounded by different authors to explain the relationshipbetween capital structure, cost of capital and value of the firm. The main contributors tothe theories are Durand, Ezra Solomon, Modigliani and Miller. The important theoriesdiscussed below are:

(1) Net Income Approach

(2) Net Operating Income Approach

(3) The Traditional Approach

(4) Modigliani and Miller Approach

(1) Net Income Approach

According to this approach, a firm can minimise the weighted average cost of capital andincrease the value of the firm as well as market price of equity shares by using debtfinancing to the maximum possible extent. The theory propounds that a company canincrease its value and reduce the overall cost of capital by increasing the proportion ofdebt in its capital structure. This approach is based upon the following

assumptions :

(i) The cost of debt is less than the cost of equity.

(ii) There are no taxes.

(iii) The risk perception of investors is not changed by the use of debt.

The line of argument in favour of net income approach is that as the proportion of debtfinancing in capital structure increases the proportion of an expensive source of fundsincrease. This results in the decrease in overall (weighted average) cost of capital leadingto an increase in the value of the firm. The reasons for assuming cost of debt to be lessthan the cost of equity are that interest rates are usually lower than dividend rates dueto element of risk and the benefit of tax as the interest is deductible expense. This theoryis explained in the following illustration.

Illustration 1

(a) A company expects a net income of Rs. 80,000. It has Rs. 2,00,000, 8% Debentures.The equity capitalisation rate of the company is 10%. Calculate the value of the firm andoverall capitalisation rate according to the Net Income Approach (ignoring income-tax).

(b) If the debenture debt is increased to Rs. 3,00,000, what shall be the value of the firmand the overall capitalisation rate?

Solution

(a) Calculation of the value of the firm

Net Income Rs.80,000

Less: Interest on debentures (8% of 2,00,000) Rs.16,000

------------

Earnings available to equity shareholders Rs.64,000

------------

Market value of Equity x Equity capitalization rate = Shareholders' earnings

Market value of Equity = Shareholder's earnings / Equity capitalization rate

= 64,000 / 10% = 6,40,000

Market value of firm = Market value of equity + Market value of debentures = 6,40,000+ 2,00,000

= Rs.8,40,000

Calculation of overall capitalization rate

Overall cost of capital (Ke) = Earnings (EBIT) / Value of the firm (V)

= 80,000 / 8,40,000 = 0.0952 = 9.52%

(b) Calculation of the value of the firm if debentures debt is raised toRs.3,00,000

Net Income Rs.80,000

Less: Interest on debentures (8% of 3,00,000) Rs.24,000

------------

Earnings available to equity shareholders Rs.56,000

------------

Market value of Equity = 56,000 / 10% = 5,60,000

Market value of firm = Market value of equity + Market value of debentures = 5,60,000+ 3,00,000

= Rs.8,60,000

Calculation of overall capitalization rate

Overall cost of capital (Ke) = Earnings (EBIT) / Value of the firm (V)

= 80,000 / 8,60,000 = 0.093 = 9.30%

Thus, it is evident that with an increase in debt financing, the value of the firm hasincreased and the overall cost of capital has decreased.

(2) Net Operating Income Approach

This theory as suggested by Durand is another extreme of the effect of leverage on thevalue of the firm. It is diametrically opposite to the net income approach. According tothis approach, change in the capital structure of a company does not affect the marketvalue of the firm and the overall cost of capital remains constant irrespective of themethod of financing. It implies that the overall cost of capital remains the same whetherthe debt-equity mix 50:50 or 20:80 or 0:100. Thus, there is nothing as an optimalcapital structure and every capital structure is the optimum capital structure. Thistheory presumes that:

(i) the market capitalises the value of the firm as a whole;

(ii) the business risk remains constant at every level of debt-equity mix.

The reasons propounded for such assumptions are that the increased use of debtincreases the financial risk of the equity shareholders and hence the cost of equityincreases. On the other hand, the cost of debt remains constant with the increasingproportion of debt as the financial risk of the lenders is net affected. Thus, the advantageof using the cheaper source of funds, i.e., debt is exactly offset by the increased cost ofequity. Net income approach has been explained in illustration 2.

Illustration 2

(a) A company expects a net operating income of Rs. 1,00,000. It has Rs. 5,00,000, 6%Debentures. The overall capitalisation rate is 10%. Calculate the value of the firm andthe equity capitalisation rate (cost of equity) according to the Net Operating IncomeApproach.

(b) If the debenture debt is increased to Rs. 7,50,000 what will be the effect on the valueof the firm and the equity capitalisation rate?

Solution

(a)

Net Operating Income = Rs. 1,00,000

Overall Cost of Capital = 10%

Market value of the firm (V) = Net Operating Income (EBIT) / Overall Cost of Capital(Ke)

= 1,00,000 / 10%

= Rs.10,00,000

Less: Market value of debentures = Rs. 5,00,000

Market value of equity = Rs. 5,00,000

Earnings available to equityshareholders

Equity Capitalization Rate or Cost of Equity (Ke) = -------------------------------------------

Market value of equity

= (EBIT - I) / (V - B)

where

EBIT = Earnings before Interest and Tax,

V = Value of the firm,

B = Value of Debt capital (Bonds),

I = Interest on debt

Ke = (1,00,000 - 30,000) / (10,00,000 - 5,00,000) = 70,000 / 5,00,000 = 0.14 = 14%

(b) If the debenture debt is increased to Rs. 7,50,000, the value of the firm shall remainunchanged at Rs. 10,00,000. The equity capitalisation rate will increase as follows:

Equity Capitalisation Rate (Ke) = (EBIT - I) / (V - B)

= (1,00,000 - 45,000) / (10,00,000-7,50,000)

= 55,000 / 2,50,000 = 0.22 = 22%

(3) Traditional (Financial Structure Theory) Approach

The traditional approach asserts that the cost of capital is not independent of the capitalstructure of the firm and that there is an optimal capital structure. The contention of thetraditional school is that there are two types of risks, viz., Business Risk and FinancialRisk. While business risk (market fluctuations, availability of materials etc.,) will alwaysbe there more or less in the same measure. Financial risk keeps on increasing after acertain stage as more and more debt capital commitments are undertaken.

According to this school there is a correlation between the cost of capital (composite)and Debt-Equity Ratio. The relation between the two, when graphically expressed, takesthe form of an U-shaped curve. Cost of Capital will be very high if Debt/Equity ratio iszero. Upto a certain stage the weighted cost of capital will progressively come down withthe injection of debt element into the capital structure step by step. But after this lowest(optimum) point cost of capital will go up (e.g., higher rate of interest may have to beoffered to attract the subsequent debenture holders) along with further introduction ofdebt element.

Assumptions are:

(i) The capital structure of a company consists of only two kinds of capital, viz.,bonded debt and ordinary shares. This assumption is made for the sake of convenience.

(ii) The firm’s total financing remains constant. The firm can change its degree ofcapital leverage either by selling shares and use the proceeds to retire debentures orby raising more debt and reduce the equity capital.

(iii) The business risk of a company remains constant over time and assumed to be ofindependent of its capital structure and financial risk. This assumption is made with aview to focus attention exclusively on financial risk, associated with the capital structuredecision.

(iv) The firm’s total assets are given and do not change. The investment decisions are,in other words, assumed to be constant.

(v) Perpetual life of the firm.

(vi) The cost of debt capital remains the same irrespective of the amount of debtcapital introduced by a company into its capital structure. Though this assumption helpsto simplify the analysis but it is not realistic.

(vii) Corporate income-tax is assumed not to exist. While this assumption is notrealistic it is made with a view to consider whether debt capital proves more attractivethan equity capital even if the tax shield on interest expense is ignored.

(viii) The company follows a 100 per cent dividend pay-out policy. This assumptionis made with a view not to complicate the capital structure issue with the effect ofretained earnings and is consistent with assumptions and (x) given below.

(ix) A company is free to repurchase and cancel its ordinary shares. Thisassumption is made with a view to simplify the analysis by confining it to the situationwherein a company can change its debt-equity ratio without at the same time, changingits total assets. Thus, the debt-equity ratio can be increased by issuing bonds torepurchase and cancel shares of an equal amount; the ratio cap be decreased by issuingshares to retire debt.

(x) Transaction costs are assumed to be nil.

(xi) The operating income of a company is assumed not to grow over time. As thecompany’s total assets will not grow, and the depreciation amount is just sufficient tomeet normal replacement, it may not be unrealistic to assume rigidity in the operatingincome. This would also simplify the analysis.

(xii) All the investors are rational and have identical (subjective) probabilitydistributions of the future operating earnings of the company. This would simplify theanalysis as all the investors have identical views with regard to the future operatingincome of the company.

(xiii) The cost of equity capital is higher than the cost of debt capital. This is veryrealistic as shareholders’ risks are greater than the risks of long-term creditors.

The traditional position if financial structure is that a financing pattern which includes a‘moderate’ amount of debt would generally result in a least-cost financing solution. Tueargument generally advanced is that because moderate debt resulted in creditor claimsthat were quite safe, creditors were not likely to notice any change in the defaultpossibilities of their earnings within safe range. Further, increased debt in the capitalstructure did not cause creditor to experience any perceptible risk, and equityshareholders were also-assumed to be responsible. The predicted result was that acapital structure with some debt would result in lower cost of capital than a structurewith no debt. The traditional theory of financial structure fails to take into account theincreased financial risk arising out of debt after a ‘moderate’ point. Obviously, it willraise the cost of equity and hence the overall cost of capital (overall cost = cost of equity+ cost of debt). However, at optimal capital structure, the marginal real cost of debt isthe same as the marginal real cost of equity. For degrees of leverage before that point,the marginal real cost of debt is less than that of equity; beyond that point, the marginalreal cost of debt exceeds that of equity.

Thus the traditional position implies that the cost of capital is not independent of thecapital structure of the firm. The firm can increase the total value of the firm and bringcost of capital down through the judicious use of ‘leverage’.

Illustration 3

Compute the market value of the firm, value of shares and the average cost of capitalfrom the following information: Net operating Income Rs. 2,00,000; Total InvestmentRs. 10,00,000; Equity capitalisation rate

(a) 10%, if the firm uses no debt

(b) 11%, if the firm uses Rs. 4,00,000 debentures

(c) 13%, if the firm uses Rs. 6,00,000 debentures

Assume that Rs.,4,00,000 debentures can be raised at 5% rate of interest whereas Rs.6,00,000 debentures can be raised at 6% rate of interest.

Solution

Computation of market value of firm, value of shares & the average cost ofcapital

Earnings

Average Cost of Capital = ------------------- = EBIT / V

Value of the firm

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

= ------------ ------------- -----------

20,00,000 20,36,363 18,61,538

= 10% 9.8% 10.7%

It is clear from the above that if debt of Rs. 4,00,000 is used the value of the firmincreases and the overall cost of capital decreases. But if more debt is used to finance inthe place of equity, i.e., Rs. 6,00,000 debentures, the value of the firm decreases and theoverall cost of capital increases.

(4) Modigliani-Miller Approach

The Franco Modigliani and Merton H. Miller (M.M.) Approach on ‘Cost of Capital’suggests that there is no correlation between cost of capital and debt-equity ratio, i.e.,average cost of capital of any firm is independent of its capital structure and equal to thecapitalisation rate of pure equity stream of its class. This hypothesis explains that thevalue of the firm and cost of capital is same for all the firms irrespective of theproportion of debt included in a capital structure.

M.M. Theorem:

The market value of any firm is independent of its capital structure and is given bycapitalising its expected nature at the rate appropriate to its risk class. That is, if changesin capital structure do not affect a firm’s cashflows, the amount of debt used by the firmhas no impact on firm’s value. Since debt equity ratio has no effect on firm’s value, itfollows that capital structure decisions is irrelevant. The value of the firm is determinedby its cashflows. These cashflows are themselves a product of the productive assets thefirm. To change the value of the firm we must change the magnitude or the risk of thefirm’s cashflows.

In this simplified model, they abstract away the effect of any taxes. The crucial supportfor this hypothesis is the presence of arbitrage in the capital markets. Arbitrage refersto a practice of simultaneous purchase and sale of a security or currency in differentmarkets to derive benefits from price differential. Arbitrage precludes perfectsubstitutes from selling at different prices in the same market. In their case, the perfectsubstitutes are two or more firms.

The assumptions underlying this approach are :

(i) The average expected future net operating income is represented by a subjectiverandom variable and that all investors agree on the expected value of this probabilitydistribution.

(ii) All the firms can be placed in equivalent risk class, so that all firms in a class can betermed homogeneous.

(iii) Capital markets are perfect; information is perfect to all investors; investors arerational; and no information cost exists.

(iv) The corporate income-tax is absent.

(v) Personal or homemade and Corporate leverage are perfect substitutes.

(vi) Institutional investors are free to deal in securities.

(vii) There does not exist any transaction costs.

(viii) Rate of interest at which company and individuals could borrow is the same.

(ix) The dividend payout ratio is 100%.

When graphically expressed, the M.M. Position would be as follows :

Fig. 13.2 M.M. Approach to Cost of Capital and Capital Structure

The M.M. thesis accepts the inherent business risk, but rules out the existence oranything called financial risk. It also seeks to prove that the 'arbitrage' mechanism ironsout the apparent differences in cost of capital consequent upon the injection ofadditional debt.


Example:

Consider two firms that comprise a single risk class. These firms are identical in everyrespect that company A is not levered and company B has Rs. 30,000 of 5% bondsoutstanding. According to the traditional position, company B may have a higher totalvalue and lower average cost of capital than company A. The valuation of the firms isassumed to be the following:

M.M. approach maintains that this position cannot continue, for arbitrage will drive thetotal value of the two firms together. M.M. argues that investors in company B are ableto obtain the same return with no increase in financial risk by investing in company A.Moreover, they are able to do so with a smaller investment. These arbitrage transactionswould continue until the share prices of both firms come to be the same.

To illustrate, suppose that a rational investor owned 1 per cent of company B worth Rs.772.72 (market value). Given this situation, he should

(a) Sell his stock in company B for Rs. 772.72.

(b) Borrow Rs. 300 at 5 per cent interest.

(c) Buy 1 per cent of the shares of the company A, per Rs. 1,000.

Prior to this series of transactions, investor’s expected return on investment in companyB was 11 per cent on Rs. 772.72 investment on Rs. 85, Now his return in company A isRs. 100 (10 per cent on Rs. 1,000). From this return they must deduct Rs. 15 for interestcharge on his personal borrowings (5 per cent of Rs. 300). Thus this net return is Rs. 85.Thus his return in both the companies is same. Moreover his cash outlay of Rs. 700 isless than Rs. 772.72 investment in company B. Because of the lower investment theinvestor would prefer to invest in company A under the conditions described. Thisaction on the part of arbitragers would continue till the value of firms turn out to besame. As a result their average cost of capital also must be the same.

Illustration 4

A company has earnings before interest and taxes of Rs. 1,00,000. It expects a return onits investment at a rate of 12.5%. You are required to find out the total value of the firmaccording to the Modigliani-Miller theory.

Solution

According to the M.M. theory, total value of the firm remains constant. It does notchange with the change in capital structure.

Value of the firm (V) = Earnings (EBIT) / Overall cost of capital (Ke) = 1,00,000 / 12.5%

= Rs. 8,00,000

Illustration 5

There are two firms X and Y which are exactly identical except that X does not use anydebt in its financing, while Y has Rs. 1,00,000 at 5% debentures in its financing. Boththe firms have earnings before interest and tax of Rs. 25,000 and equity capitalisationrate is 10%. Assuming the corporation tax of 50%, calculate the value of the firm.

Solution

The market value of firm X which does not use any debt, Vx = EBIT / Ke = 25,000 / 10%

= Rs. 2,50,000

The market value of firm Y which uses debt financing, Vy = Rs.2,50,000+ 5 x 10,000

= Rs.3,00,000.

Criticisms of M.M. Approach

This approach has, however, been critisised. According to David Durand, personalleverage is not equivalent to corporate leverage. Due to capital marketimperfections, the cost of borrowings may be higher for individuals than for thecorporation. This proposition further concentrates on equilibrium state, which in actualpractice is unrealistic.

MM’s theory seems to have ignored the vital fact that business risk is a function ofthe degree of financial leverage. If a firm fails to service the debt during the loanperiods, it is very likely to collapse and will, therefore, not survive to reap the benefits ofleverage during the loan periods. Further, bank policy involves high costs and theprobability of the firm’s having to bear these costs tends to rise with leverage.

Another objection hurled against the MM’s proposition is that it is unrealistic to assumethat there is ‘no restriction on institutional investors in respect of theirdealing in securities’. In real life situations, funds that many institutional investorsare not allowed to engage in the ‘home made leverage’ that was described. Furthermore,the Reserve Bank of India regulates margin requirements in respect of different types ofloans and has stipulated the percentage of advances under a margin loan. As a result, asignificant number of investors cannot substitute personal for corporate leverage.

It is also unrealistic to presume that there are 'no transaction costs'. In actual practicesecurity dealers have to incur brokerage, underwriting commission and similar othercosts in buying and selling corporate securities. Consequently, effectiveness of thearbitrage mechanism may be impeded. Arbitrage will take place only up to the limitsimposed by transaction costs, after which it is no longer profitable. As a result theleveraged firm could have a slightly higher total value.

The assumption of ‘no corporate tax is basically wrong. Nowhere in the world corporateincome has been untaxed. As a matter of fact everywhere taxation laws have providedfor deductibility of interest payments of debt of calculating taxable income. If this is so,debt becomes relatively much cheaper means of financing and the financial manager isnaturally encouraged to employ leverage. For that very reason debt may be preferred topreferred stock. In view of this controversy, Modigliani and Miller in their subsequentpaper admitted that given the tax factor overall cost of capital can be lowered as moreleverage is inducted in capital structure of the firm. Consequently, the total market valueof the firm also increases with rising leverage.

To sum up, the Modigliani and Miller theory may be consistent with the assumption ofperfect competition. But since this assumption rarely holds in practice the financialmanager should, therefore, strive to achieve optimal capital structure. Butdetermination of optimal mix of debt in capital structure is not an easy matter. The mostdirect method is perhaps to let the firm’s lenders locate that point. In negotiating withthe firm seeking loan, the long-term lenders put restrictions as protective clause in loancovenant on the amount of additional debt the firm may acquire in future. The financialmanager may also detect the optimal point by noting, in course of negotiation for loan,reluctance of lenders to lend at the earlier rate of interest or without incorporatingadditional restrictions in the agreement. The market reaction to additional bond issuesbeing contemplated by the firm is manifested in share prices. Hence, optimal amount ofdebt can be located by studying behavioural changes in share prices in response to thetrends that additional debt financing by the firms is under consideration.

Empirical Studies of the Leverage Effect

The M.M. approach has been tested by several researchers, the most important of thembeing A. Barges, R.F. Wippern, L.V.N. Sarma and K.S. Hanumanta Rao.

Barge's Approach: A.Barges employed two approaches to test the validity of M.M.hypothesis. First was the relation between the average cost of capital and the degree ofleverage employed which was analysed by him. Secondly the relation between yield of

the share and the debt equity ratio was analysed. The tests indicated that the averagecosts had a tendency to decline and then to increase as leverage increased. His testsrevealed no significant correlation between equity shares yield, and debt equity ratio. Inthe result in his analysis his calculation was that the M.M. hypothesis appeared to beuntenable.

Wippens Approach: He made statistical analysis on the basis of data from a numberof manufacturing industries. He argues that the debt equity ratio contains conceptualbiases irrespective of the fact whether book value or the market value is used. His resultsrevealed an increasing relationship between equity yield and leverage linearly. But theratio of increase in yield was not as much as that supported by M.M. approach. Hisconclusion was in favour of the traditional approach in that share value can be increasedby the judicious use of debt financing.

Sarma and Rao's Approach: L.V.N.Sarma and K.S.Hanumanta Rao tested the M.M.hypothesis by taking samples from several engineering industries. As a result of theiranalysis, they got different results from those got by M.M, by investigating U.S. firms.They concluded that their analysis revealed evidence in support of the proposition thatthe value of the firm can be raised by a judicious use of leverage.

Reconciliation of the two Approaches:

A reconciliation between the two diametrically views has been made. The actual relationbetween cost of capital and debt-equity ratio has been accepted to be somewherebetween the two views as given below:

Fig. 13.3 Reconciliation of Traditional and M.M. Approaches.

Cost of capital will come down initially as debt element is progressively introduced froma zero-debt position. But after sometime and till a significant period in the life of the

company, cost of capital will not be influenced by debt equity ratio. This is representedby the long horizontal segment of the curve. After this long period, of course, furtherdebt element would increase the composite cost of capital. This (reconciliation)approach more or less represents the real situation.

REVIEW QUESTIONS

1. Explain "Net Income approach" to the problem of capital structure.

2. Explain "Net Operating Income Approach" as suggested by Durand to capitalstructure planning.

3. Explain briefly the view of traditional writers on the relationship between capitalstructure and the value of the firm.

4. Give a critical appraisal of the traditional approach and the Modigliani-MillerApproach to the problem of capital structure.

5. Is the M.M. thesis realistic with respect to capital structure and the value of a firm? Ifnot, what are its main weaknesses?

6. How can the effect of profitability on designing an appropriate capital structure beanalysed? Illustrate your answer with the help of EBIT-EPS analysis.

7. "The total value of a firm remains unchanged regardless of variations in its financingmix". Discuss this statement and point out the role of arbitraging and homemadeleverage.

SUGGESTED READINGS

1. Pandey, I.M: Financial Management New Delhi, Vikas Publishing House.

2. Rathnam.P.V.: Financial Advisor, Allahabad, Kitab Mahal.

3. Sharma R.K. & Gupta S.K : Financial Management, Ludhiana, Kalyani Publishers.

- End of Chapter -

LESSON - 14

EQUITY AND PREFERENCE SHARES

Learning Objectives


· Understand the features of equity shares· Evaluate equity shares as a source of finance.· Explain Right shares, bonus shares· Know the different kinds of preference shares· Evaluate preference shares as a source of finance

Lesson Outline

· Features of Equity Shares· Evaluation of Equity Shares as a source of finance· No-par Shares - Right Shares - Bonus Shares· Preference Shares· Evaluation of Preference Shares as a source of finance· Guidelines for issuing CCP shares

The equity share capital is the backbone of any company's financial structure. The word'equity' means the ownership interest as measured by capital, reserves-and surplus. Thisterm is also used to refer to the unlimited interest of ordinary shareholders. Hence,ordinary shares are often called 'equities'.

Features of Equity Shares

(1) Risk Capital: Equity shareholders have an unlimited interest in the company'sprofits and assets. They are, in effect, the owners of the business. They provided the so-called 'risk' or 'venture' capital of the company. In short, their prospects rise or fall withthe prosperity of their company and with the state of business conditions in general.

(2) Fluctuating Dividend: If the profits arc substantial, they may get good dividend;if not, there may be little or no dividend, Thus, their return of income, i.e., dividend is offluctuating character and its magnitude directly depends upon the amount of profitmade by a company in a particular year.

(3) Changing Market Value: The par or paid up value of the equity share has norelation to its market value. The former is fixed while the latter, i.e., the market value ofordinary shares, depends mainly on the profit by the company. The market value isdetermined by buyers and sellers who take into account earning dividends, prospects,the quality and caliber of management and general business outlook.

(4) Growth Prospects: Equity share of a company may also act as 'growth' share i.e.,with prospects for future growth in case the company over a period of has good scope forquick expansion. Such, shares enjoy considerable of capital appreciation within 5 to 10years.

(5) Protection against Inflation: Equity shares represent the best hedging orinsurance device, fully protecting investors against rising prices and against diminishingpurchasing power of the currency. Investments in fixed income securities such asgovernment security, debenture and preference shares are poor hedges in aninflationary period.

(6) Voting Right: Equity shareholder enjoys a statutory right to vote in the generalmeeting and thus exercise his voice in the management and affairs of his company. He isalso entitled to appoint a proxy to vote on his behalf and a proxy need not be a member.His voting right is governed by the Articles but it must be in proportion to the amountpaid-up on shares. Usually one share one vote is the rule.

Evaluation of Equity Shares as a Source of Finance

While evaluating the potentialities of this source of finance, attention should be paidboth to its positive and negative aspects. From the Company's view point: (1) equityshares are the most potent source of financing. Although a company may issue sharesunder other circumstances, the main advantage of equity shares is that it provides a wayof raising funds for the company with no fixed commitment charges attached to it; (b)Equity stock also facilitates the company to take benefits of leverage by taking debtcapital which is cheaper; (c) Equity shares do not create any charge on the assets of thecompany and the assets may be used as security for further financing. All thisstrengthens the credit of the company.

From investor’s viewpoint equity ownership gives the shareholders (i) an opportunity toshare in the profits when declared as dividends, (ii) an opportunity to make money onappreciation in the value of the securities, (iii) to participate in Rights share issue orbonus share issue, and (iv) the opportunity to vote for directors of the corporation. It isespecially important that the motives of investors be understood by those interested infinancial management because the securities must be made attractive to investors.

The above discussion of equity shares as a method of raising finance clearly brings out aseries of perquisites conferred on the company and shareholders. It must not, however,be inferred that equity shares are free of limitations. In fact, the following problemsbecome apparent when one analyses the nature of equity shares: (a) the issuing of equitycapital causes dilution of control by the equity holders, (b) The exclusive use of equityshares as a fund-raising device by the management deprives it from trading on equitywhich results in losing opportunity of using cheap borrowed capital, (c) Also, theexcessive use of equity shares is likely to result in over-capitalisation with all itsattendant consequences, (d) It attracts only those classes of investors who can take risk.Conservative and cautious investors (both individual and institutional) find it difficult tosubscribe for such issues.

No-par Shares

In the U.S.A. and Canada, many companies issue shares which have no-par or facevalue. The total owned capital of the company is divided into a certain number of shares.The share certificate merely states the number of shares held by a particular holder anddoes not mention the face value of the share. The dividends on such shares are paid atthe rate of given amount per share instead of a certain percentage of the par value ofeach share. Such shares cannot be issued in India, because the law requires every shareto have fixed nominal value. In the U.K., the Gedge Committee recommended that thecompany law should allow companies to convert their ordinary shares having nominalvalue into no par value shares.

The advantages usually claimed for such shares are:

(a) the balance sheet presents a realistic picture with such shares because the capital isequal to the net worth (assets minus external liability) and is not an imaginary amountas with shares of nominal value.

(b) Since the value of such shares is related to the earnings, the shareholders alwaysknow the real value of their holdings.

(c) The shareholders are not liable to pay further calls because the total value of a no-parshare is collected in the beginning.

(d) The shares need not be marketed at a discount because there is no minimum jarvalue of these shares. This avoids a lot of legal formality.

(e) Since the value of the shares is automatically adjusted with the earning capacity, noreduction of capital is necessary.

On the contrary, the no-par value shares suffer from the following drawbacks:

(a) The no-par value shares may easily be used to deceive ignorant investors. In case ofsuch shares there is no standard by which fluctuations in share values can beascertained.

(b) Such shares make the balance sheet unduly complex and difficult to understand.This makes the task of investors, creditors and tax authorities difficult.

(c) Unscrupulous management gets an opportunity to manipulate the sale proceeds ofshares and pay dividend out of capital.

(d) The creditors lose the additional security of uncalled capital which they get in case ofpartly paid shares with par value.

(e) Since the capital account remains fluctuating from time to time, the promoters maysnatch unduly high amounts of remuneration for themselves.

Right Shares

Whenever an existing company wants to issue new equity shares, the existingshareholders will be potential buyers of these shares. Generally, the Articles orMemorandum of Association of the company gives the right to existing shareholder toparticipate in the new equity issues of the company. This right is known as pre-emptiveright and such offered shares are called Right shares or Right Issue or 'PrivilegedSubscription'. The term simply indicates the fact that such shares will be first offered tothe existing shareholders.

Under Section 81 of the Companies Act, 1956 where at any time after the expiry of twoyears from the formation of a company or at any time after the expiry of one year fromthe allotment of shares being made for the first time after its formation, whichever isearlier, it is proposed to increase the subscribed capital of the company by allotment offurther shares, then such further shares shall be offered to the persons who, at the dateof the offer, are holders of the equity shares of the company, in proportion as nearly ascircumstances admit, to the capital paid on those shares at that date. Thus, the existingshareholders have a pre-emptive right to subscribe to the new issues made by acompany. This right has at its root in the doctrine that each shareholder is entitled toparticipate in any further issue of capital by the company equally, so that his interest: inthe company is not diluted.

Right Issue and Financial Policy

The issue of right shares always affects financial policy of the company as well as themarket. Some of the important ways in which financial policy is affected are givenbelow.

(i) When the right shares at low price available then share market of the existing sharesmight be adversely influenced.

(ii) When the right shares at low-price are available then the potential investors mightfeel tempted to invest money thereby the finances of the business can become sound.

(iii) Financial Policy will be unfavourably influenced in case right shares are offered toexisting shareholders much above their purchasing capacity.

(iv) When new shares have been added then less dividend will be paid and that willadversely affect the business.

Whenever right shares are offered it is essential to review the market trends andearnings position of the company so as to know how the shares are being traded in thestock market. While fixing the price of the right shares, the following facts will have 1.0be taken into consideration: (i) the price what the market can bear, (ii) state of thecapital market, (iii) trends in share market, (iv) profit earning capacity of the existingshares, (v) the proposed plan of expansion, (vi) dividend policy of the company, (vii)

resource position of the enterprise, (viii) reserves position of the company, and (xi) thesize of the right issue.

Advantages of Right Issue

(a) Right issue gives the existing shareholders and opportunity for the protection oftheir pro-rata share in the earning and surplus of the company,

(b) Existing shareholders can also maintain their proportion in the voting power asbefore.

(c) There is more certainty of the shares being sold to the existing shareholders. If aright issue is successful it is equal to favourable image and evaluation of the company’sgoodwill in the minds of the existing shareholders;

(d) The flotation costs of a right issue will be comparatively lower than a public issue.The expenses to be incurred, otherwise of shares are offered to public, are avoided.

Illustration 1

A corporation earns Rs. 80 lakhs after tax and has 18 lakh shares of Rs. 10 eachoutstanding. The market price of a share is 25 times the EPS. The corporation plans 10raise Rs. 180 lakhs of new equity funds through a rights offering and decides to sell thenew stock to shareholders at a subscription price of Rs. 60 per share. The financialposition before the company offers the right shares is as given below:

Balance Sheet as on.

(in Rs. Lakhs)

-------------------------------------------------------------------------

Liabilites Assets

-------------------------------------------------------------------------

Debentures @ 10% 800

Common Stock 200 Total Assets 2,000

Retained Earnings 1,000

----------- --------

Total 2,000 2,000

-------------------------------------------------------------------------

(i) How many rights will be required to purchase a share of the newly-issued stock?

(ii) What is the value of each rights?

(iii) What effect will the rights offering have on the price of the existing stock?

Solution

The corporation desires to raise Rs. 200 lakhs of new equity funds through a rightsoffering. For this purpose, it will have to issue 3 lakhs of new shares to existingstockholders.

New Equity Funds 1,80,00,000

----------------------------- = ------------------- = 3,00,000

Subscription price of a share 60

The outstanding stock of the corporation is 18 lakh shares. There are, therefore, 18 lakhrights, as one share has one right. Hence,

(i) To purchase a share of the newly issued stock, 18,00,000 / 3,00,000 = 6 rights willbe required.

(ii) The value of each right

Mo - S 80 - 60

R = ------------- = ---------- = 20 / 7 = Rs. 2.86

N + 1 6 + 1

(iii) The stockholder has the choice of exercising his rights of selling them. If he hassufficient funds, and if he wants to buy more shares of the company's stock, he willexercise the rights. If he does not have the money, or does not want to buy more stock,he will sell his rights. In either case, the stockholder will neither benefit nor lose by therights offering. This can be illustrated further. Suppose, a shareholder has 12 shares. Aseach share has a market value of Rs. 80 per share, the stockholder has a total marketvalue of Rs. 960 in the company’s stock. If he exercises his rights, he will be able topurchase two additional shares (one share for 6 rights) at Rs. 60 each.

His new investment will thus amount to Rs. 960 + (60 x 2) = Rs. 1,080.

He now owns 12 shares of his company's stock which, after the rights offering have avalue of Rs. 1080 / (12+2)

= Rs.77.14

The value of his stock is Rs. 1,080, that is to say, exactly what he has invested in it.Alternatively, if he sold his 12 rights, which have a value of Rs. 2.86 each as shown in (ii)above, he would receive Rs. 34.32. He would now have his original 12 shares of stock,plus Rs. 34.32 in cash. His original 12 shares of stock now have a market value of Rs.77.14 each Rs.925.68 market value (77.14 x 12 = 925.68) of his stock plus Rs.34.32 incash is the same as the original Rs. 960 market value of stock with which he began (80 x12 = 960). From a purely mechanical or arithmetical point, the stockholder neitherbenefits nor gains from the sale of additional shares of stock through rights. Of course, ifhe forgoes to exercise or sell his rights, or if the brokerage costs of selling the rights areexcessive, he may suffer a loss. But, in general, the issuing corporation would makespecial efforts to minimise the brokerage costs; and adequate time is given to enable thestockholder to take some action so that his losses are minimal.

Illustration 2

A company plans to issue common stock by privileged subscription. Twenty four rightsare needed to get one additional share of stock. The corporation declares thesubscription price at Rs. 9 against the current market price of Rs. 11 per share. You arerequired to find out:

(a) The market value of one right when stock is selling rights;

(b) The market price of the stock when the stock goes ex-rights;

(c) The market value of a right when the stock sells ex-rights; and

(d) The value of one share of ex-rights stock, if only 5 rights are needed to get oneadditional share of stock.

Solution

(a) The market value of one right, when the stock is selling rights on, is calculated bythe following formula:

Me - S

R = -----------

N

where Me is the rights on market price of outstanding stock;

S is the subscription price of the new stock;

N is the number of rights needed to purchase one new share.

In the above example,

R = (11 - 9) / 25 = 2/25 = Re. 0.08 = 8 paise

(b) The market price of the stock trading ex-right is computed by the following formula:

Me = Mo - R

where, Me is the market value of the stock trading ex-rights;

Mo is the market value of the stock with rights on;

R is the theoretical value of a right.

In the above example,

Me = 11 - 0.08 = Rs. 10.92

This can also be worked out with another formula:

(Mo x N) + S (11 x 24) + 9

Me = ------------------ = ------------------ = Rs. 10.92

N + 1 24 + 1

(c) The market value of 1 right, when the stock is selling ex-rights, may be calculatedwith the following formula:

Mo - S 10.92 - 9

R = ------------- = ------------- = 1.92 / 24 = Rs. 0.08

N + 1 24

(d) The market value of one share of ex-rights stock, if it takes only 5 rights to subscribeto an additional share of stock, will be:

(Mo x N) + S (11 x 5) + 9

Me = ------------------ = ----------------- = 64 / 6 = Rs. 10.66

N + 1 5 + 1

BONUS SHARES : Bonus shares are issued to the existing equity shareholders. Whenthe company has sufficient reserves and surplus but its cash position is weak, it maythink of issuing bonus shares. Issues of bonus shares in lieu of dividend are not allowedas per section 205 of the Companies Act, 1956. By issue of bonus shares, theaccumulated profits and reserves of the company are converted into share capital andhence it is also known as Capitalisation of Profits and Reserves.

Bonus shares may be paid to the existing shareholders in the following manners:

(a) Making the partly paid equity shares fully paid up without asking for cash fromshareholders; or

(b) Issuing and allotting equity shares to existing shareholders in a definite proportionout of profits. For example, if a company has 50,00,000 equity shares of Rs. 10 eachfully paid up and reserves of Rs. 8,00,00,000. Now the company can issue bonus sharesin the ratio of 1 : 1, if desired.

Bonus shares are issued for any one of the following reasons:

(i) to give some benefit out of the reserves accumulated in excess of present or futureprobable needs of the company;

(ii) to bring the issued share capital of the company in true relation to the capitalemployed in the business;

(iii) to avoid exceptionally high profits and dividends from attracting competitors in theline where monopoly has so far been enjoyed;

(iv) to prevent unduly high rates of dividends from dissatisfying their own employeeswho might feel to have been underpaid and might seek for a claim to higher wages;

(v) to prevent such excessive profits from disturbing the company’s business by creatingdissatisfaction amongst its own customers or suppliers.

Circumstances warranting the issue of bonus shares

(i) When the company wants to capitalise the huge accumulated profits and reserves;

(ii) When the company is unable to declare higher rates of dividend on its capital,despite sufficient profits, due to legal restrictions on payment of dividends;

(iii) When the company cannot declare a cash bonus because of unsatisfactory cashposition and its adverse effects on working capital of the company;

(iv) When there is wide difference in the nominal value and market value of the sharesof the company.

Advantages of Bonus Shares

I. Advantages to the issuing company:

(a) Maintenance of liquidity position : A company can maintain its liquidityposition because cash dividends are not paid to the shareholders but bonus sharesissued by the company.

(b) Remedy for under-capitalisation : In under-capitalised concern the rateof dividend is high. But by issuing bonus shares the rate of dividend per share canbe reduced and a company can be saved from the effect of undercapitalisation.

(c) Economic issue of securities : The issue of bonus shares is the mosteconomical whereas other types of securities cannot be issued at this minimumcost.

(d) Other benefits : Issue of bonus shares increases the confidence ofshareholders in the company besides the conservation of control.

II. Advantages to investors:

(a) Tax saving : Bonus shares are issued out of profits and free from income taxin the hands of individual investors. Otherwise had the profits been used forpayment of dividend, such payments are subject to income tax by the recipient ofdividend income.

(b) Increase in Equity holdings : Issue of bonus shares to existingshareholders increases the size of individual shareholdings.

(c) Increase in income : In the long run the dividend income of theshareholders is also increased. But it will be possible only when the company isable to maintain the same rate of dividend as before on the increased capital also.

Disadvantages of Bonus Shares

(i) Issue of bonus shares excludes the possibility of new investors coming into thecompany and throws more liability in respect of future dividend on the company shares.

(ii) Issue of bonus shares lowers the market value of the existing shares also in theshort-run.

Guidelines for issue of Bonus Shares

Issued by Securities and Exchange Board of India (SEBI) on 11th June 1992)

A company, shall, while issuing bonus shares, ensure the following:

1. No bonus issue shall be made within 12 months of any public/right issue.

2. The bonus issue is made out of free reserves built out of the genuine profits or sharepremium collected in cash only,

3. Reserves created by revaluation of fixed assets are not capitalised.

4. The Development Rebate Reserve or the Investment Allowance Reserve is consideredas free reserve for the purpose of calculation of residual reserves test only.

5. All contingent liabilities disclosed in the audited accounts which have bearing on thenet profits, shall be taken into account in the calculation of the residual reserves.

6. The residual reserves after the proposed capitalisation shall be at least 40 per cent ofincreased paid-up capital.

7. 30 per cent of the average profits before tax of the company for the previous 3 yearsshould yield a rate of dividend on the expanded capital base of the company at 10 percent.

Let the increased paid-up capital be Rs. 100. The residual reserve must be 40percent, i.e. Rs. 40.

Total Rs. 100 + Rs. 40 = Rs. 140.

If total is Rs. 280, residual reserve must be (40 / 140) x Rs. 280 = Rs. 80

Reserve available for capitalisation Rs. 120 - Rs. 80 = Rs. 40

(ii) Profitability test

Average profits before tax during the last 3 years = Rs. 80

30 per cent of the average profit = (30 / 100) x Rs. 80 = Rs. 24

Rs. 24 should give a rate of dividend on the increased capital base at 10%

The increased capital base = (24 /10) x 100 = Rs. 240

Existing paid-up capital = Rs. 160

Amount available for capitalisation = Rs. 80 (Rs. 240 - Rs. l60)

Therefore, the amount available for capitalisation should be the lower of (i) and(ii), i.e. Rs. 40

8. The capital reserves appearing in the balance sheet of the company as a result ofrevaluation of assets or without accrual of cash resources are neither capitalised nortaken into account in the computation of the residual reserves of 40 per cent for thepurpose of bonus issues.

9. The declaration of bonus issue in lieu of dividend is not made.

10. The bonus issue is not made unless the partly-paid shares if any existing, are madefully paid-up.

11. The company (i) has not defaulted in payment of interest or principal in respect offixed deposits and interest on existing debentures or principal on redemption thereof,and (ii) has sufficient reason to believe that it has not defaulted in respect of thepayment of statutory dues of the employees such as contribution to provident fund,gratuity, bonus etc.

12. A company which announces its bonus issue after the approval of the board ofdirectors must implement the proposal within a period of 6 months from the date ofsuch approval and shall not have the option of changing the decision.

13. There should be a provision in the articles of association of the company forcapitlisation of reserves etc. and if not, the company shall pass a resolution at its generalbody meeting making provisions in the articles of association for capitalisation.

14. Consequent to the issue of bonus shares, if the subscribed and paid-up capitalexceeds authorized share capital, a resolution shall be passed by the company at itsgeneral body meeting for increasing the authorized capital.

15. The company shall get a resolution passed at its general body meeting for bonusissue and in the said resolution the management’s intention regarding the rate ofdividend to be declared in the year immediately after the bonus issue should beindicated.

16. No bonus issue shall be made which will dilute the value or rights of the holder ofdebentures, convertible fully or partly.

Further in respect of the nonresidential shareholders, it would be necessary for thecompany to obtain the permission of the Reserve bank under the foreign exchangeRegulation Act, 1973.

PREFERENCE SHARES

'Preference' share as the name implies, have a prior claim on any profits the companymay earn ,but only a fixed rate of return (namely divident in this case) has been paid tothe debenture holders. Thus, it may suit the investor who wants limited but steadyreturn on his money. The preferential treatment is available on both the rights - right toreceive dividend and also right to receive back the capital in the event of dissolution orliquidation, if there be any surplus.

Features of Preference Share

Preference shares have the following features:

(1) Return of income: As the name indicates, they have the first preference to get areturn of income, i.e.to share in the profits among all shareholders.

(2) Return of capital: Similarly, they have also the first preference to get back theircapital at the time of winding up of the company, among all shareholders.

(3) Fixed Dividend: As per terms of issue and as per articles of association, they shallhave a fixed rate dividend, e.g., a maximum of 15 percent cumulative or non-cumulativeas the case may be. Hence, they are called fixed-income securities.

(4) Non participation in prosperity: On account of fixed dividends, theseshareholders cannot have any chances to share in the prosperity of the company'sbusiness. This drawback can be removed to some extent by granting them an additionalprivilege to participate in the surplus profits along with equity shareholders at a certainratio, e.g. 2 : 1.

(5) Non-participation in Management: As per the Act, preference shares do notenjoy normal voting rights and voice in the management of the company's affairs exceptwhen their interests are being directly affected, e.g., change in their rights and privilegesor arrears of dividends for more than two or three years successively.

Voting Right of Preference Shares

From the commencement of the Amendment Act of 1974, no extra voting right can beenjoyed by preference shares which were issued prior to April 1, 1956. However, privatecompanies which are not subsidiaries of public companies are not affected by thisSection.

Kinds of Preference Shares

1. Participating Preference Shares: The preference shares which are entitled toparticipate in the surplus of profits of the company available for distribution over andabove the fixed dividend, are called as participating preference shares. Once the fixeddividend on preference shares is paid, a part of the surplus profit is utilised for paymentof dividend to equity shareholders. The balance again may be shared by both equity andparticipating preference shareholders. Thus, the participating preference shares areentitled to (a) a fixed dividend and (b) a share in the surplus profits. The preferenceshares, which do not carry a right to participate in the surplus profits in addition to afixed dividend, are called non-participating preference shares.

2. Redeemable Preference Shares: The share capital of a company can never bereturned to the shareholders during the life-time of the company. It will be returned tothem only at the time of winding-up of the company, should the proceeds of sale ofassets of the company remain after meeting the claims of its creditor But sec. 80 of theCompanies Act, 1956 permits a company limited by shares to issue preference shareswhich may be redeemed after a specified period or at the discretion of the company, if soauthorised by the articles of the company. These preference shares are called

redeemable preference shares. It should also be remembered that the redemption ofredeemable preference shares does not amount to reduction of capital. However, theissue of redeemable preference shares is subject to the following conditions:

a. The issue of redeemable preference shares must be duly authorised by theArticles of Association of the company.

b. Preference shares should be fully paid so that they can be redeemed. It onlymeans that the partly paid-up shares cannot be redeemed.

c. Redeemable preference shares can be redeemed only out of the profits of thecompany or out of the proceeds of fresh issue of shares specifically made forthe purpose of redemption.

d. If the shares are to be redeemed out of the profits of the company a sum equal tothe value of such shares should be transferred out of the net profits of thecompany to a special reserve fund called "Capital Redemption Reserve Account".

e. The premium, if any, payable on redemption of the shares should have providedfor out of the profits of the company before the shares are redeemed.

f. New shares up lo the nominal value of the redeemable preference shares may beissued for the purpose of redemption either before redemption of old shares orwithin one month after the redemption of old shares.

g. Shares already issued cannot be converted into redeemable preference shares.

The preference shares which are not to be redeemed after a specific period are calledirredeemable preference shares. They become a perpetual liability to the company andcannot be redeemed during the lifetime of the company.

With effect from 15/06/1988 in India a company cannot issue irredeemable preferenceshares and existing irredeemable preference shares are to be redeemed within 10 yearsfrom the above date or date of redemption whichever is earlier; Preference shareshaving redemption period of ten or less years can be issued at present. If a company isunable to redeem the preference shares, it has to petition to Company Law Board toissue fresh redeemable preference shares in place of the existing including the dividendthere on. (Section 80A of the Companies Act 1956).

3. Cumulative Preference Shares: Normally when a company does not earn anyprofit in a particular year no dividend on any share becomes payable for that year. Butthe cumulative preference shares confer on the holders a right to dividend which iscumulative in character. It only means that where in a particular year no dividend hasbeen declared on preference shares in the absence of profit, such unpaid dividendswould be considered as arrears and carried forward to subsequent years for the purposeof payment. Only after the payment of such arrears from the profits of the company inthe subsequent years, any dividend on other type of shares can be paid. All preference

shares issued by a company are only cumulative unless otherwise stated in the articles ofthe company. Those preference shares which do not carry cumulative right to dividendsare called non-cumulative preference shares. If a company does not earn any profit in aparticular year, neither dividend is declared on non-cumulative preference shares northe unpaid dividend is considered as arrears and carried forward to the subsequent yearfor purpose of payment.

4. Convertible Preference Shares: The preference shares which carry the right ofconversion into equity shares within a specified period, are called ConvertiblePreference Shares. The issue of convertible preference shares must be duly authorisedby the articles of association of the company. The preference shares which do not carrythe right of conversion into equity shares are called non-convertible preference shares.

Guidelines for Issue of CCP Shares

The following is the text of guidelines for issues of cumulative convertible preferenceshares:

1. Applicability: The guidelines will apply to the issue of Cumulative ConvertiblePreference (CCP) shares by public limited companies which propose to raise finance.

2. Objects of Issue: The objects of the issue of the above instrument should as under:(i) setting up new projects, (ii) expansion or diversification of existing projects (iii)normal capital expenditure for modernisation, and (iv) working capital requirements.

3. Quantum of Issue: The amount of issue of CCP shares will be to the extent thecompany would be offering equity shares to the public for subscription. In case ofprojects assisted by financial institutions, the quantum of the issue would be approvedby financial institutions/banks. The applicant company should submit to the SecuritiesExchange Board of India (SHBI) a realistic estimate of the project costs, along withcopies of loiters indicating the approval/participation of the public financial institutionsin the financing of the project costs.

4. Terms of Issue:

(i) The aforesaid instrument would be deemed to be equity issue for the purpose ofcalculation of debt equity ratio as may be applicable.

(ii) The entire issue of CCP would be convertible into equity shares between theend of 3 years and 5 years as may be decided by the company and approved bythe SEBI.

(iii) The conversion of the CCP shares into equity would be deemed at being oneresulting from the process of redemption of the preference shares out of theproceeds of a fresh issue of shares made for the purpose of redemption.

(iv) The rate of the preference dividend payable on CCP would be 10 per cent.

(v) The guidelines in respect of issue of preference shares, ratio of 1:3 as betweenpreference shares and equity shares would not be applicable to the newinstrument.

(vi) On conversion of the preference shares into equity shares, the right to receivearrears of dividend, if any, on the preference shares upto the date of conversionshall devolve on the holder of the equity shares on such conversion. The holder ofthe equity shares shall be entitled to receive the arrears of dividend as and whenthe company makes profit and is able to declare such dividend.

(vii) The aforesaid preference share would have voting rights, as applicable topreference shares under the Companies Act, 1956,

(viii)The conversion of aforesaid preference shares into equity shares would becompulsory at the end of 5 years and the aforesaid preference shares would not beredeemable at any stage.

5. Denomination of CCP: The face value of aforesaid shares will ordinarily be Rs.100 each.

6. Listing of CCP: The aforesaid instrument shall be listed on one or more stockexchange in the country.

7. Articles of association of the company and resolution of the generalbody: The articles of association of the applicant company should contain a provisionfor the issue of CCP. Further the company shall submit with the application to the CCI acertified copy of special resolution in this regard under Section 81 (IA) of the company.This resolution shall specifically approve the issue of the CCP shares and provide forcompulsory conversion of the preference shares between the 3rd and 5th year as thecase may be.

8. Miscellaneous:

(a) All applications should be submitted to the SEBI in the prescribed form dulyaccompanied by a demand draft for fees payable under the Act.

(b) The applications should be accompanied by a true copy of the letter ofintent/industrial license, whichever is necessary, or registration with the DirectorGeneral of Technical Development (DGTD) for the project.

(c) In respect of companies registered under the MRTP Act, they should ensure that therequisite approval under the said Act has been obtained before making an application tothe SEBI. Documentary evidence of the foregoing should invariably be submitted withthe application.

(d) A certificate duly signed by the secretary and/or director of the company stating thatthe information furnished is complete and correct should be annexed to the application.

Similarly, a certificate from the auditors of the company stating that the information inthe application has been verified by them and is found to be true and correct to the bestof their knowledge and information, be furnished.

Merits of Preference Shares

(i) These shares are preferred by people who do not like to risk their capital completelyand yet want an income which is higher than that obtainable on debentures and othercreditorship securities.

(ii) These shares have the merit of not being a burden on finances because dividend onthese will be paid if profits are available;

(iii) These shares are particularly useful if its assets are not acceptable as collateralsecurity for creditorship securities such as debentures, bonds etc.,

(iv) These shares can well save it from the higher interest which will have to be paid by itin case it wishes to issue debentures against assets which are already mortgaged;

(v) The property need not be mortgaged as in the case of debentures if these shares areissued;

(vi) Preference shares bear a fixed yield and enable the company to declare higher ratesof dividend for the equity shareholders by trading on equity;

(vii) The promoters can retain control over the company by issuing preference shares tooutsiders because these shareholders can vote only where their own interests areaffected ;

(viii) In the case of redeemable preference shares, there is the advantage that theamount can be repaid as soon as the company gets more funds out of profits.

Evaluation of Preference Shares as a Source of Finance

The exact role of preference shares in meeting the financial requirements is debatable.The attitude of financial managers towards preference shares seems to vary widely. Thisdivergence is probably explained by the 'in-between' nature of this type of ownershipsecurity. In creating some sort of obligation to pay a fixed dividend, the companyassumes a risk to its credit rating and shareholders relations.

Reasons to issue preference shares are:

(a) it is desirable to enlarge the sources of funds for the business. Certain financialinstitutions (and even individual investors) that can buy equity shares can not invest inpreference issues. The yield premium over debt is attractive to these and other investorswho wish to assume the risk of equity shareholders;

(b) the sale of preference shares may be an economical way of raising funds. If earningsof assets exceed the dividend rate and the preference shares are non-participating, thiseconomy is obvious;

(c) the sale of preference shares makes it possible to do business with other people’smoney without giving them any participation in the affairs of management;

(d) Preference shares can be considered a type of semi-permanent equity financing;

(e) Preference share carries less risk than debt.

From the investor's viewpoint, preference share is safer than equity share within thesame company. Because of the priority over equity shares in the receipt of dividends andrepayment of capital, preference shareholders believe themselves to be in a strongerposition than equity shareholders. However, this advantage is somewhat offset by thefact that preference shareholders can usually receive only a limited return on theirinvestment. In other words, preference shareholders sacrifice income in return forexpected safety.


The limitations attached with preference shares are quite obvious:

(1) Those who doubt the usefulness of preference shares point out that it is tooexpensive to use under the present tax structure. While the yield to investor onpreference shares is not much higher than on debt issues, the cost to the company ismore than double. It is so because the company cannot deduct this dividend on its taxreturn; this fact is the principal drawback of preference shares as a means of financing.In view of the fact that interest obligations on debt are deductible for tax purpose, thecompany that treats to preference share dividend as a fixed obligation, finds the explicitcost to be rather high.

(2) Critics of preference shares also argue that while no legal obligations exist to paydividends, the passing of preference dividends and accumulation of arrears can have anadverse effect upon the credit of the company.

REVIEW QUESTIONS

1. What are the characteristics of equity shares?

2. Critically evaluate equity shares as a source of finance both from the point of (i) thecompany and (ii) the investing public.

3. What do you understand by no-par shares? State the advantages claimed by suchshares.

4. What are Right Shares? What is its significance for financial management?

5. What do you mean by Bonus Shares? State the guidelines for issue of such shares.

6. Explain essential characteristics of preference shares.

7. State and explain the various kinds of preference shares.

8. State the conditions to which the issue of redeemable preference share is subjected toin India.

9. Explain the merits and demerits of preference shares as a source of industrial financeboth from the point of (i) the company and (ii) investing public.

10. What are the relevant factors, necessary to be kept in mind by a corporate financialcontroller in recommending the issue of (i) Bonus shares and (ii) CumulativeConvertible Preference Shares?

SUGGESTED READINGS

1. Chandra, Prasanna: Fundamentals of Financial Management, New Delhi, TataMcGraw Hill Co.

2. Kulkarni, P.V.: Corporate Finance Bombay, Himalaya Publishing House.

3. Saravanavel, P.: Financial Management, New Delhi, Dhampat Rai & Sons.

- End of Chapter -

LESSON - 15

DEBENTURES AND BONDS

Learning Objectives


· Understand the features of debentures· Detail the types of debentures· Distinguish between fully convertible and partly convertible debentures· Evaluate debentures as a source of finance· Know the SEBI guidelines to issue debentures

Lesson Outline

· Features of Debentures· Type of Debentures· Advantages and Limitations of Debenture Finance· Procedure for the issue of Debentures· Suggestions to develop Debenture Market

A debenture is a document issued by the company as an evidence of debt. It is theacknowledgement of the company's indebtedness to the debenture holders. Debenturesand bonds are called as creditorship securities. In the United States of America, onlyunsecured bonds are termed as debentures. But in Britain, no distinction is madebetween debentures and bonds. In India, the words 'debentures' and 'bonds' are usedinterchangeably.

The Companies Act, 1956 has not defined as to what a debenture means. It simply statesthat a "debenture includes debenture stock, bonds and any other securities of acompany whether constituting a charge on the assets of the company or not [Sec.2(12)]." Thus, the Act only states that it is a kind of security that constitutes a charge byway of security on issuing debentures. In other words, debenture is a long-termpromissory note that usually runs for duration of not less than ten years.

FEATURES OF DEBENTURES

Debenture financing has the following features:

(1) Debenture is a credit instrument: The debentureholder is a creditor of theissuing company: Debenture is the promise by the company that it owes a specific sumof money (debt) to the holder.

(2) Provision for a trustee: When the debenture issue is floated as a privateplacement, the issuing company and the debenture buyers are the only parties to theissue. When a debenture issue is sold to the investing public, there are three parties tothe issue: the issuer, the debentureholders, and the trustee.

(3) Debentureholders are entitled to periodical payment of interest at an agreedrate.

(4) Debentureholders are also entitled to redemption of their capital as per theagreed terms.

(5) Priority in case of liquidation: In the event that the issuing company isliquidated, debentureholders' claims are honoured ahead of the shareholders' claims.When more than one debenture issue must be retired, the priorities among thedebenture issues are contained in the indenture like the pari passu (meaning, with anequal step) clause.

(6) Debentureholders have no voting rights. Under Section 117 of the CompaniesAct, 1956, debentures with voting rights cannot be issued.

(7) Usually debentures are secured by charge on or mortgage of the assets of thecompany.

(8) Debentureholders have the right to sue the company for any unpaid dues.

(9) They can enforce their claim over the security by the sale in case of default.

(10) They can apply for foreclosure or even for winding up of the company tosafeguard their interests.

TYPES OF DEBENTURES

There are several types of debentures. A brief analysis about the different types ofdebentures is given below.

1. Registered Debentures: Registered debentures are those which are recorded witha Register of Debentureholders with full details about the number, value and types ofdebentures held by each of them. The payment of interest and the repayment of capitalis made to those whose names are registered with the company and duly in the Registerof Debentureholders. Registered debentures are not negotiable. Transfer of ownershipof these debentures cannot be valid unless the regular instrument of transfer, dulystamped and signed both by the owner (transferor) and the transferee, is passed by theBoard of Directors. The transfer of such debentures is recorded in the Register of thecompany.

2. Bearer Debentures or Unregistered Debentures: These debentures arepayable to the bearer of the debentures. The names of the debentureholders are not

recorded in the Register of debenture holders. They are negotiable instruments bycustom. So they are transferable by mere delivery. Registration of transfer is notnecessary.

3. Secured Debentures or Mortgage Debentures: These debentures are securedfully or partly by a charge on the assets of the company. The charge may be either a fixedcharge or a floating charge.

4. Unsecured Debentures or Naked Debentures: These debentures are notsecured either fully or partly by a charge on the assets of the company. The generalsolvency of the company is the only security for the debentureholders. Here, thedebentureholder is treated as an unsecured creditor.

5. Redeemable Debentures: These debentures are repayable after a certain period.Sometimes they can be redeemed by the company on demand by the holders or at thediscretion of the company.

6. Irredeemable Debentures: These debentures are also known as "perpetualdebentures". These debentures are not repayable during the life-time of the company.Such debt becomes due for redemption only when the company goes into liquidation orwhen interest is not regularly paid as and when accrued.

7. Equitable Debentures: These debentures are secured by deposit of title deeds ofthe property, with a memorandum in writing creating a charge.

8. Legal Debentures: These debentures are those in which the legal ownership of theproperty of the corporation is transferred by a deed to the debentureholders as securityfor the loans.

9. Preferred Debentures: Preferred debentures are those which are paid first in theevent of winding up of the corporation.

10. Ordinary Debentures: Also known as "second debentures", these debentures arepaid only after the preferred debentures have been redeemed.

11. Convertible Debentures: Holders of these debentures are given the choice toconvert their debenture holdings into equity shares of the company at stated rates aftera specified period. Thus these debentureholders get an opportunity to becomeshareholders and take part in the company management at a later stage. On the basis ofconvertibility, they can be classified into

(a) Non-Convertible Debenture (NCDs): These debentures cannot beconverted into equity shares and will be redeemed at the end of the maturityperiod.

ICICI offered for public subscription for cash at par 20,00,000 16% unsecuredredeemable bonds (debentures) of Rs. 1000 each. These bonds are fully non-

convertible and interest paid half yearly on June 30 and December 31 each year.The company proposes to redeem these bonds at par on the expiry of 5 years fromthe date of allotment i.e. the maturity period is 5 years. But ICICI has also allowedits investors the option of requesting the company to redeem all or part of thebonds held by them on the expiry of 3 years from the date of allotment, providedthe bond holders give the prescribed notice to the company.

(b) Fully Convertible Debentures (FCDs): These debentures are convertedinto equity shares after a specified period of time either at one stroke or ininstallments. These debentures may or may not carry interest till the date ofconversion. In the case of a fully established company with an establishedreputation and good, stable market price, FCDs are very attractive to the investors,as their bonds are getting automatically converted into shares that may at the timeof conversion be quoted much higher in the market compared to what thedebentureholders paid at the time of FCD issue.

Recently three reputed companies, Apple Industries Limited, Arvind PolycotLimited and Jindal Iron and Steel Company Limited have come out with the issueof zero percent FCDs for cash at par. Let us take a look at the Jindal issue...

The total issue was for 3,01,72,080 secured zero-interest FCDs. Of these,1,29,30,000 FCDs of Rs. 60 each were offered to the existing shareholders of thecompany on Rights basis in the ratio of one FCD for every one fully paid equityshare held as on 30.03.93. The balance of 1,72,42,080 secured zero-interest FCDswere offered to the public at par value of Rs. 100 each. The terms of conversionwere as follows: Each fully paid FCD will be automatically and compulsorilyconverted into one equity share of Rs. 10 each at a premium of Rs. 90 per sharecredited as fully paid up. Conversion into equity shares will be done at the end of12 months from the date of allotment.

(c) Partly Convertible Debenture (PCDs): These are debentures, a portion ofwhich will be converted into equity share capital after a specified period, whereasthe non-convertible (NCD) portion of the PCD will be redeemed as per the term ofthe issue after the maturity period. The non-convertible portion of the PCD willcarry interest right upto redemption, whereas the interest on the convertibleportion will be only upto the date immediately preceding the date of conversion.

Let us look at the Ponni Sugars and Chemicals in greater detail. The company isoffering PCDs worth Rs.2205 lakhs, of which Rs.605 lakhs is being offered to theexisting shareholders. The issue is for 14,70,000 16% Secured Redeemable PCDsof Rs. 150 each. Out of this, 4,06,630 PCDs are by a of Rights Issue, in the ratio ofone PCD for every ten equity shares held. The balance 10,63,370 PCDs are offeredto the public. Of the total face value of Rs. 150, the convertible portion will have aface value of Rs.60 and the non-convertible portion a face value of Rs.90. Atradable warrant will be issued in the ratio of one warrant for every 5 fully paidPCDs. Each such warrant will entitle the holder to subscribe to one equity share ata premium that will not exceed Rs.20 per share within a period of 3 years from the

date of allotment of the PCDs. This is not included in the conversion at the rate of1:10. The tradable warrants will also be listed in stock exchanges to ensureliquidity. Interest at 16% on the paid-up value of the PCD allotted shall accruefrom the date of allotment, but interest on the convertible portion of the PCD willbe paid only up to the date immediately preceding the date of conversion. Thenon-convertible portion of the PCD will be redeemed in the stages at the end of the6th, 7th and 8th years from the allotment of the PCD.

(d) Secured Premium Notes (SPNs): This is a kind of NCD with an attachedwarrant that has recently started appearing in the Indian Capital Market. This wasfirst introduced by TISCO which issued SPNs aggregating Rs.346.50 crores toexisting shareholders on a rights basis. Each SPN is of the face value of Rs.300. Nointerest will accrue on the instrument during the first 3 years after allotment.Subsequently, the SPN will be repaid in 4 equal installments of Rs.75 each fromthe end of the fourth year together with an equal amount of Rs.75 with eachinstallment. This additional Rs.75 can be considered either as interest (regularincome) or premium on redemption (capital gain) based on the tax planning of theinvestor.

The warrant attached to the SPN gives the holders the right to apply for, and getallotment of one equity share for cash by payment of Rs. 100 per share. This rightis to be exercised between one and one-and-half years after allotment, by whichtime SPN will be fully paid up. The instrument was first issued by IDBI, laterfollowed by SIDBI. The above bond issued by IDBI had a face value of Rs. 1 lakhbut was at a 'deep discounted' price of Rs. 2700. This bond appreciates to its facevalue over the maturity period of 25 years. But a unique advantage of this bond isthat it gives the investor an option of contracting upto maturity or seekredemption at the end every 5 years with a given deemed face value. These bondscan be sold by the investor in the stock exchange and the difference between thesale price and original cost acquisition will be treated as capital gain. The bond hasbeen assigned AAA rating by CRISIL, indicating the highest safety with regard topayment of interest and principal.

The face value of SIDBI's Deep Discount Bond is also Rs. 1 lakh, but the initialinvestment required is only Rs.2,500. These bonds have got AA rating fromCRISIL indicating high safety with regard to timely payment of principal andinterest.


REASONS FOR ISSUING CONVERTIBLE BONDS

The management inserts conversion feature in bond indenture for four main reasons,viz., to sweeten the issue, to eliminate debt with unduly restrictive conditions, to deferthe sale of equity stock and prevent dilution of earnings available to currentstockholders, and to reduce cost of financing. It is generally believed that convertiblebonds enjoy high marketability because of three-fold benefits available to bondholders.Thus, a convertible bondholder has the advantage of certainty of income, the priority ofclaim as to income and assets, and the opportunity of sharing in the profits if thecompany prospers. Management uses conversion method to extinguish debt which isunduly restrictive in terms, hampering the progress of the organisation, and to get rid ofburden of fixed obligation. Frequently, when there is a slump in stock market andacquisition of capital through equity stock possess a great problem or the company hasbeen caught temporarily in financial trouble or due to poor cash dividend policy, it is feltthat the new stock-issue will elicit poor response from investors, then the managementmay decide to defer the stock issue and float convertible bonds with an intention toconvert them in near future when, it is believed, earnings of the company will improve

substantially and market conditions will change. Furthermore, cost consideration alsomotivates the management to issue convertible bonds. The underwriting cost of aconvertible bond is lower than common stock or ordinary bonds because of the fact thatthe former is more appealing to the investor and hence easier to sell.

Another factor, which has made convertible bond more popular with the management,is lower interest rate. Because of conversion privilege investors may forego higherinterest rate.

FEATURES OF CONVERTIBLE SECURITIES

There are four important features of convertible securities:

(i) Conversion Ratio : The conversion ratio is the ratio in which the convertiblesecurity can be exchanged for equity stock. The conversion ratio may be stated byindicating that the security is convertible into a certain number of shares of equity stock.In this situation, the conversion ratio is given, and in order to find the conversion price,the face value of the convertible security is divided by the conversion ratio. An exampleof this case is given here.

Example: A corporation has outstanding a convertible security issue - a debenture withRs. 1,000 face value convertible into 25 shares of equity stock. The conversion ratio forthe bond is 1:25. From this, the conversion price for the bonds is arrived at as Rs.1,000/25 shares = Rs.40

Sometimes, instead of the conversion ratio, the conversion price is given. In that case,the conversion ratio can be obtained by dividing the face value of the convertible by theconversion price. This case can be explained with the following example.

Example: A corporation has an outstanding convertible bond with a face value ofRs.1,000. The bond is convertible at Rs.50 per share into equity stock. From thisinformation, the conversion ration is calculated at 1:20 (Rs. 1000 / Rs. 50) = Rs. 20.

(ii) Conversion Period : Convertible bonds are often convertible only within or aftera certain period of time. Sometimes, conversion is not permitted until a certain periodhas passed. In another instance, conversion is permitted only for a limited number ofyears after its issuance. Sometimes, bonds may be convertible at any time during the lifeof the security. Time limitations on conversion are imposed by the corporation to suit itslong-run financial needs.

(iii) Conversion Value : It is the value of the security measured in terms of themarket value of the security into which it may be converted. Since convertible bonds areconvertible into equity stock, the conversion value can generally be found simply bymultiplying the conversion ratio by the current market price of the corporation's equitystock.

Example: A corporation has an outstanding Rs.1016 bond which is convertible intoRs.31.25 a share. The current market price of the equity stock is Rs.32.50 per share. Theconversion ratio is therefore (Rs.1000 / Rs.31.25) = 32.

The current market price of the equity stock is Rs.32.50 per share. The conversion valueof the bond is (Rs.1016 / 31.25) x Rs. 32.50 = Rs.1056.

(iv) Conversion Premium : The conversion value depends on the market value ofshares at the time of issue of convertible bonds. Normally, the market price of theconvertible security will be higher than the conversion value at the time of issue. Thedifference between the two is conversion premium. So, it is this difference between themarket price of the shares and the low conversion value that acts as an incentive for thepublic to invest in convertible debentures.

Where the difference between the face value and the market price is high, companiesput a premium on shares at the time of conversion and when the difference is not high,there is normally no premium and the shares are aliened at par.

The conversion premium is the percentage difference between the current price andconversion price. The actual size of the premium depends largely on the nature of thecompany. If the company’s stock is not expected to appreciate greatly, a low premiumwill be used. The convertible premium given to a convertible security can greatly affectthe future success of the security. This can be explained by the following example.

Example: A corporation has issued a Rs. 1,000 convertible bond. The bond isconvertible into 20 shares of the corporation's equity stock at a price of Rs.50 per share.The corporation's equity stock is currently selling at Rs.45 per share. From thisinformation, it is clear that the conversion premium is Rs.50 - Rs.45 = Rs.5 per share orRs.5 x 20 shares = Rs. 100. Conversion premium in this case is (Rs.5 / Rs.45) x 100 =11.11 percent.

UTILITY OF CONVERSION METHOD

The conversion privilege of the bond is very appealing to the issuer as well as toinvesting community. It enables the issuing company to attract savings of investors eventhough the company's current position does not favour issue of stock.

Furthermore, this provides a convenient and relatively easy way of getting rid of bondedindebtedness and the fixed interest charges attached thereto. Without making any cashpayment and simply by further dividing the ownership, the company can extinguishindebtedness.

To investors who at the moment are not prepared to invest in stocks but who are notcontent to continue indefinitely as creditors, conversion privilege has great valuebecause it would give safety of principal and a certain ratio of income and a right toconvert it for stock in case the company prospered so that its stock paid at a high rategets reasonably secured. Thus, the purchase of convertible bonds gives investors the

opportunity to have their cake and eat it too. Such bonds also appeal to speculators whoare interested more in capital appreciation than income. They could borrow on theirbond to make a large percentage of appreciation on their investment.

However, convertible bonds may be said to have adversely affected, though to a limitedextent, the investment position of the company's stock. In the event of depression theconsequences may be serious. Further, conversion injures the market position of thebonds that remain unconverted. The value of such bonds will be very low.

ADVANTAGES OF DEBENTURE FINANCE

Debenture finance has its own importance and significance in company finances:

1. The company is able to secure capital without giving any control to thedebentureholders.

2. In every country and in every section of society there are investors who want todo secured investment with an attractive rate of interest. But they are notprepared to expose their money to risk. Debentures very much suit theirinvestment pattern.

3. Debentures are less risky securities from the investors' point of view. Hence, thecompany is able to raise capital through the issue of debentures at relativelylesser cost.

4. Debentureholders pay to the company for a specific period and cannot withdrawtheir money before the expiry of that period. In this way there is certainty aboutthe availability of finance for a specific period and plans can be made accordingly.

5. The company has the scope for 'trading on their equity' by raising the bulk of itscapital in the form of debentures with fixed rate of interest. The equityshareholders are thus enabled to get maximum possible return out of the residualprofits, during boom period.

6. Since debentures are generally issued on redeemable basis, the company canavoid over-capitalisation by refunding the debt when the financial needs are nolonger there.

7. Issue of debentures reduces the dependence of the company on uncertain sourcesof finance such as deposits, commercial banks etc.

8. In case the company has already incurred a number of small debts of shortduration, it may be costlier for it to maintain them. Under such circumstances,they may be converted into a single issue of debentures which will prove lesscostly.

9. Debentures have a great market response during depression or when thepossibilities of inflationary profits are rare.

LIMITATIONS OF DEBENTURES

In spite of the fact that the debentures offer several advantages mentioned above, it isfound that in practice they have several limitations:

1. Debenture interest has to be paid to the debentureholders whether thecorporation earns profit or not. It becomes a great burden on the finances of thecorporation.

2. When assets of the company get tagged to the debentureholders, thecreditworthiness of the company in the market comes down and in some caseseven the banks refuse loans to that company.

3. If the capital structure is heavily loaded with debentures, the major part of thecompany's earnings is absorbed in servicing the debts, and little is left fordistribution of dividends. This lowers the value of shares of such company.

4. If the company has already raised large amount through the issue of debentures,it has to offer higher rates of interest to market its subsequent issue ofdebentures.

5. From the investors' point of view, safety of capital is likely to be vitiated by lack ofcontrol over the company's affairs. The speculative ventures, overtrading andmismanagement of the company would harm the interest of debentureholdersand weaken the safety of their capital.

6. The proportion of fixed assets to total assets is an important determining factorfor the issue of debentures. A corporation with low proportion of fixed assets tototal assets will not find itself under congenial conditions for the issue ofdebentures because it has no substantial security to offer to debentureholders.Mostly the trading enterprises and concerns dealing in consumer goods belong tosuch category.

7. There is a ceiling imposed by financial institutions on the maximum debt-equityratio of a company which in turn limits the quantum of funds that can bemobilised from this source.

8. Since financing by way of debentures increases the financial risk of the company,the equity shareholders tend to demand a higher rate of return to compensate forthe additional risk assumed.

9. The debenture contract can have several protective covenants which restrict thefinancial flexibility of the company.

LAW RELATING TO ISSUE AND REDEMPTION OF DEBENTURES

Procedure for the issue of Debentures:

1. A resolution authorising the issue has to be passed by the Board of Directors ofthe Company at a meeting of the Board.

2. There must be a provision in the Articles for issue of debentures.3. Consent of the SEBI has to be obtained for the issue of debentures.4. Consent of the shareholders has to be obtained at a meeting of the shareholders if

the borrowings under the debenture, together with any money already borrowedby the company (apart from temporary loans obtained from the company'sbankers in the ordinary course of business) are going to exceed the aggregate ofthe company's paid up capital plus free reserves in the case of public and theirsubsidiaries.

5. Sanction of the shareholders by ordinary resolution is also necessary if the wholeor substantial part of the company's undertaking is proposed to be chargedagainst the debentures by use of mortgage.

6. The particulars of the charge created by the debentures have to be filed with theRegistrar of Companies within 30 days after the execution of the deed containingthe charge. A Certificate of Registration has to be obtained from the Registrar anda copy of the certificate has to be endorsed on every debenture certificate.Particulars of the debentures have also to be entered in the company's Register ofCharges.

7. Where the debentures are offered to the public, then a Debenture Prospectus hasto be filed with the Registrar on the same date on which the said prospectus isissued. If prospectus is not issued, then a statement in lieu of prospectus has tobe filed with the Registrar at least 3 days before the first allotment of debentures.The prospectus shall state the name of the stock exchange or exchanges to whichthe application will be made. Before the 10th day after the issue of the prospectus,the company should apply for permission from the stock exchange(s). If thepermission is not applied for within the 10th day after the first issue of theprospectus, then the allotment becomes void. Even if such permission wasapplied for within ten days, but permission is not granted within ten weeks fromthe date of the closing of the subscription lists even by one of the stock exchanges,the allotment becomes void. If the application has not been disposed of withinthe time limit stated above, it shall be deemed that the application has not beengranted.

8. If the allotment becomes void, the money received from the applicants must berepaid within eight days after expiry of ten days (where permission was notapplied for within stipulated time) or ten weeks (where permission was refusedor the period of ten weeks has expired) as the case may be. If the money is notrepaid within eight days after the company becomes liable to repay it, theDirectors of the company will be jointly and severally liable to repay that moneywith interest at the rate of 12% per annum from the expiry of the eighth day,unless such Directors prove that the default was not because of their misconductor negligence.

9. An appeal against the decision of the stock exchange refusing permission for theproposed debentures may be preferred under Section 22 of the SecuritiesContracts (Regulation) Act. If such an appeal has been preferred then theallotment is not considered void until the appeal has been dismissed.

10. If permission has been granted by a recognised stock exchange or exchanges todeal with the debenture issue, the excess money received on application must beforthwith returned without interest to the applicants and where the money is notrepaid within eight days from the date of allotment, an interest at the rate of 12%per annum on the refundable amount accrues and penal consequences follows fordefault. All moneys received from the applications for debentures must be kept ina separate bank account in a scheduled bank. If a prospectus has been issued, theallotment of debentures should be made after 5th day from the issue of theprospectus.

11. It is not necessary to file a return of allotment with the Registrar after theallotment of debentures. However, within three months of the allotment, the

debentures must be completed and made ready for delivery. After the allotment,the name of the debentureholder with his/her address, occupation, number ofdebentures held by him/her, and the date of allotment of the debentures, must beentered in the Register of Debentureholders. In case the number ofdebentureholders exceeds fifty, then, the names of the debentureholders shouldbe entered in the Index of Debentureholders.

FORMS OF DEBENTURES

Its principal contents are:

(a) Date when the principal is to be repaid by the company;

(b) Rate of interest;

(c) Dates on which the interest is to be repayable;

(d) A statement that the undertaking of the company is charged with such payments;and

(e) A statement that the debenture is issued subject to "conditions".

Debenture cannot be issued to a foreigner or non-resident Indian without priorpermission of the Reserve Bank of India under the Foreign Exchange Regulation Actand Rules made thereunder.

Debentures Stock Certificates must be completed and ready for delivery within twomonths after allotment, or after Lodging of Transfer, unless the conditions of issueotherwise provide (Section 113 of the Companies Act, 1956). A contract to take updebenture may be enforced by specific performance (Section 112 of the Companies Act).

Issue of Debentures at Commission or Discount: (S.129) Where anycommission, allowance or discount has been paid, or from holders having bonds of notmore than Rs. 40,000 face value in each case.

Guidelines for issue of Fully Convertible Debentures (FCDs)/PartiallyConvertible Debentures (PCDs)/Nonconvertible debentures (NCDs):

The guidelines issued by the Securities and Exchange Board of India (SEBI) on 11thJune, 1992 are as follows:

1. Issues of FCDs having a conversion period of more than 36 months will not bepermissible, unless conversion is made optional with "put and call" option.

Put option is an option to sell a fixed amount of stocks/shares/debentures on a certainfixed day and at a fixed price.

Call option is an option to buy a fixed amount of stocks/shares/debentures on a certainfixed day and at a fixed price.

Put and call option is a double option to buy or sell a fixed amount ofstocks/shares/debentures on a certain fixed day and at a fixed price.

2. Compulsory credit rating will be required if conversion is made for FCDs after 18months.

3. Premium amount on conversion, time of conversion in stages, if any, shall bepredetermined and stated in the prospectus. The interest rate for above debentures willbe freely determinable by the issuer.

4. Issue of debentures with maturity of 18 months or less are exempt from therequirement of appointment of debenture trustees or creating a Debenture RedemptionReserve (DRR). In other cases, the names of the debenture trustees must be stated inthe prospectus and DRR will be created in accordance with guidelines for protecting theinterest of the debentureholders. The trust deed shall be executed within 6 months ofthe closure of the issue.

5. Any conversion of debentures will be optional at the will of the debentureholder if theconversion takes place at or after 18 months from the date of allotment, but before 36thmonth.

6. In case of NCDs/PCDs, credit rating is compulsory where maturity period is morethan 18 months.

7. Premium amount at the time of conversion for the PCDs shall be predetermined andstated in the prospectus. Redemption amount, period of maturity, yield on redemptionfor the PCDs/NCSs shall be indicated in the prospectus.

8. The discount on the non-convertible portion of the PCDs in case they are traded, andthe procedure for their purchase on spot-trading basis must be disclosed in theprospectus.

9. In case, the non-convertible portions of the PCDs or NCDs are to be rolled over(renewed), a compulsory option should be given to those debentureholders who want towithdraw from the debenture programme and encash. Roll over shall be done only incases where debentureholders have sent their positive consent and not on the basis of'no negative reply received from them.

10. Before rollover of any NCDs or non-convertible portion of the PCDs, fresh creditrating shall be obtained within a period of 6 months prior to the due date of redemption.

11. A letter of information regarding rollover shall be vetted by SEBI with regard to thecredit rating, debenture-holder's resolution, option for conversion, and such other itemswhich SEBI may prescribe.

12. The disclosures relating the debentures will contain amongst other things:

(i) the existing and future equity and long-term debt ratio;

(ii) servicing behaviour on existing debentures;

(iii) payment of due interest on due dates on term loans and debentures;

(iv) certificate from a financial institution or banker about their 'no objection' for asecond or parri passu charge being created in favour of the trustees to the proposeddebenture issues.

REVIEW QUESTIONS

1. Define the word 'debenture' and bring out its salient features.

2. What are the different types of debentures that may be issued by a company?

3. What are the advantages and disadvantages of debenture finance to industries?

4. Explain briefly the law relating to issue and redemption of debentures in India.

5. Summarise the guidelines for issue of debentures by public limited companies inIndia.

6. Account for the increasing popularity of convertible debentures with the investingpublic and companies in India.

7. Are debentures becoming popular with public sector enterprises in India? Statereasons for your answer.

8. What suggestions would you offer to develop further the corporate debenturemarket in India?

SUGGESTED READINGS


2. Khan, M Y and Jain, P K: Financial Management, New Delhi, Tata McGraw Hill Co.

3. Pandey, I M: Financial Management, New Delhi, Vikas Publishing House.

4. Saravanavel P: Financial Management, New Delhi, Dhanpat Rai & Sons.

- End of Chapter -

LESSON -16

UNDERWRITING OF SECURITIES

Learning Objectives


· Understand the concept of underwriting of securities· Recognise the need for underwriting· Detail the different forms of underwriting· Examine the legal provision and regulations relating to underwriting· Evaluate Merchant Bankers as underwriters

Lesson Outline

· Meaning and Types of Underwriting· Who can Underwrite - Authorised Merchant Bankers· Choosing an Underwriter· SEBI Guidelines for Underwriting· Government Guidelines for Underwriting· Underwriting Agreement· Payment of Underwriting Commission· Future of Underwriting business in India

In terms of Section 69 of the Companies Act, 1956, no allotment shall be made of anyshare capital of a company for subscription to the public unless the minimum amount tobe subscribed, as stated in the prospectus, has been subscribed, and the applicationmoney has been received by the company in cash or by cheque or other instrument andpaid. If the minimum subscription mentioned in the prospectus is not subscribed within120 days from the date of opening of issue, all the application moneys are forthwithliable to be refunded by the company within 128 days with interest for delay beyond 78days from the date of closure of the issue as per Section 73 of the Companies Act, 1956.In view of the far-reaching consequences of failure to raise the "minimum subscription"there is need to ensure that this subscription is procured. Hence, there is need for aninsurance against under-subscription. This is obtained from reliable persons whoundertake to procure/subscribe in the event of the failure to evoke adequate response

from the public. Such an arrangement is called "Underwriting" and the person whoundertakes is called "Underwriter".

MEANING OF UNDERWRITING

Underwriting is an act of providing a guarantee (undertaking a guarantee) of buying theshares offered to the public in the event of non-subscription or under-subscription ofthe shares by the public. For this purpose, the shares issuing company may enter into anagreement with an underwriter or with a number of underwriters or with an institution,for underwriting the issue of shares to the public.

TYPES OF UNDERWRITINGS

There are four types of underwriting agreements:

1. Firm Commitment Underwriting: An underwriter guarantees the sale of allshares offered to the public at an agreed price. The underwriter may agree topurchase all the shares outright from the issuing company and arrange to sell thestock to the public themselves.

2. Standby Underwriting: The underwriter guarantees to buy the unsold sharesoffered in the stock issue.

3. Sub-underwriting: After entering into underwriting agreement with theissuing company, the underwriter may invite other underwriters or underwritingfirms to join in with him and share the risk in mutually agreed proportions.

4. Syndicate Underwriting: The issuing company enters into underwritingagreements with multiple underwriters to underwriters a large issue. They agreewith the company to share the joint responsibility in an agreed ratio. The issuingcompany has to mention the name of the underwriters and the number of sharesunderwritten by him in the prospectus as prescribed in the Companies Act, 1956.


WHO CAN UNDERWRITE?

Underwriting is generally undertaken by:

1. Public Financial Institutions,2. Banks,3. Investment Companies, or4. Trusts of appropriate standing or experience.

Members of the recognised stock exchange are prohibited from entering intounderwriting or getting into agreements related to floating of new issues, unless theyhave got permission of the stock exchange of which they are members. Such permissionis granted subject to certain conditions, like, the members cannot undertakeunderwriting commitments of more than 5% of the public issue; the underwriting ofissues should be widely distributed amongst the members of stock exchange in such away that no single member of the stock exchange is allowed to underwrite substantialportion of the issue; new members are permitted to share the responsibility subject totheir financial position.

Authorised Merchant Bankers

The Securities and Exchange Board of India (SEBI) registers the organisations to carryout merchant banking activities. SEBI classifies its authorisation into 4 categories,namely Category I, Category II, Category III and Category IV merchant bankers. OnlyCategory I, II and III merchant bankers (with capital adequacy of Rs. 1 crore, Rs. 50lakhs and Rs. 20 lakhs respectively) are permitted to take up underwriting business.Whenever a merchant banker is acting as the lead manager, it has to mandatorilyunderwrite the issue. The mandatory underwriting is limited to 5% of the public issue orRs. 25 lakhs whichever is lower.

Limitations

This traditional system has many limitations. Some of the limitations pertain to:

(i) Capital adequacy,

(ii) Control,

(iii) Recovery procedure, and

(iv) Legal procedure, etc.

(i) Capital Adequacy: Of the above categories of underwriters, only the All IndiaDevelopment Financial Institutions, the All India Investment Institutions and Bankshave sufficient capital adequacy, whereas members of the stock exchange and mostmerchant bankers do not have enough capital. Capital or networth is very important inthe event of issue not getting subscribed fully. When an issue does not get fullysubscribed, it devolves on the underwriters. If they do not have enough capital, they willnot be able to take up their portion of risk or fulfill their commitment. Authorised

merchant bankers of Categories I, II, and III are permitted to underwrite capital issuessubject to the limit that outstanding commitments of any such individual merchantbanker at any point of time should not exceed five times his networth (paid-up capitaland free reserves minus revaluation reserves). They must send a monthly report to SEBIand to the regional stock exchanges where the merchant bankers are located, regardingtheir underwriting activities and commitments.

(ii) Control: Members of the stock exchanges, as on date, are controlled by therespective stock exchanges. Members of the stock exchange control their stock exchangethrough an elected Governing Board. Wherever there is a default by a member, there isnot strict enforcement on him by the stock exchanges.

(iii) Recovery Procedure: In the event of development of an issue, recovery from themembers of stock exchanges becomes very difficult. There are quite a few instanceswhere brokers backed out of their commitment.

CHOOSING AN UNDERWRITER

In choosing an underwriter the potential issuer usually considers such factors as thereputation of the investment bank, its past experience in doing equity issues forcompanies similar to the issuer, and, more importantly, its placement power, i.e., itsability to distribute successfully the issue on the basis of the price and other agreedconditions. Underwriters should be at least as selective in choosing clients as clients arein choosing them because one of the prime assets of an investment bank is itsreputation, and the clients of an investment bank and its success in placing issues aremajor factors in their reputation. Obviously, an unsuccessful underwriting damages thereputation of the investment bank.

SEBI GUIDELINES FOR UNDERWRITING

The Securities and Exchange Board of India (SEBI) has issued guidelines for issue ofcapital by companies. The guidelines pertaining to underwriting are enumeratedhereunder:

a. Underwriting is mandatory for the full issue and the minimum requirement of90% subscription is also mandatory for each issue of capital to public. Number ofunderwriters would be decided by the issuing company.

b. If the company does not receive 90% of issued amount from public subscriptionplus accepted devolvement of underwriters within 120 days from the date ofopening of the issue, the company shall refund the amount of subscription. Incase of disputed devolvement, the company should refund the subscription if theabove conditions are not met.

c. The Lead Manager(s) must satisfy themselves about the networth of theunderwriters and the outstanding commitments and disclose the same to SEBI.

d. The underwriting agreement may be filed with the stock exchanges.

Underwriting should be only for issue to the public, and will excludereserved/preferential allotment to reserved categories. In other words, underwriting ismandatory only to the extent of net offer to the public.

Minimum subscription clause is applicable for both the public and rights issue with aright of renunciation.

The intention is that the lead manager should satisfy himself in whatever manner hedeems fit about the ability of the underwriters to discharge their underwritingobligations. There is no need for lead manager(s) to furnish any certificate to SEBI inthis behalf. A statement to the effect that in the opinion of the lead managers, theunderwriters' assets are adequate to meet their obligations should be incorporated inthe prospectus.

GOVERNMENT GUIDELINES FOR UNDERWRITING

Government has issued guidelines relating to the underwriting of capital issues to befollowed by the stock exchanges, merchant bankers and other agencies associated withthe management of the public issues of capital. These should be read along with SEBIguidelines:

i. The stock exchanges will satisfy themselves that the company's securities beingunderwritten would be officially quoted on a recognised stock exchange;

ii. Members of the stock exchange desiring to underwrite will satisfy themselvesthat the company has duly complied with the listing regulations;

iii. The Governing Bodies of recognised stock exchanges shall have the discretion torefuse permission or impose such conditions in respect of the underwriting ofsecurities by members of stock exchanges as they may deem necessary in thespecial circumstances of any given case;

iv. The underwriting of the public issues should be distributed amongst themembers of the stock exchanges as widely as possible;

v. No member should be allowed to undertake an underwriting commitment ofmore than 5 per cent of the public issue; and

vi. The stock exchanges should prescribe procedures for advance action to thecompanies, merchant bankers, etc., for making underwriting arrangements, so asto ensure that all relevant information is furnished in the draft prospectussubmitted to the stock exchanges for approval.

UNDERWRITING AGREEMENT

It is an agreement entered into between the company and the underwriters agreeing tounderwrite the proposed issue of the company. The agreement should provide theamount of the issue agreed to be underwritten by the underwriters in case of under-subscription and the commission payable for such undertaking. It should also stipulatethat in the event of under-subscription, the underwriters or their nominees would takeup the shares for which they are liable or at least that quantity of issue which wouldmake up the minimum subscription, within three to four weeks of the closing of

subscription list. The agreement should provide that the underwriters would bedischarged of their underwriting obligations to the extent of applications bearing theirstamps.

In order to avoid unfair discrimination between the underwriters, the company shouldensure that application forms supplied and distributed among the members of stockexchanges do not bear the stamp of any underwriter.

PAYMENT OF UNDERWRITING COMMISSION

The provisions of Section 76 of Companies Act are to be complied with while paying theunderwriting commission. Section 76 (1) states that a company may pay a commissionto any person in consideration of:

(a) his subscribing or agreeing to subscribe, whether absolutely or conditionally, for anyshares in or debentures of the company, or

(b) his procuring or agreeing to procure subscription whether absolute or conditional forany shares in or debentures of the company, if the following conditions are fulfilled:

(i) payment of the commission is authorised by the articles;

(ii) the commission paid or agreed to be paid does not exceed, in the case ofshares, 5% of the price at which the shares are issued or the amount or rateauthorised by the Articles, whichever is lesser, and in the case of debentures, 21%of the price at which the debentures are issued or the amount or rate authorised bythe Articles, whichever is lesser;

(iii) the amount or rate of commission is disclosed in the Prospectus or Statementin lieu of Prospectus, as the case may be, or in a statement filed with the Registrarbefore the payment of the commission.

(iv) the number of shares or debentures which persons have agreed to subscribedshould be disclosed in the Prospectus, and

(v) a copy of the contract relating to the payment of the commission should bedelivered to the Registrar.

(vi) no underwriting commission can be paid if the issue is privately placed. Inother words, underwriting commission is payable only on such shares ordebentures as are offered to the general public [(Section 76 (4A)]

Stock Exchange Division of the Department of Economic Affairs, Ministry of Financeissued guidelines dated 7-5-1985 for payment of underwriting commission.

The rates of underwriting commission are in force as follows:

On amounts devolving on theunderwriters (%)

On amounts subscribedby the public (%)

(A) Equity Shares 2.5 2.5(B) Preference shares / convertible and non-convertible debentures(a) For amounts uptoRs.5 lakhs 2.5 1.5

(b) For amounts inexcess of Rs. 5 lakhs 2 1

Notes:

(i) The above underwriting commissions are maximum ceiling rates within which anycompany will be free to negotiate with the underwriters.

(ii) Underwriting commission will not be payable on the amounts taken up by thepromoter's group, employees, directors, their friends, and business associates.

(iii) The underwriter gets commission at the above rates on shares, debenturesundertaken by him irrespective of the number of shares & debentures subscribed by thepublic. Even if the issue is fully subscribed by the public, he will get commission at theabove rates on all shares & debentures paid by him.

FUTURE OF UNDERWRITING BUSINESS IN INDIA

With the introduction of free pricing of securities, underwriting business is undergoingmetamorphic changes. Gone are the days when the underwriting business was taken lessseriously by the parties involved. There are already reports of under-subscription ofquite a few public issues and consequent devolvement on underwriters. Capitaladequacy assumes significance for fulfilling underwriting obligations in the event ofdevolvement. Only Financial Institutions and Commercial Banks have enough capitaladequacy to meet such obligations. Merchant Bankers' foremost task is, therefore, toenhance their capital base.

Moreover, companies are also not happy with the situation. Bulk holdings withunderwriters also expose them to a takeover bid. There has, in fact, been a reportedinstance of a major underwriter taking over a company whose issue wasundersubscribed.

Further, with mega issues coming in large numbers, it becomes essential to go in forsyndicate approach. There is already a forceful demand from underwriters associationsfor upward increase in underwriting commission. In the free pricing scenario, a liberalfree market driven fee structure is likely to emerge sooner or later. Brokers are alsodemanding that bank finance be made available to them to carry on the business ofunderwriting.

Merchant bankers / underwriters will also have to develop a large investor base andnetwork throughout India since they would be required to approach the investor directlyand would also have to provide efficient secondary market services.

Lastly the merchant bankers / underwriters will have to be selective in new floatations.The fundamental strengths of the companies will, therefore, come under sharper focusand there will be increasing demand for more and more financial information anddisclosures about the performance of the companies. The underwriters will have todevelop their own assessment network for critical appraisal of projects. The marketdriven forces will, therefore, help the capital market to attain greater depth and maturityin the coming years.

REVIEW QUESTIONS

1. What is underwriting of securities? State the guidelines issued by Government ofIndia and SEBI in this connection.

2. Explain the legal provisions and regulations regarding payment of underwritingcommission.

3. Explain the salient features of underwriting of securities by merchant bankers.

SUGGESTED READINGS


2. Rathnam, P. V.: Financial Advisor, Allahabad, Kitab Mahal.

- End of Chapter -

LESSON - 17

TERM-LOANS

Learning Objectives


· Understand the concept of term-loan· Identify the purposes of term-loans· Detail the features of term-loans

· Explain the covenants of term-loan agreement· Evaluate term-loan as a source of finance

Lesson Outline

· Concept of Term-Loans: Term Lending institutions· Purposes of Term-loans· Distinctive Features of Term-Loans· Appraisal of Term-Loan Proposal: Feasibility Studies· Terms & Conditions of Term-Loan Agreement· Equity Kicker

Since 1950s, the role of term-loans has considerably increased and in many casesgreater reliance is being placed on term-loans vis-a-vis the owned funds, because of thegrowth of term-lending institutions and growing participation by commercial banks interm-lending.

CONCEPT OF TERM-LOANS

The term 'Term-Finance' relates to the money, required either for setting up a new unitor financing the expansion/diversification/ modernisation of a project in terms of land,building, plant and machinery or permanent addition to current assets, with a durationthat may extend beyond 3 years up to 10 years or even more in certain cases. Thus,'Term-Loan' is a debt instrument that has a longer maturity providing a specific largeamount of financing, and contains a repayment schedule (typically in annuity form) thatrequires the borrower to make regular principal and interest payments. Term-loans area type of trading on the equity and thus increase the borrower's financial leverage.Term-loan is a business project-oriented medium- or long-term loan with a maturity ofmore than 3 years. Commercial banks and various financial institutions constitute thehard core of the term-financing in India. Specialised financial and investmentinstitutions were established in India as an integral part of the capital market. Suchinstitutions are known as Development Banks or Term Finance Corporations, forexample, The Industrial Development Bank of India (1964), the Industrial FinanceCorporation of India (1948), the Industrial Credit and Investment Corporation of India(1955), the State Financial Corporation (1951), the National Small IndustrialCorporation Limited (1955), the Industrial Reconstruction Bank of India (1971), the UnitTrust of India (1964), Small Industries Development Bank of India (SIDBI) 1990 etc.The terms and conditions usually vary from institution to institution and also dependingupon the purpose of loan.

PURPOSES OF TERM-LOANS

Some of the important purposes for which term-loans are sought are given below:

(a) An undertaking might be interested in installing new plants, for which it mightneed term-loan in the hope that installed capacity will enable the firm to repay the loansquickly.

(b) It may need money for the purchase of permanent assets and additions in theproperty which already it has.

(c) Due to repaid industrialisation many undertakings might need loans to takeadvantage of industrialisation process.

(d) Some undertakings might need term-loans for modernisation of their plants.

(e) Loans sometimes become unavoidable for refinancing of funded debts.

(f) Some of the firms might be paying heavy interests on bond issues. Such loans can goa long way in reducing the bond interest burden. Obviously it is a major relief.

(g) A term-loan can also help in rearranging of maturities, elimination of restrictiveprovisions of the bond issues and in returning redeemable preference shares.

DISTINCTIVE FEATURES OF TERM-LOANS

Term-loans are negotiated directly between the borrower and the lender. As a result, theprovisions contained in the loan agreements can differ widely. Because the loan isobtained directly from the lender, term-loans can be viewed as a form of privateplacement except the registration requirements.

a. Purposes: Term-loans are granted for purposes such as expansions,diversification, modernisation and renovation schemes. Sometimes they may alsobe granted for liquidation of prior debts.

b. Security (Collateral): The security cover for term-loans comprises the existing(fixed) assets as well as those to be acquired from such loans. Usually, first legalmortgage on such assets is created in favour of the creditor. Besides, personalguarantees of the promoters, directors etc., are also obtained to ensure continuityof the interests of the sponsors of the project.

c. Project-Oriented approach: The approach of the term-lending institution isproject-oriented. The underlying theory of term-loan is that the ability of theborrower to repay the loan is judged by the flow of anticipated income from theproject rather than from the liquidity of his assets. The term-lending institutionsthoroughly examine the viability and profitability of the project in order to assessthe repaying capacity and feasibility of project from economic, technical,commercial, managerial, financial and social point of view.

d. Period (Repayment schedule): Generally, term-loans are repayable in semi-annual installments over a period of 3 to 15 years, including an initial graceperiod.

e. Interest rate: The rate of interest on term-loans is usually 1 -2 points above thebank's advance rate, but the development banks charge a rate of interest lesser onshort period loans.

f. Refinance: Term-loans are eligible for refinance facilities from the IndustrialDevelopment Bank of India, Small Industries Development Bank of India, ExportImport Bank of India, etc.

g. Consortium approach: Where the total term-loan required by an industrialunit is too large for a single bank, some form of participation arrangement is alsomade on the part of different financial institutions. Such a consortium approachis known as co-financing or joint financing of projects.

h. Follow-up measures: As the term-loan spreads over a number of years,several post-sanction measures are undertaken e.g. the assisted concern isrequired to submit regular progress reports about the project under construction.The term-lending institution also sends its officials to inspect the progress of theproject.

i. Commitment Charge: The lending institution also charges a nominalcommitment charge of 1 to 2 % per year on the un-utilised portion of loan from astipulated date. With effect from 1990-91 financial institutions have decided toreplace commitment charge with upfront charge or frontend charge as is thepractice internationally.

j. Nominee Director: It is not uncommon for a creditor institution to nominateits representation in the board of directors of the borrowed unit.

k. Convertibility Clause: Recently the term-lending institution insists forconversion of whole or part of loans into equity by inserting the convertibilityclause in the Loan Agreement itself. This convertibility clause enables thecreditor to participate in the prosperity of a successful project.

l. Bridge Loans: Sanctioning and disbursement of term-loans requires sometime. In the meantime borrowing units require funds to meet their immediateneeds. The borrowing unit makes an arrangement with the commercial banks orlending financial institutions for temporary but short-term loans from them forthe purpose, which are known as bridge loans. Such loans are granted normallyon the personal guarantee given by promoters or directors and repaidimmediately after sanctioning of the term-loan.

m. Covenants: Term-loans contain both affirmative and negative covenants.Affirmative covenants require the borrower to keep the lender informed of itsfinancial position by submitting periodical financial statements - actual andprojected - or any event that have or could have a significant impact on theborrower's financial position. Negative covenants restrict or prohibit theborrower from specified actions such as increasing its dividend payments, makesure the minimum liquidity is maintained, and impose capital structure changes.


APPRAISAL OF TERM-LOAN PROPOSAL: FEASIBILITY STUDIES

There are broadly six aspects of appraisal of term-lending proposals. They are:

(i) Technical feasibility

(ii) Economic feasibility

(iii) Commercial viability

(iv) Managerial competence

(v) Financial feasibility

(vi) Social considerations

An appraisal for all the six factors in aggregate will certainly help the financier to decidethe viability of the proposal for finance.

(i) Technical feasibility: The examination of this aspect requires a thoroughassessment of the various requirements of the actual production process and includes adetailed estimate of the goods and services needed for the project - land, machinery,trained labour or training facilities, raw-materials, transportation, fuel, power, wateretc. Where these resource factors are not domestically available and are to be imported,conditions in the foreign market and the Government policy at home are to be reviewedvis-a-vis the availability of the foreign exchange in the country. For certain projects,foreign experts of foreign training of local staff may be necessary. Another importantfeature of technical feasibility relates the types of technology to be adopted for theproject. In case new technical processes are adopted from abroad, attention is to be paidto the differences in conditions. The lending banks should employ technocrats orconsultants to study the projects on their technical aspects.

(ii) Economic (Marketing) feasibility: This aspect of an appraisal relates to theearning capacity of the project. Earning of the project depends on the volume of sales.Therefore, it is highly pertinent to determine how much output of the new unit or theadditional production from an existing unit can be absorbed by the market at givenprices. In other words, it takes into account the total output of the product concernedand the existing demand for it in order to establish whether there is an unsatisfieddemand for the product. Two general indicators of the existence of dissatisified demandare 'price level' and 'prevalence of controls'. When demand is greater than the availablesupply and there are no controls, prices would be much higher than the production cost,

yielding abnormal profits to producers. On the other hand, where price controls exist,like rationing, it is prima facie that the entire demand is not being met by currentproduction.

Possible future changes in the volume and pattern of supply and demand will have to beestimated in order to assess the long run prospects of the industry as well as earningcapacity of the unit. In calculating the future demand, the lending bank has to take intoconsideration the potentialities of the export market, the changes in incomes and prices,multiple uses of the product, probable expansion of the industries using such goods, andgrowth of new industries requiring them. On the supply side, several factors which affectsupply position, such as the competitive position of the unit in question, existing andpotential competitors, the extent of capacity utilisation, units cost advantages anddisadvantages, structural changes, and technological innovation bringing substitutioninto the market, should also be scrutinised.

(iii) Commercial viability: The appraisal of commercial aspects of a project involvesa study of the proposed arrangements for the purchase of raw materials and sale offinished products etc. The basic question to be asked in this respect are whetheradequate arrangements have been made for buying the materials and services needed toconstruct the facility, and when the construction is finished, for obtaining power, labourand raw materials to operate the plant and market its product. The problems are muchthe same for all projects during the construction phase. The main objective is to see thatthe proposed arrangements ensure that the best value is obtained for the money spent.

In the operating phase, commercial problems vary considerably from sector to sector. Inindustry, the likely terms of purchase of the ingredients of production and of the sale ofproducts need careful examination, since these terms may have an important bearing onthe amount of working capital required. Where the concern proposes to appoint soleselling agents, the same should be examined in the interest of the concern and from thepublic policy angle.

(iv) Managerial competence: To a large extent, the lending bank's confidence in therepayment prospects of a loan is conditioned by its opinion of the borrowing unit'smanagement. Where the technical feasibility, economic feasibility, and financialfeasibility are well established, but the integrity and resourcefulness of the managementis doubtful, the proposal is worth leaving where it is. Thus it has been aptly remarkedthat appraisal of management is the touchstone of term-credit analysis. The calibre ofthe people with whom he is dealing can be judged with reference to their knowhow ofthe business as reflected in their purchase, production, sales, labour, personal credit,and financial policies.

(v) Financial feasibility: The financial position of the concern has to be examinedduring the running of the loan. For having a proper perspective of the financial position,it is not sufficient to consider a single year's performance as revealed in the BalanceSheet and Profit & Loss Account. On the other hand, a dynamic view has to be taken ogthe organisation in next few years. The basic data required for a financial analysis can begrouped under the following heads:

(a) Cost of the project (whether additional or new) - The cost of the projectshould normally includes study of land (including development expenses),building, machinery and plant (including spare parts, insurance, freight, duty,transportation to site, and erection charges), technical knowhow (includingconsulting and engineering fees), preliminary expenses, pre-operative expenses(up to start of normal production, interest during construction, allowance forunseen costs), and net working capital requirements. The usual sources of financeare share capital, debenture capital, reserves and surplus, retained earnings, long-term borrowing and deferred payments.

(b) Cost of the production and profitability - The profitability of anenterprise depends on the total cost of production and aggregate sale price of theoutput. In calculating the total cost of production, the data regarding eachelement/component of cost of the product are essential. The tendency tounderestimate the cost of production should be avoided. Before estimating sale inmoney terms, it is necessary to estimate the sales likely to be made, not only forone year, but during each of the next three or four years. The volume of sales isinfluenced by a variety of factors, including the quality of the product, its price andthe general market conditions. The cost of production and sales estimates is alsouseful in working out the "breakeven" point which would indicate to the bankerthe ability of the industry to face a difficult situation.

(c) Cash flow estimates (sources and application of funds) during the currencyof the loan-Cash-flow estimates are obtained for the future period (of years)during which the term-loan will be outstanding. These estimates are necessary toascertain as to when the project will need money for different purposes, and whatdifferent sources for such funds are available. Repayment of installments of loansis arranged according to the cash accruals shown in cash-flow statement. The cashflow estimates in respect of a new concern will have to be prepared on the basis ofthe prospects for the project under consideration. For an existing concern,however, the estimates would take into account the cash flow arising from itscurrent business as well as from the expansion under consideration.

(d) Projected working capital requirement

(e) Projected Profit & Loss Account and Balance Sheet at the end of eachfinancial year during the period of the loan - The Balance Sheets and Profit andLoss Accounts for the past three to five years can be studied as a first step infinancial appraisal of existing concerns. The second step would be the preparationof estimates of the cash flow statements for the next four to five years. The thirdstep would be the preparation of the projected balance sheets for a similar period.The figures in the cash-flow statements would provide a link between the balancesheet of one year and the next. For a new project all the necessary figures mustcome from the cash flow estimates. The proforma will reflect the projectedfinancial position of the concern in the future years.

As a pre-sanction measure, the lending bank should depute an officer to verify thecorrectness of the information furnished by the borrower, and supplement it ifnecessary through investigation. The valuation of the assets and the depreciation policyadopted by the concern has also to be checked. After sanctioning a term loan anddisbursing it, the lending bank has to make post-sanction inspection to ensure whetherthe amount borrowed has been actually used for the purpose for which it was borrowedand whether terms and conditions of the loan have been complied with. The value of thesecurity, production, sales, position regarding insurance and defaults in repayment, ifany, should be reviewed at regular intervals.

(vi) Social Consideration: The social objectives of the project are also consideredkeeping in view the interests of the general public. The projects offering largeemployment potential, which channelise the income of the agricultural sector forproductive use, or projects located in totally less developed areas, or projects which willstimulate small industries or the growth of ancillary industries, are given specialconsiderations.

Energy Management and Ecological Aspects

Along with economic and social appraisal, ecological considerations are also kept inview and given due weight. It is ensured that the applicant concern has made adequateprovision for treatment of effluents so that the environmental pollution remains undercontrol. In the context of high priority and significance given to conservation and use ofalternative sources of energy, term-financing institutions have been attachingconsiderable importance to 'energy management' while financing industrial projects.For this purpose, the steps proposed to be taken for the conservation of energy or use ofalternate sources of energy is now examined in depth while appraising a project.

Balancing of Various Factors

While it is necessary to look into all the above aspects of appraisal, the extent ofinvestigation and the importance to be attached to each aspect depend upon thecircumstances of individual projects. Not all term-loan proposals may require full-scaleappraisal of all aspects. For instance, in the case of a project that is obviously profitable,a general consideration of the unit's position with reference to its cash-flow shouldsuffice. Again, where the product has an assured market, a laborious market analysis isneedless. In the ultimate analysis, however, the skills lie in identifying and sorting outstrong points and weak points, and arriving at a final view on the project. Weaknesslocated in certain areas may be offset by strengths in other areas. Possibly, soundmanagement and bright economic outlook may outweigh mediocre caliber ofmanagement and doubtful economic prospects. In some cases, negative factors maydominate; managerial competence may be so much below par so as to off-set all otherconsiderations. In this way, a large number of variations and combinations are possible.Thus, the crucial responsibility of the lending bank lies in balancing judiciously differentconsiderations for arriving at a proper decision. There cannot be readymade formulae,by using which a term-loan proposal can be pronounced as acceptable or otherwise.

Nevertheless, scientific approach helps considerably in arriving at proper decisions.There is no mechanical substitute for a banker's judgment. Decision-making in this areacalls for full appreciation of all relevant factors and sound judgment based onexperience.

TERMS & CONDITIONS OF TERM-LOAN AGREEMENT

Term-loans attract several restrictive terms and conditions other than those related tocreation of charges. Different lending institutions stipulate different kinds of conditionsdepending on the nature of the project, the borrower, etc. The commercial banksstipulate only a minimum number of conditions, whereas the financial institutions applya large number of more comprehensive conditions. By-and-large, the main clauses of aterm-loan are as follows:

(a) Government clearance: The loan agreement stipulates the borrowing companyto obtain all relevant government clearances as may be applicable. Sanctioning of theloan must not be construed to be lifting of any other restrictive barrier by thegovernment such as licensing, MRTP clearance, capital goods clearance for importedmachines, import license, FERA, RBI clearance, clearance from the SEBI for securityissues, etc.

(b) Consent of other lenders: Usually for a consortium loan, a condition aninstitution stipulates is that for other parts of the loan, the borrower should be able tosatisfy other lending institutions separately.

(c) Repayment: Repayment of any existing loan or long-term liabilities is to be madein concurrence with the financial institutions.

(d) Additional loans: Any additional loans to be taken by the Company, the interestto be paid and repayment of the principal are, usually, subject to the financialinstitution's consent.

(e) Capital structure: The term-loan agreement may stipulate the equity and/orpreference shares that the company must issue in order to support the project. It mayalso stipulate changing of proportionate shareholding between the various ownergroups, mainly between the Indian and the overseas entrepreneurs.

(f) Dividend declaration: As long as there is a loan outstanding, and declaration ofdividend beyond certain percentage is made subject to the lender's approval.

(g) Directorship: Usually, a term lending institution may reserve the right tonominate one or more directors (called Nominee Directors) to the Board of theborrowing company to indicate the institution's views to the management. Anyintervention by the institutions is usually done through the nominee directors.

(h) Commercial agreement: Usually any major commercial agreement such as anyorders for equipment, consultancy, collaboration agreement, selling agency agreement,

agreement with senior management personnel, etc., needs the concurrence of the term-lending institutions if they are entered into after the loan agreement has been signed.

(i) Restriction to expand: Any further expansion plan would need to be cleared bythe institutions, as it may have an adverse impact on the future cash flow of thecompany. No expansion plan can be contemplated without the knowledge of theinstitutions once the loan agreement has been signed.

(j) Restriction to create further charge: The borrower is usually not allowed tocreate any further charge on the assets without the knowledge of the financialinstitutions.

(k) Information: The borrower must agree to furnish any information which theinstitution may consider to be relevant, as and when they are asked for, within areasonable time.

(l) Organisation: Depending on the nature of the project, the financial institutionsmay insist on appointing suitable personnel in the organisation to their satisfaction.This could be in the area of marketing, R & D, design or production, depending on thenature of project.

(m) Shareholding: The institutions, usually, stipulate that the promoters cannotdispose of their shareholdings without the consent of the lending institutions. This ismade with a view to keeping the promoters involved as long as the institutions remaininvolved.

(n) Convertibility: Any large loans from all-India financial institutions (usually aboveRs. 50 lakhs) attract a convertibility clause, as in debentures. The institutions normallyask for 20 percent convertibility, and sometimes accept a firm allotment of shares in lieuof such a convertibility clause. In an era of liberalisation, the convertibility condition hasbeen dispensed w.e.f. April 1991.

(o) Additional clause: Usually, the term-loan agreement carries a clause where bythe financial institution can insert any other restrictive clause at a later date at theiroption. The purpose of this clause is to bolster the security in case any future unforeseendevelopments weaken the security.

(p) Project finance: Usually, the term-loan agreement puts one or more clauses, likethe borrower would make arrangements to raise the other part of the project finance tothe satisfaction of the particular lending institution. This clause safeguards aninstitution against any unforeseen happening by which the other participatinginstitutions back out, but it is unable to do so just because the sanction letter has beenissued earlier.

EQUITY KICKER

Lenders also may require so called "equity kickers". For example, a commercial banklender may require the borrower to pay an agreed percentage on any profits generatedfrom the loan. An insurance company may use an equity kicker in the form of options,like warrants, which allow the insurance company to purchase a specified number ofequity shares directly from the borrower at a price set below the borrower's currentmarket share price.

REVIEW QUESTIONS

1. What is term-financing? Explain the major sources of term-finance in India.

2. What are the special features of term-loans? Discuss the disadvantages attachedwith term-loans.

3. What precautions will be taken by term-lending institutions while granting term-loans?

4. What are the broad aspects of appraisal of term-loan proposals in India?

5. Explain the terms and conditions usually found in term-loan agreements.

SUGGESTED READINGS




4. Rathnam, P.V. : Financial Advisor, Allahabad, Kitab Mahal.

5. Saravanavel, P.: Financial Management, New Delhi, Dhanpat Rai & Sons.

- End of Chapter -

LESSON - 18

LEASE FINANCE

Learning Objectives


· Understand the concept of leasing· Identify the equipment suitable for teasing· Know the kinds of lease· Distinguish between lease financing and debt financing· Ascertain which is better - Lease vs Purchase or Lease vs Hire Purchase· Specify the advantages and disadvantages of lease.

Lesson Outline

· Lease Transaction· Equipment suitable for leasing· Kinds of Leases - Financial Lease, Operating Lease· Maintenance, Non-Maintenance and Net Leases· Lease versus Buy· Lease Financing versus Debt Financing· Lease versus Hire-Purchase· Income-Tax Implications of Leasing· Advantages & Disadvantages of Leasing Finance· Hire Purchase Finance

Concept of Lease

A lease is an agreement whereby a lessor (one who leases out) conveys to the lessee (oneto whom something has been leased out) the right to use an asset for an agreed period oftime in return for rent. The essential features of a lease are:

(i) It is an agreement between the lesser and lessee,

(ii) The agreement is for a stipulated time period,

(iii) The lessor conveys to the lessee the right of using an asset owned by him,

(iv) The lessee pays the rental in exchange for the right of using the asset.

When the lessor and lessee belong to two different countries it is known as 'Cross-Border Leasing'.

Lease Transaction: Leasing is a method of financing equipment, where the lessee(the user of the equipment) selects the equipment, acquires it on lease and is allowed theuse the equipment during the period of lease, which may be spread over the entireeconomic life of the asset, by paying a predetermined lease rental, while the ownershipin legal terms continues to rest with the lessor (who finances the cost of the equipmentand gives it out on lease). The lessor may or may not be the manufacturer of the

equipment. In case the lessor is the manufacturer, he will have to capitalise it in hisbooks, fund it as a capital asset and give it out on lease to the lessee. If the lessor is aleasing company and not the manufacturer, which is usually the case, the lessor wouldpurchase the equipment from the manufacturer by paying for the cost (including dutiesand taxes) using his own finances, thereby becoming its owner, capitalise it in his books,and give it out on lease to the lessee.

Thus, there are basically three parties involved in a leasing transaction - the leasingcompany (lessor) that finances the transaction, the manufacturer or supplier fromwhom the leasing company purchases the equipment, and the party who needs theequipment (lessee) who will possess and use the equipment, for which it will pay aperiodic lease rental to the lessor. In this manner, the lessee is able to exploit theeconomic value of the equipment by using it as if he owned it without having to pay forthe capital cost (for which he possibly may not have the necessary long-term funds),borrowing capability or cash flow. Lease rentals can be conveniently paid over the leaseperiod out of profits earned from the use of the equipment and the rental is 100% taxdeductible.

Equipment suitable for leasing: Generally high value and technology orientedproducts are most suitable for leasing, though there are no restrictions. Further, asmentioned earlier, imported equipment at present would not lead itself to leasing.Typical items that could be leased are computers, transport vehicles, machine tools,diesel generators, earth-moving equipment, printing presses, textile machinery, air-conditioning equipment, agricultural equipment, hotel equipment, pumps, quarryequipment, compressors, containers, hospital equipment, locomotives and rollingstocks, etc.

Solvency of parties: It is very essential for the leasing company to evaluate thefinancial position and cash flow of the lessee to determine the ability of the lessee to paythe rentals over a long period. If the lessee goes bankrupt, the leasing company will rankonly as a creditor in the winding-up. In certain cases, collaterals, or bank acceptances orguarantees may have to be obtained from the lessee. On the other hand, the lessee mustalso evaluate the financial standing of the leasing company since the lessee's unlimitedright to use the equipment can get seriously affected if the leasing company becomesinsolvent, and the assets have to be called back on winding up.

Kinds of Leases

There are basically two kinds of leases - financial lease and operating lease.

1. Financial Lease : A Financial Lease (also called Finance Lease, Capital Lease orFull Pay-out Lease) is generally a long-term lease, where leasing is used as the methodof financing the capital expenditure. The lessee selects the equipment, settles the priceand terms of sale, arranges with a leasing company to buy it, takes it on lease byentering into an irrevocable (non-cancellable) contractual agreement with the leasingcompany for a fixed long-term period, pays the lease rentals to the leasing company on a

periodic basis over the period of lease, uses the equipment exclusively, maintains it,insures and avails of the after-sales service and warranty backing it.

The lessee also bears the risk of obsolescence as he stands committed to pay the rentalfor the entire lease period even though equipment may become obsolete during theperiod of lease. A finance lease, as is evident from the above explanation, transferssubstantially all the risks and rewards linked to its ownership. Such a lease can be splitup into two or three periods over the life of the equipment. The lease during the firstperiod is called the primary lease which is for a pre-determined period of say, fiveyears (during which the leasing company recovers the complete cost of the equipmentalong with the cost of capital and profit) followed by a perpetual lease on nominalterms / token rental for the remaining life time of the asset.

Primary lease of five years can alternatively be followed by a secondary lease ofanother 3 to 4 years thereafter followed by a perpetual lease, and the lease rental willaccordingly stand during the primary lease period. In fact, there is a fair degree offlexibility possible, and packages can be tailor-made to suit the needs of the lessee. Thelease agreement can stipulate that at the end of pre-determined lease period theequipment will be sold / scrapped and the proceeds received will accrue to the lessee orthe lessor as agreed, and the lease rent will be adjusted accordingly. Such a financiallease would be without the purchase option, and at best, the lessee may be entitledto buy the equipment at the then prevailing market value at the end of the lease.

The financial lease could also be with purchase option, wherein, at the end of thepre-determined lease period, the lessee has the right to buy the equipment at a pre-determined value or at a nominal value, and the lease rental will be adjustedaccordingly. However, there is a view that a lease with purchase option is construed tobe a hire-purchase transaction and, therefore, the lease rentals will, for tax purposes, besplit into principal and interest, and only the interest portion, and not the entire leaserental, will be allowed as a deduction.

The rate of rental would be fixed based on the kind of financial lease taken, the period oflease, the periodicity of rental payment and the rate of depreciation and other taxbenefits available.

The periodicity of lease rental could be monthly, quarterly or half yearly.

Normally, an advance of three months rental is taken by the leasing company and isadjusted at the end of the lease period. The leasing company also charges nominalservice charges/management fees to cover legal and other costs, and it may also insiston collaterals or bankers' guarantees in individual cases.

2. Operating Lease : An Operating Lease (also known as Maintenance Lease orService Lease) is a short-term lease. The lease period is insignificant as compared to thelife of the equipment and the lease is usually cancellable. The lessor insures andmaintains the equipment and the lease rental takes all these costs into account. The riskof obsolescence lies with the lessor, who gives it out on lease to one lessee after another

for short periods. In such a lease, substantially all the risks and rewards incidental toownership are not transferred to the lessee.

The important characteristics that distinguish an operating lease from a finance leaseare given below:

i. The cost of the asset is not received by the lessor from a single lessee;

ii. The lease term is not for the duration of economic life of the asset;

iii. The type of assets leased out are "general purpose" and not "special purpose"assets. Such assets are usual and needed by many;

iv. The lessor is responsible for repairs and maintenance and other supportservices to the lease;

v. The risk of obsolescence is borne by the lessor.

The chart prepared by the secretariat of IASC illustrates the classification of lease intoFinance Lease and Operating Lease.

Fig. 18.1 Distinction between Financial lease and Operating lease

Sale and Leaseback

A sale and leaseback transaction involves the sale of an asset to the lender (leasing orfinance company) and the leasing of same asset back from the lender. The transactionmay be with respect to new equipment or second hand equipment which the seller hasbeen already using. The rentals and sale price are usually interdependent and may notrepresent fair values. This method has a great advantage in that the vendor has theuninterrupted use of equipment and of the same time it helps him to expand hisbusiness with the funds released by the sale. The vendor also makes a profit if the fairvalue is more than the depreciated value, and this helps to improve his net worth. Thetransaction is completed on paper without any physical movement of assets which staywhere there are i.e., in the organisation which continues to use them as before withoutany interruption.

In the sale and lease back method there are only two parties to the transaction instead ofthree, as the supplier of the equipment and its lessee are the same person, and the otherparty is the leasing company. Charging a higher sale price on the sale of the assets to theleasing company is not necessarily an advantage to the organisation selling them forleaseback, since the supplier and lessee are the same, and the leasing company onlyplaying the role of a financier. If the sale price received by the selling organisation ishigh, it also has to shell-out a higher lease rental, and if the sale price received is low, therental paid out is also correspondingly reduced.

In fact, if the sale price is low the sale tax payable on the sale to the leasing company isalso reduced. In certain circumstances, perhaps, no sales tax may be payable. The saleand lease back technique is popular abroad, and is likely to gain immense popularity inIndia as well, on account of its advantages.

Maintenance, Non-maintenance, and Net Leases

Based on leasing contracts, leases may also be classified into three types: maintenance,non-maintenance and net. The maintenance lease provides that the lessor pays acomplete upkeep of the equipment. The type of lease frees the lessee from maintenanceheadaches and from worries over equipment breakdowns; if the equipment cannot bereadily repaired, the lessor usually furnishes a replacement. In non-maintenancelease, the full cost of maintaining the equipment or property is in the hands of thelessee and he incurs all taxes. For net lease, the lessor makes arrangements forpurchasing the equipment, delivery, and financing as a little more than an agent for thelessee. However, such a lessor has nothing to do with maintenance and repair of theequipment.

In lease financing, the nature of the obligations of the lessor and the lessee are specifiedin the lease contract. This contract contains:

(i) the basic period during which the lease is non-cancellable,

(ii) the timing and amounts of periodic rental payments during the basic lease period,

(iii) any option to renew the lease or to purchase the asset at the end of the basic leaseperiod, and

(iv) provision for the payment of the costs of maintenance and repairs taxes, insurance,and other expenses. With a 'net lease' the lessee pays all of these costs. Under a'maintenance lease', the lessor maintains the asset and pays the insurance cost.


Lease Financing versus Debt Financing

Conceptually, leasing is quite similar to borrowing, so leasing provides financialleverage. In fact, a lease is a type of debt. Whether lease financing or debt financing isfavoured will depend upon the pattern of cash-outflows for each financing method andupon the opportunity of funds. Several methods are used to compare the twoalternatives. The important ones are:

1. Present Value Analysis2. Internal Rate of Return Analysis3. Bower-Herringer-Williamson Method

The decision to lease or borrow can be made on the basis of which alternative has thelowest present value of cash outflows or lowest after-tax internal rate of return. Becausethe latter does not require specifying a discount rate, it is preferred by a number oftheorists. If the Present Value method is used, the after-tax cost of debt, perhaps, therisk-free rate should be employed as the discount rate. Another method of analysis callsfor the separation of difference in explicit financing costs from differences in taxes, withthe two methods of financing compared according to their present values.

All the above methods, usually, indicate the answer that borrowing generally will be thepreferred alternative because the interest cost typically is somewhat lesser than leasing.As long as the interest cost is lower, debt financing will be superior to lease financing. Itis important to stress that in the absence of economic advantages, such as taxes, and/ormarket imperfections, lease financing will not be superior to debt financing.

Lease versus Buy (Purchase) Decision

A lease versus buy (purchase) decision should be evaluated in each case especially wherefunds are not a constraint. Various factors such as the rental charge, prevailing rates ofinterest on borrowed funds, availability of funds, tax rates applicable to the lesseeorganisation, depreciation rate, and availability of other tax benefits such as additionaldepreciation, investment allowance on the capital cost of the equipment, have to betaken into consideration. The tax benefits based on the ownership and capital cost of theequipment are available to the leasing company (lessor) and not to the lessee who, onthe other hand, is entitled to a complete tax deduction for rentals paid.

On balance, therefore, while it may be better to 'buy' in one case, it may be better to'lease' in another. Further, certain caution has to be exercised before entering into aleasing agreement and all the legal aspects should be carefully considered. At present,while there is a law governing hire purchase transactions and while lease of immovableproperty is covered by the Transfer of Property Act 1882, there is no specific enactmentin respect of equipment leasing, and as a result, different laws are to be construed tointerpret legalities involving equipment leasing.

Lease versus Hire-Purchase

A leasing transaction must be distinguished from a hire-purchase transaction ortransaction of payment by installments. In the case of payment by installments, the useractually purchases the capital equipment himself and merely makes the payment inperiodic installments over a specified period, and becomes the owner at the very outset.In a hire-purchase transaction, a sizable down payment is made and balance amount ispayable over a specified period as installments comprising of principal and interest, andownership in the property passes to the person taking the equipment at the end of theperiod when the last payment is made.

The main advantage of buying assets on hire purchase is that the business is able to usethe earnings (by employing the asset) to pay the hire-purchase charges as they fall due.The asset must normally have a longer expected life than the length of the hire-purchaseagreement, and the value should also be in excess of the amount outstanding on theagreement.

The main disadvantage of hire-purchase financing is that the interest rates are usuallyhigh (more than 15%). As this rate is applied to total amount involved (i.e. the initialbalance) the effective rate charged on the balances outstanding will tend to double theactual rate charged. Due to this grave disadvantage, this method is not always favoured.In spite of its expensiveness, this method is more particularly used by those businesshouses whose work necessitates their expenses and profits to be spread over a lengthyperiod e.g. the building construction industry.

Thus, in installment and hire-purchase transactions, the user gets vested withownership and custody of the equipment, as against a lease transaction where the user(lessee) has only the custody and usage of the equipment while the ownership vests inthe lessor.

Income-Tax Implications of Leasing

The income-tax implications of leasing need to be clearly understood as they play animportant role in the lease transaction. While the tax treatment for the leasing companyis more intricate, it is simple for the manufacturer or lessee. In the case of themanufacturer, the transaction of sale to the leasing company is like a sale to any othercustomer, and income tax will be payable on the profit earned through the sale. On theother hand, the lessee is entitled to a 100 percent tax deduction for the lease rental paid,but it may be noted that, as stated earlier, there is a view that if the lease is with thepurchase option, the transaction may be regarded as hire-purchase, in which case thelease rental will be split between principal and interest, and only the interest elementwill be allowed as a tax deduction.

Advantages of Leasing Finance

There are numerous advantages of obtaining equipment on lease, which must be takeninto account in evaluating a lease versus buy decision. These are as follows:

1. It has a tremendous cash flow advantage as it enables one to acquire a capital asseteven though he does not have the ability to immediately generate cash resources to meetthe cost of the capital expenditure for buying the asset. As long as the user has the abilityto pay the rentals through profits generated from utilisation of the equipment or fromprofits of the other activities or otherwise, leasing enables the user to use the equipmentfor his business. Thus, if the lessee does not have the ability or desire to raise equity orhas used all his borrowing capability and cannot borrow any further under the norms ofbanks and financial institutions, leasing comes to the rescue and enables the borrowerto acquire and use the asset.

2. Even if the user has borrowing power and can borrow funds, he may need suchborrowed funds for other equipment or activities. Leasing again comes to the rescue asit keeps the borrowing powers intact.

3. The sale and lease back technique comes in very handy when the borrower has limitedor no borrowing powers and wishes to borrow for a specific project or for workingcapital needs. This may be particularly true in the case of a growing organisation whereworking capital needs would also be growing, but the organisation is unable to obtainhigher borrowing, as its long term funds base is fixed and cannot itself be increased forvarious reasons. In such a situation, the sale and leaseback technique enables theorganisation to make higher borrowings to meet the growing working capitalneeds without having to bring in any additional equity.

Leasing is, therefore, also called "off balance sheet financing", as it finances new capitalassets without bringing them on the balance sheet, and also has the advantage of takingexisting capital assets 'off balance sheet' without disrupting their user.

4. Even where the organisation has borrowing power, it may prefer to adopt leasing asthe mode of financing its capital assets instead of resorting to borrowings on account of

the strings attached to borrowing, and restrictions imposed on the borrower. Financialinstitutions in India impose a lot of onerous conditions on the borrower. However, leasefinance is free from restrictive covenants of borrowing.

5. The leasing alternative provides "off balance sheet financing" and therefore, thereis scope for the lessee to escape asset based restrictions impose by the authorities (e.g.under the MRTP Act, etc.). Under the I (D & R) Act, however, the Government hasissued a notification that the value of assets obtained on lease is to be taken intoaccount.

6. Leasing provides 100% finance, as the lessee does not have to provide any marginmoney. The entire cost of the equipment is financed by the lessor.

7. Leasing avoids raising of equity and thereby prevents change in theshareholding pattern, which is important from the stand point of control overmanagement.

8. The leasing transaction can be completed swiftly as against the time-consumingand procedure-bound approval and disbursement process of loans. In fact, in manycases, the delay in sanction of loans results is an over-run of expenditure apart fromother hardships.

9. Leasing can take care of urgent non-budget additions expeditiously, as it doesnot upset the capital expenditure funding plans.

10. Though a pseudo advantage, in most cases, it is easier to obtain internalsanctions for acquiring assets on lease as against incurring capital expenditurethrough purchase.

11. Lease rental is entitled to a 100 percent tax exemption. Thus, if the rate ofincome tax payable by the lessee is say 60% and the lease rental is say 30% p.a.,effectively the lessee has to pay a rental of only 12% p.a. post-tax (i.e. 40% of 30%).

12. Acquiring equipment on lease provides a hedge against inflation, as the lessee paysfor today's equipment in tomorrow's currency, as against outright purchase, where thebuyer pays entirely in today's currency.

13. A lease rental package can be tailor-made to suit the needs of the lessee, and as it is acontract of mutual convenience. Rentals can be fixed to suit the cashflow of thelessee. Though lease rentals normally commence from the date of delivery, a holiday oflease rentals for a specified number of months can be considered in individual cases.The terms relating to onus of insurance and maintenance, period of lease, rate of rental,frequency of rental payment, etc. can be mutually agreed upon.

14. Apart from advantages to the lessee, leasing is also beneficial to themanufacturers and suppliers of equipment since it helps in boosting the sale oftheir equipment which is made available on lease. In fact, manufacturers stand to gain

by having tie-ups with leasing companies in order to push sales of their products in themarkets.

Disadvantages of Lease

Because the lease obligation generally is not disclosed in the balance sheet as aliability, but rather treated as a footnote to the financial statement, certain creditors andinvestors may not recognise the full implications of this contractual commitment. To theextent that it is not recognised, the ability of the firm to raise additional funds may seembetter if the asset were purchased and financed out of the debt.

One of the principal disadvantages of lease financing is that the lessee does not own theasset; any residual value after the basic lease period goes to the lessor.

Another major disadvantage is that the interest cost of lease financing usually is higherthan the interest cost of borrowing.

Also, long term leasing of assets is generally more expensive to the lessee.

Miscellaneous expenses have often to be borne by the lessee.

When a lease is long-term and non-cancellable, there is no chance for the lessee to shiftthe danger of obsolescence to the lessor.

REVIEW QUESTIONS

1. Explain the meaning of the term 'leasing' and state the different types of leases.

2. Leasing is often called "off balance sheet" financing. Explain reasons for agreeing ordisagreeing with this characterisation.

3. A sale and lease-back arrangement may be thought of as a special type of financiallease. How?

4. Is leasing an investment decision or a financing decision? How does lease financingprovide for financial leverage?

5. What are the major differences between (i) financial lease and operating lease, (ii)financial lease and sale-and-lease-back arrangement?

6. Distinguish between service lease and financial lease. Would you be more likely tofind a service lease employed for a fleet of trucks or for a manufacturing plant?

7. How will you evaluate lease financing versus debt financing decisions?

8. Explain the advantages and disadvantages of a lease as a source of finance.

9. Discuss the similarities and differences, if any, between a lease and a hire purchaseagreement.

10. Explain the following: (a) Maintenance lease, (b) Net lease, (c) Primary lease, (d)Perpetual lease, (e) Tax implications of leasing.

SUGGESTED READINGS

1. Rathnam, P V: Financial Advisor, Allahabad, Kitab Mahal

2. Saravanavel, P: Financial Management, New Delhi, Dhanpat Rai & Sons.

- End of Chapter -

LESSON - 19

DIVIDEND POLICY

Learning Objectives


· Understand the scope of management of earnings· Identify the determinants of dividend policy· Ascertain different kinds of dividend policies· Distinguish between stock dividend and stock split· The rules as to payment of dividend

Lesson Outline

· Management of Earnings - Sources of Profits - Profit Gear· Dividend Policy - Determinants of Dividend Policy· Kinds of Dividend Policies· Forms of Dividends - Stock Dividend and Stock Split· Companies Act and Payment of Dividend

Procurement of adequate amount of capital is not the be-all-and-end-all of the entireduties of management. As a matter of fact, the dexterity of management lies more in themanagement of earnings than in the procurement of capital. After obtaining the

necessary amount of capital, the next important function is to invest and utilise theprocured capital in such a way that the investors may get an adequate return on theirinvestments and the capital too may remain intact. Procurement of capital iscomparatively an easier task and it depends more on the condition of the money market.But efficient utilisation of the capital and the management of earnings are delicateissues which depend upon the internal administration of enterprises. The procuredcapital is usually invested in the further procurement of men, machines, and materials,and the ultimate result of this investment is either profit or loss, which in turn dependsupon the earning capacity of the company. The more the earning capacity of thecompany, the higher would be the profits.

MANAGEMENT OF EARNINGS

In the words of Gerstenberg, "Management of income in its broadest sense includes themanagement of each phase of the company’s business because each activity of businessusually involves income or expenditure." Creation of ill-planned reserves, unsounddepreciation policy and absence of scientific internal financial control are symbols ofdefective administration of income and may lead to liquidation. Hence, rationalmanagement of earnings is considered as an important tool of financial administration.The scope of management (or maximization) of earnings are:

(i) Increasing the level of profits of the company through capital-gear and profit-gear,

(ii) Management of dividends, and

(iii) Management of reserves and surpluses.

Level of Profit of the Company and its Significance

1. Correct financial performance reporting to the shareholders.2. Dividend declaration depending upon the determination of profit.3. Intensive use of capital can be ascertained by the earning capacity.4. Ascertaining the operating efficiency of the company.5. Future expansion and diversification of the company.6. Ease in obtaining loan or creating public response to further issue of securities.7. Determining the correct basis of merger or consolidation.8. Correct taxation planning is possible.9. Ascertaining the importance of the industry in national economy.10. Inter-firm and intra-firm comparison are made effective.

Sources of Profits

The principal sources of earning for a company may be classified into three groups:

1. Income from the main business : Internal financing or ploughing back of profitsdepends mainly on the income from this main source. The higher the profits, the heavierwould be the reserve of retained earnings.

2. Income from Other Sources : Any other income, besides the main source, fallsunder this head. The term 'other sources' refers to those sources which are allied to themain objective. Such income is separately shown in the accounts of the company.

3. Income from Investment : More often, the surplus funds of a company areinvested in the purchase of securities of other companies. Such investment may bepermanent or temporary. Certain companies are legally bound to invest a part of theircapital in government securities, e.g., banks and insurance companies. Income frominvestments is also separately shown in the Profit and Loss account/Balance Sheet of acompany.

Advantages of Stable Earnings

Although there is no direct correlation between the stability of earnings and theprofitability of a business over a complete business cycle, stability of revenues is one ofthe aims of business.

(i) The stable flow of income simplifies the task of management by facilitating long-termplanning and enabling it to control the performance efficiently

(ii) It permits the enterprise to maintain its organisation

(iii) It also helps in building a sound capital structure

(iv) Forecasting and business budgeting can be done successfully on proper lines

(v) Stable dividend policy depends considerably on stable earnings

(vi) It increases the credit-worthiness of a company, which can get the companyadequate loans at a reasonable rate of interest

(vii) Stable earnings also help in keeping the price steady, which is beneficial from thestandpoint of consumers.

Hence, all possible efforts be taken to keep the earnings of a company stable.

Factors Affecting the Stability of Earnings

Generally speaking, the stability of gross earnings depends upon the following fourelements:

1. Nature of business: It is a notable fact that enterprises dealing in basic andessential services, low-priced commodities, non-durable goods, or consumergoods have more stable earnings than those dealing in luxurious, high-priced ornovelty goods, heavy goods and raw materials.

2. Size of business: Mere size of business has a salutary effect in keepingrevenues steady, where size is a result of product diversification. Enterprises

characterised by large scale production, upto a certain point at least, have a widemargin of profit when compared with smaller concerns, and can withstandtemporary losses better than the small companies.

3. Possession of elements of a monopoly: Other things being equal, a concernthat enjoys some elements of monopoly will have steadier revenues than one thatis subject to intense competition. The monopoly benefits may arise on account ofpatents, copyrights, particular locational site etc.

4. Profit gear: The profit derived by some tactical policies i.e., by taking properadvantage of a situation may be termed as tactical profit. Profitability may beimproved at least temporarily by some management tactics apart from routinepolicies and plans. The tactical profit has special significance in the total profit.The relation of such tactical profit with the routine profit may be Profit Gear. Thehigher the Profit Gear the greater is the importance of such tactical policies. In aperiod when there is no occasion to take tactical decision to increase profit or ifwrong policies are followed, the profitability may be substantially affected. Thustactical decisions may be taken up as profit-boosters. Even moderate dose ofover-trading may boost up the profit.

Similarly, timely action may act as loss-breaker or loss-absorber. Special sales drive mayresult in extra contribution and reduction in loss. Timely closure of seasonal factory likea sugar mill will result in avoiding loss by avoiding avoidable daily expenses. That is, indifficult days, loss minimisation, rather than profit maximisation may be the suitableobjective. In the case of reduction of loss by tactical decision, the profit gear may becalculated by finding out the ratio of loss avoided with usual loss.

DIVIDEND POLICY

Dividend policy, as intimately related to retained earnings, refers to the policyconcerning quantum of profits to be distributed as dividend. This is probably the mostimportant single area of decision making for the finance manager. Action taken by themanagement in this area affects growth of the firm. An erroneous dividend policy mayland the firm in financial predicament and capital structure of the firm may becomeunbalanced. Progress of the firm may be hamstrung owing to death of resources, whichmay result in fall in earnings per share. Stock market is very likely to react to thisdevelopment and share prices may tend to, sag leading to decline in the total value ofthe firm. Extreme care and prudence on the part of the policy framers is, therefore,inevitable.

If strict dividend policy is formulated to retain larger share of earnings, plenty ofresources would be available to the firm for its growth and modernisation purposes.This will give rise to business earnings. In view of the improved earnings position andfinancial health of the enterprise, the value of shares will increase and a capital gain willresult. Thus, shareholders earn capital gain in lieu of dividend income, the former in thelong-run and the latter in the short-run. The reverse holds true if liberal dividend policyis followed to pay out higher dividends to shareholders. Consequently, the stockholders'dividend earnings will increase but the possibility of earning capital gains is reduced.Investors desirous of immediate income will greatly value shares with high dividend.

The stock market may, therefore, respond to this development and value of shares mayzoom.

It is, thus, evident that retention of earnings lies on capital gains. Distribution ofincome, on the other hand, increases dividend earnings. Owing to varying notions andattitudes of shareholders due to difference in respect of age, tax bracket, securityincome, habits, preferences and responsibilities, some shareholders are primarilyconcerned with the short-run returns, others think in terms of long-range returns, andstill others seek a portfolio which balances their expectations over time. The aboveanalysis lead us to conclude that dividend decision materially affects the stockholder'swealth and the valuation of the firm. However, financial scholars have not beenunanimous on this issue.

Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial considerations. It isdifficult to determine a general dividend policy which can be followed by different firmsat different times because the dividend decision has to be taken considering the specialcircumstances of an individual case. The following are the important factors whichdetermine the dividend policy of a firm:

1. Legal Restrictions : Legal provisions relating to dividends as laid down in sections93, 205, 205A, 206 and 207 of the Companies Act, 1956 are significant because they laydown a framework within which dividend policy is formulated. These provisions requirethat dividend can be paid only out of current profits or past profits after providing fordepreciation or out of the money provided by Government for the payment of dividendsin pursuance of a guarantee given by the Government. The Companies Act, further,provides that dividends cannot be paid out of capital, because it will amount toreduction of capital, adversely affecting the security of its creditors.

2. Magnitude and Trend of Earnings : The amount and trend of earnings is animportant aspect of dividend policy. It is rather the starting point of the dividend policy.As dividends can be paid only out of present or past year's profits, earnings of acompany fix the upper limits on dividends. The dividends should generally be paid outof current year's earnings only, as the retained earnings of the previous years becomemore or less a part of permanent investment in the business to earn current profits. Thepast trend of the company's earnings should also be kept in consideration while makingthe dividend decision.

3.Desire and Type of Shareholders : Although, legally, the discretion as to whetherto declare dividend or not has been left with the Board of Directors, the directors shouldgive due importance to the desires of shareholders in the declaration of dividends, asthey are the representatives of the company. Desires of shareholders for dividendsdepend upon their economic status. Investors, such as retired persons, widows andother economically weaker persons view dividends as a source of funds to meet theirday-to-day living expenses. To benefit such investors, the companies should pay regulardividends. On the other hand, a wealthy investor in a high income tax bracket may not

benefit by high current dividend incomes. Such an investor may be interested in lowercurrent dividends and high capital gains. It is difficult to reconcile these conflictinginterests of the different types of shareholders, but a company should adopt its dividendpolicy after taking into consideration the interests of its various groups of shareholders.

4. Nature of Industry : Nature of industry, to which the company is engaged, alsoconsiderably affects the dividend policy. Certain industries have a comparatively steadyand stable demand irrespective of the prevailing economic conditions. For instance,people used to alcohol continue to buy it both in boom as well as recession. Such firmsexpect regular earnings and hence, can follow a consistent dividend policy. On the otherhand, if the earnings are uncertain, as in the case of luxury goods, conservative policyshould be followed. Such firms should retain a substantial part of their current earningsduring boom period in order to provide funds to pay adequate dividends in the recessionperiods. Thus, industries with steady demand of their products can follow a highestdividend payout ratio while cyclical industries should follow a lower payout ratio.


5. Age of the Company : The age of the company also influences the dividenddecision of a company. A newly established concern has to limit payment of dividendand retain a substantial part of earnings for financing its future growth anddevelopment, while older companies which have established sufficient reserves canafford to pay liberal dividends.

6. Future Financial Requirements: In addition to desires of the shareholders,future financial requirements of the company also must be taken into considerationwhile making a dividend decision. The management of a concern has to reconcile theconflicting interests of shareholders and the company's financial needs. If a companyhas highly profitable investment opportunities it can convince the shareholders thatthere is a need to limit dividend payment in order to increase the future earnings andstabilise the company's financial position. But when profitable investment opportunitiesdo not exist, then the company may not be justified in retaining substantial part of itscurrent earnings. Thus, a concern having few internal investment opportunities shouldfollow high payout ratio as compared to one having more profitable investmentopportunities.

7. Government's Economic Policy: The dividend policy of a firm has also to beadjusted to the economic policy of the Government, as was the case when theTemporary Restriction on Payment of Dividend Ordinance was in force. In 1974 and1975, companies were allowed to pay dividends not more than 33.33 per cent of theirprofits or 12 per cent on the paid-up value of the shares, whichever was lower.

8. Taxation Policy: The taxation policy of the Government also affects the dividenddecision of a firm. A high or low rate of business taxation affects the net earnings of acompany (after tax) and thereby its dividend policy. Similarly, a firm's dividend policymay be dictated by the income-tax status of its shareholders. If the dividend income ofshareholders is heavily taxed being in high income bracket, the shareholders may foregocash dividend and prefer bonus shares and capital gains.

9. Inflation: Inflation acts as a constraint in the payment of dividends. Profit arrivedfrom the Profit & Loss account on the basis of historical cost has a tendency to beoverstated in times of rise in prices due to over-valuation of stock-in-trade and writing-off depreciation on fixed assets at lower rates. As a result, when prices rise, fundsgenerated by depreciation would not be adequate to replace fixed assets, and hence tomaintain the same assets and capital intact, substantial part of the current earningswould be retained. Otherwise, imaginary and inflated book profits in the days of risingprices would amount to payment of dividends much more than warranted by the realprofits out of the equity capital resulting in erosion of capital.

10. Control Objectives: When a company pays high dividends out of its earnings, itmay result in the dilution of both control and earnings for the existing shareholders. Asin case of a high dividend pay-out ratio, the retained earnings are insignificant and thecompany will have to issue new shares to raise funds to finance its future requirements.The control of the existing shareholders will be diluted if they cannot buy the additionalshares issued by the company. Similarly, issue of new shares shall cause increase in thenumber of equity shares and ultimately cause lower earnings per share and their price inthe market. Thus, under these circumstances to maintain control of the existingshareholders, it may be desirable to declare lower dividends and retain earnings tofinance the firm's future requirements.

11. Requirements of Institutional Investors: Dividend policy of a company can beaffected by the requirements of institutional investors such as financial institutions,banks, insurance corporations, etc. These investors usually favour a policy of regularpayment of cash dividends and stipulate their own terms with regard to payment ofdividend beyond certain percentage on equity shares.

12. Stability of Dividends: Stability of dividends is another important guidingprinciple in the formulation of a dividend policy. Stability of dividends simply refers tothe payment of dividend regularly. Shareholders generally prefer payment of suchregular dividends. Some companies follow a policy of constant dividend per share whileothers follow a policy of constant payout ratio, while there are some others who follow apolicy of constant low dividend per share plus an extra dividend in the years of highprofits. A policy of constant dividend per share is most suitable to concerns whose

earnings are expected to remain stable over a number of years or those who have builtup sufficient reserves to pay dividends in the years of low profits. The policy of constantpayout ratio, i.e., paying a fixed percentage of net earnings every year may be supportedby a firm because it is related to the firm's current ability to pay dividends. The policy ofconstant low dividend per share plus some extra dividend in years of high profits issuitable to the firms having fluctuating earnings from year to year.

13. Liquid Resources: The dividend policy of a firm is also influenced by theavailability of liquid resources. Although, a firm may have sufficient available profits todeclare dividends, yet it may not be desirable to pay dividends if does not have sufficientliquid resources. Hence, the liquidity position of a company is an importantconsideration in paying dividends.

Kinds of Dividend Policies

There are a wide variety of dividend policies followed by companies. Selection of aparticular dividend policy is decided by the management after considering severalfactors. The possible policies are :

(a) Policy of no Immediate Dividends: Payment of dividends is desirable from thecompany's and shareholders' point of view, but it is not compulsory. The Board ofDirectors may decide to pay no dividend, even though the earnings are substantial andavailable for the purpose. A company following this policy may justify it under thefollowing conditions:

(i) The company is new and growing

(ii) The needed capital cannot be raised except at very high cost and earnings,therefore, must be ploughed back in the business

(iii) The shareholders are willing to wait for a return on their investment, and inthe meantime, are content to have their holdings appreciate in value (capitalgains).

The no dividend policy must be used with great caution as it may cause dissatisfaction toshareholders because of non-payment of current dividends. After a period of nodividends while the surplus is increasing, it may be a good policy to issue bonus shares(stock dividend) so that the net worth of the company is not affected.

(b) Stable Dividend Policy: A stable dividend policy is one that maintains regularityin paying some dividend regularly even though the amount of dividend may fluctuatefrom year to year and may not be related with earnings. More precisely, stability ofdividends refers to the amount paid out regularly. Stability of dividends can take threeforms:

i. Constant dividend per share, i.e., paying a fixed amount per share asdividend every year irrespective of the fluctuations in the earnings.

ii. Constant percentage of net earnings, i.e., paying a fixed percentage of netearnings every year (here, the amount of dividend will fluctuate in directproportion of earnings), and

iii. Small constant dividend per share plus extra dividend.

Generally, when we refer to a stable dividend policy, we refer to the first form of payingconstant dividend per share. A stable dividend policy, therefore, does not mean aninflexible policy, but one that involves payment for a fair rate of returns after taking intoconsideration the gradual growth of the business and the gradual evolution of externalvalues.

Merits of Stable Dividend Policy: Stable dividend policy brings various benefits tothe company and shareholders.

(1) It helps in long-term financing. If a company anticipates having to raiseadditional funds some time in the future, it must keep in mind that today'soperations will be part of the record that investors would like to examine criticallyin deciding whether to buy the company's securities. A stable dividend policy, inthat event, would make financing easier.

(2) It improves the company's credit and enhances the market value of securities.

(3) It creates shareholder's confidence in the management and reduces investor'suncertainty. Dividends have informational value a company can make statementsabout its expected earnings growth to inform shareholders in order to create afavourable impression on them.

(4) The benefits outlined above would bring a great relief to the management informulating long-term planning for the company.

From what has been said above, one should not get an erroneous impression that thestable dividend policy is without any drawback. The greatest danger associated with astable dividend policy is that once it is adopted by the firm, it cannot be changed easily.It is, therefore, prudent that the dividend rate is fixed at a lower level so that it can bemaintained even in years with reduced profits.

(c) Policy of Regular and Extra Dividends: This policy carries out the intention ofregular (stable) dividend rate, and at the same time allows shareholders to have a shareof additional earnings through extra dividends. It is not an unusual practice forcompanies to pay extra year-end dividends if the results of business operations indicatetheir justifiability. In order to avoid any possible misunderstanding, it is alwaysadvisable to clearly indicate to shareholders the amount of regular and extra dividends.In future if extra dividend is not paid, then the shareholders would not get disillusionedwith the company. Large companies, usually, number their dividends and label them asregular or extra.

(d) Policy of Regular Stock Dividends: A stock dividend policy refers to thedistribution of shares in lieu of (or in addition to) cash dividend (known as bonus sharesin India) to the existing shareholders. Such a policy results in increasing constantly thenumber of outstanding shares of the company. The policy to pay regular stock dividendsis justified when:

(i) there are earnings available with the company but the need is to retain cash inthe business, and

(ii) companies have modernisation and extension programmes, which need to befinanced immediately.

The policy of regular stock dividends is not generally advisable. The policy can applyonly temporarily, however, the constant cutting up of the corporate ownership into alarge number of shares may prove harmful in periods of reduced earnings. Also, thevalue of shares may fall below a desirable range from the stand-point of later financing.Those shareholders who have a strong preference for cash dividends would feel totallydisillusioned with the company.

(e) Policy of Regular Dividends and Stock Dividends: The company using thisdividend policy pays regular (stable) dividend in cash and extra dividend in stock. Thisdividend policy is adopted when a company:

(i) wants to continue its records of regular cash payments,

(ii) has reinvested earnings that it wants to capitalise, or

(iii) wants to give shareholders a share in the additional earnings but cannot affordto use up its cash.

(f) Policy of Irregular Dividends: This policy is based upon an attitude thatshareholders are entitled to as much dividends as the earnings and financial conditionof the company warrant. Having this policy of declaring dividends is entirelyappropriate for a company that has highly unstable earnings. If this dividend policy isadopted by a company with stable earnings, it will have disastrous consequences for thecompany and shareholders.

Forms of Dividends

1. Annual or Regular Cash Dividends: It is the dividend being paid annually by thecompany. It is also known as final dividend. When annual accounts of the companyhave been finalised and audited, the directors recommend the rate of dividend whichcan be distributed on the capital of the company. When approved by the shareholders atan annual general meeting, the dividend is paid within 42 days from the date ofdeclaration by the company. It is generally paid in cash and as a percentage of the paid-up capital, e.g. 10% or 15% of the face value of the share. Though in some cases,dividend per share can also be distributed.

2. Interim Dividends: When companies have heavy earnings during a year anddirectors wish to pay them to the shareholders but at same time, they do not wishshareholders to regard the amount as a precedent for later years, they can distributeinterim dividend. So, it is an extra dividend paid during the year. Such dividends areimmediately paid after the recommendation of the Board of Directors, as there is noneed of shareholders' approval. Interim dividends are also cash dividends.

3. Scrip Dividends: Scrip dividends are used when earnings justify a dividend, but thecompany's cash position is temporarily weak. So, shareholders are issued transferablepromissory notes, which may or may not be interest bearing.

4. Bond Dividends: In rare instances, dividends are paid in Bonds or Notes that havea long enough term to fall beyond the current liability group. Except that the date ofpayment is postponed, the effect is the same as that of paying dividends in scrip. Theshareholders become a secured creditor if the bond has a lien on assets.

5. Property Dividends: Property dividends involve a payment with non-cash assets.Such a distribution may be made whenever these are assets that are no longer necessaryin the operation of the business. The investment held by the company also can bedistributed by the company in the form of property dividends.

However, it is important to note that only cash dividends and stock dividends (i.e.,bonus shares) are permissible in India; other types of dividends are not allowed. TheIndian Companies Act, 1956 governs the declaration and payment of dividends.

6. Stock Dividends: It is a form of dividend in which the surplus of company istransferred to capital account and shareholders are given the dividend in the form ofshares rather than cash. Such shares are called bonus shares. This dividend isdeclared to only Equity Shareholders and it may take two forms:

(i) converting the partly paid equity shares into fully paid up without asking forcash from the shareholders, or

(ii) issuing and allotting shares to existing equity shareholders in a definiteproportion out of reserves and surpluses.

Thus, the shareholders receive stock or share certificate for the dividend. This process isalso known as 'capitalisation of profits'. Stock dividend does not alter the cash positionof the company. It serves to commit the retained earnings to the business as a part of itsfixed capitalisation.

Objects of Stock Dividend: Stock dividends may be issued to serve one or more ofthe following objectives:

1. Conservation of Cash: By issuing bonus shares, a company gives profits of itsprosperity to the shareholders without giving away cash. Hence, distribution ofdividends "in kind" conserves the cash in the business.

2. Lowering the rate of dividend: Stock dividend is a remedy for undercapitalisation too. Under-capitalised enterprise having a high rate of earnings onthe capital employed lowers the rate of dividend by increasing theircapitalisation. The increase in the number of shares is intended to reduce the rateof dividend per share.

3. Transferring the formal ownership of surplus and reserves to theshareholders: The existence of huge accumulated profits and other reservesmay provide temptation to the corporate management to indulge in speculativeactivities and to manipulate the market value of the company shares. But oncethese reserves are capitalised by issuing bonus shares, the scope for the aboveactivities is reduced.

4. Widening the share market: A company desiring wider ownership of itsshares may issue bonus shares. Some of the old shareholders might sell their newshares. Moreover, the probable reduced value of the share prices may fall withinthe buying range of more number of investors.

5. Financing the expansion programs: The expansion and modernisationprogramme of a company can easily be financed by utilising the corporate savingsthrough the issue of bonus shares. Bonus shares become the permanent part, ofthe capital structure of a company.

6. Enhanced prestige: Bonus shares tend to increase the credit-standing of theissuing company. Its borrowing capacity goes high in the eyes of lendinginstitutions. It can arrange loans at a reasonable cost.

7. True depiction of earning capacity : If the revenues are not capitalised, afalse idea about the rate of profits is created because shares capital is leftunchanged while profits continue to accumulate.

8. Tax advantage: Bonus shares are sometimes issued to reap the benefit of ahigher rate of deduction allowed on paid-up capital than on the reserves underthe Payment of the Bonus Act, 1965.

Advantages of Stock Dividends

1. Maintenance of liquidity position: By issuing bonus shares a company canmaintain its liquidity position, as cash dividends are not paid to the shareholders;only bonus shares are issued.

2. Satisfaction of shareholders: By the issue of bonus shares, the number ofequity shareholders in the company increases and they gain by the increasedconfidence of investors in the soundness of the corporation. Hence, shareholderscan be satisfied by issuing bonus shares.

3. Remedy for under-capitalisation: In under-capitalised enterprises, the rateof dividend is high. By issuing bonus shares, the rate of dividend per share can bereduced, and a company can be saved from the negatives of wider-capitalisation.

4. Economical issue of securities: The issue of bonus shares is the mosteconomical issue of securities, because other types of securities cannot be issuedat this minimum cost.

5. There is conservation of control, and internal financing is available to thecompany.

6. Tax Saving: Bonus shares are issued to take the benefit of a higher rate ofdeduction allowed on paid up capital than on the reserves under the Payment ofthe Bonus Act, 1965.

7. Increase in their equity: By issuing bonus shares, the equity of theshareholders increases in the company. For example, A is the owner of 20 equityshares of Rs. 100 each. Now the company issues four bonus shares to him i.e.,one bonus share for every 5 shares held. In the beginning, his equity was Rs.2000 in the company, but now his equity increased upto Rs. 2,400 in thecompany.

8. Increased marketability of shares: When a company issues bonus shares,some of the old shareholders sell their new shares to the other persons. Hence, byissuing bonus shares the marketability of shares is increased.

9. Increase in income: In the long-run the income of the shareholders is alsoincreased. But it will be possible only when company is able to maintain the samerate of dividend as before on the increased capital also.

Disadvantage of Bonus Shares Issue

(1) It leads to an increase in the capitalisation of the corporation which cannot bejustified until and unless there is a proportionate increase in the earning capacity of thecompany.

(2) It throws more liability in respect of future dividend on the company.

(3) It excludes the possibility of new investors coming in contact with the company.

(4) The market value of existing shares goes down.

(5) Some shareholders may not like bonus shares; they might prefer only cashdividends. Such investors may be disappointed. It lowers the market value of theexisting shares too.

Stock Split-ups

A corporation may issue stock split-ups to its shareholders. A stock split-up increasesthe number of shares of the outstanding stock. There is no change in the total statedvalue of the stock or in the surplus. It has no effect on shareholders’ equity. Its effect issolely to repackage the evidence of ownership in small units. Stock split-ups are issuedwith the following objectives:

a. To increase the number of outstanding shares for the purpose of effecting areduction in their unit market price and obtaining an orderly distribution ofshares;

b. To conceal the distribution of large profits by reducing the rate per share;

c. To provide a broader and more stable market for the stock;

d. To prepare for corporate mergers;

e. To please shareholders, since stock split-ups are viewed as bullish by the marketand stockholders take split-ups as on indicator of the financial success of acorporation;

f. To facilitate manipulation by insiders;

g. To precede new financing.

Comparison of Stock Dividend and Stock Split

Stock Dividend Stock Split

1 The par value of the stock isunchanged

The par value of the stockreduces

2 A part of reserves is capitalized There is no capitalization ofreserves

In a nutshell, a stock-split is similar to a bonus issue from the economic point of view,though there are some differences from the accounting point of view.

COMPANIES ACT AND PAYMENT OF DIVIDEND

Provisions of Companies Act relating to Declaration and Payment of Dividend:

Declaration and payment of dividend is an internal matter of the company and isgoverned by its Articles. The power regarding appropriation of profits is given to theBoard of Directors. The Directors are to follow Table A or provisions of Articles and theprovisions of the Companies Act 1956 in this regard. These are the rules regardingdeclaration and payment of dividend:

1. Dividend on Paid up Capital : A company may, if so authorised by its Articles, paydividend on the paid up value of shares (section 93 of the Companies Act).

2. Provisions of Articles of Association (Rules 85 to 94 of Table A)

(a) A company may declare dividend in its General Meeting provided it does not exceedthe amount recommended by the Board of Directors,

(b) The Board of Directors may, from time to time, pay to the members such interimdividends as appears to be justified by the profits of the company,

(c) Notice of dividend should be given to those who are entitled to receive it,

(d) The Directors may transfer any amount they think proper to the Reserve Fund,which may be utilised for any contingencies, and

(e) When a dividend has been declared, it becomes a liability of the company towardsthe shareholders from the date of its declaration, but no interest can be claimed on it.

3. Dividends only out of Profit (Sec. 205 (i))

(a) Dividends can only be declared or paid out of

i. the current profits of the company,

ii. the past accumulated profits, or

iii. money provided by the Central or State Government for the payment ofdividends in pursuance of a guarantee given by that government.

No dividend can be paid out of capital. Director responsible for payment of dividend outof capital shall be personally liable to make good such amount to the company.

(b) Companies are not entitled to pay any dividend unless present or arrears ofdepreciation have been provided for out of the profits, and an amount of 10% of profitshas been transferred to the Reserve. However, Central Government may allow anycompany to declare or pay dividends out of profits before providing for anydepreciation.

(c) Capital Profits may also be utilised for the declaration of dividend provided

i. there is nothing in the Articles prohibiting the distribution of dividend out ofcapital profits,

ii. they have been realised in cash, and

iii. they remain as profits after revaluation of all assets and liabilities.

(d) Dividend cannot be paid out of accumulated profits unless current losses are madegood.

4. Payment of Dividend only in Cash (Sec. 205(iii))

Dividends are to be paid in cash only except

(a) by capitalising the profits by issue of fully paid bonus shares if Articles so permit,provided all legal formalities have been satisfied in respect of issue of bonus shares, and

(b) by paying up any unpaid amount on partly paid up shares.

5. Payment of Dividend to Specified persons (Sec. 206)

Dividend shall be paid only to those whose names appear on the Register of members onthe date of declaration of dividend or to the holders of dividend warrants if issued by thecompany.

6. Payment of Dividend within 42 days (Sec. 207)

Dividend must be paid within 42 days of its declaration except in the followingcircumstances:

(a) by operation of law of insolvency,

(b) in compliance of the directions of the shareholders,

(c) where right to receive dividend is pending decision,

(d) where it is not due to the default of the company, and

(e) if the company lawfully adjusts the amounts against any debt due from theshareholder.

Any director in default shall be liable to punishment of seven days of simpleimprisonment or fine or both.

7. Payment of Interim Dividend:

The directors of a company can pay interim dividend, subject to the provisions ofArticles. Interim dividend can be paid at any time between the two AGMs (annualgeneral meetings) taking into full year's accounts and after providing full year'sdepreciation on fixed assets.

8. Transfer of Unpaid Dividend to a Special Bank Account (Sec. 205 (A))

According to section 205 A, newly inserted by the companies (Amendment) Act 1974,where a company has declared a dividend but has not posted the dividend warrant inrespect thereof within 42 days to the shareholders entitled to it, such unpaid dividendsshall be transferred to a special account to be opened by the company in the behalf inany Scheduled Bank to be called 'Unpaid Dividend Account of. Co. Ltd.' If the unpaiddividends are not so transferred, the company shall pay an interest at 12% p.a.

9. Transfer of Unclaimed Dividend to Central Government:

Any amount transferred to the unpaid dividend account which remains unpaid orunclaimed for 3 years from the date of such transfer, shall be transferred to the InvestorProtection Fund by the company along with a statement giving full particulars in respectof the sums so transferred and the last known addresses of the persons entitled toreceipt and such other particulars as may be prescribed. The company is entitled to areceipt for such transfer from the Reserve Bank of India.

If a company fails to comply the above said provisions (given in Para 8 and 9 above), thecompany and every officer of the company who is in default shall be punishable with afine which may extend to Rs. 500 for every day during which default continues.

REVIEW QUESTIONS

1. Explain the significance of dividend decisions in financial management.

2. Outline and analyse the fundamental issues concerning corporate dividend policy.

3. Explain the various external and internal factors which influence the dividenddecision of a firm.

4. What are the different types of dividends that can be paid by a company?

5. Explain (i) Constant-Pay-out Ratio Policy (ii) Constant Rupee Policy, and (iii)Regular-Extra dividend Policy. What are the ramifications of these policies?

6. What are the advantages and disadvantages of stock dividend to the company and tothe shareholders? Explain.

7. As a firm's financial manager, which policy would you recommend to the Board ofDirectors that the firm should adopt - a stable dividend payment per share policy or astable pay-out ratio policy?

8. Write a short note on Pay-out Ratio. What is its importance in dividend decisions?

9. What are Bonus Shares? Explain in brief the provision of Company Law relating tothem and the guidelines issued by SEBI.

10. Describe the various provisions of Companies Act, 1956 governing the declarationand payment of dividend.

SUGGESTED READINGS




- End of Chapter -

LESSON – 20

RELEVANCE AND IRRELEVANCE OF DIVIDEND DECISION

Learning Objectives


· Recognise the controversies as to relevance of dividends· Understand the different models - dividend theories

Lesson Outline

· Dividend Theories· Walter's Model· Gordon's Model· M.M. Model· M.M. Theory Criticisms· Illustrative Examples

Several theories studying relationship between dividend and value of the firm have beenadvanced. Broadly speaking, these theories can be grouped into two categories, viz.

(a) Theories relating to relevance of dividend decision in valuation of firm, and

(b) Theories concerning irrelevance of the dividend decision.

The former set of theories, with which James E. Walter, Myron Gordon, JohnLinter and Richardson are associated, hold that there is a direct relationship betweendividend policies of the firm and its market valuation of earnings, since the investor isconcerned about how the earnings are split up between dividends and retention.

The irrelevance approach of dividend decision was propounded by Merton Miller andFranco Modigliani. According to these scholars, dividend decision is irrelevant and

does not affect share values as investors are basically indifferent to whether they getreturns in the form dividends or in the form of capital gains.

DIVIDEND THEORIES

I. Walter's Model : The basic emphasis of Walter's model is "maximisation of wealthfor the shareholders". Professor Walter brings about the importance of the relationshipbetween a firm's internal rate of return and its cost of capital in determining a dividendpolicy.

Walter's model is based on the following assumptions:

1. All investment opportunities are financed by retained profits.

2. The firm's Internal Rate of Return (IRR) and its Cost of Capital (CoC) are constant.

3. All the profits are immediately either distributed as dividends or re-investedinternally.

4. The firm has a very long and continuous life.

The value of earnings per share (EPS), and dividend per share (DPS) may be varied todetermine the results, but any given values of EPS and DPS are assumed to be constantforever for determining a given value.

The model is as follows:

DPS IRR (EPS – DPS)/CoC

MPS = --------- + -----------------------------

CoC CoC

where,

MPS = Market Price Per Share

DPS = Dividend Per Share

EPS = Earnings Per Share

IRR = Internal Rate of Return

CoC = Cost of Capital

The above can be written as:

IRR

DPS + -------- (EPS – DPS)

CoC

MPS = ------------------------------

CoC

From the above we are able to conclude that the two major factors influencing themarket price of a share are

(1) the dividend per share, and (2) the relationship between IRR and CoC.

One can visualise mathematically three kinds of relationship between IRR and CoC.

IRR > CoC (Growth firms)

IRR = CoC (Normal firms)

IRR < CoC (Declining firms)

Let us take an example and find out the optimal dividend policy for the first cases: IRR> CoC

Assuming, CoC = 15% and EPS = Rs. 10. Since IRR > CoC, let us take IRR = 20%. Then,if dividend payout is 0 (i.e., DPS = 0),

It is seen clearly that the optimal policy for a growth firm is to have dividend payout atzero, since its Market Price goes down as the dividend is increased.

Similarly it can be established for a normal firm (IRR = CoC) that MPS is not affected bythe payout ratio, and as such there is no optimum policy.

For a declining firm (IRR < CoC), optimal policy would be to have the dividend pay-outat 100%

Criticism: Walter's Model is criticised for the following:

1. There is no external financing,

2. The IRR is constant, and

3. The cost of capital is also constant.

In practice the IRR and CoC can never be constants as they change from time to time.


II. Gordon's Model

This model is also called Dividend Capitalisation Model. Here, the market value ofshare is equated to the present value of an infinite stream of dividends to be received bythe shareholder.

The Model is as follows:

DPS = Dividend Per Share

K = Appropriate discount rate (Cost of Capital)

In this model, the dividend rate is assumed to grow in future when earnings areretained. Assuming a growth percentage of 'g' the above model can be re-looked at asfollows:

When the above is solved, the equation reduces itself to:

The following are the assumptions of the Gordon Model:

1. The firm is an all equity firm.

2. No external finance is assumed. All retained earning is used for further expansion.

3. The IRR is constant and also the appropriate discount rate (k) or cost of capital is alsoconstant.

4. Corporate taxes do not exist.

5. The earnings are continuous.

6. The proportion of retained earnings is constant and the discount rate (cost of capital)is greater than the growth rate (k > g).

The Gordon Model can be restructured from the assumptions. Since the proportion ofretained earnings is always constant, dividend will be always constant. Dividend willalways be (1 - RE%). If total earnings in a period is E, then dividend will be (1 - RE%)and earning would grow at a constant IRR.

We can substitute the above assumptions and study the results for variouscharacteristics of the firm.

As seen before, MPS = D1 / (k - g) = E1 (1 - RE) / (k - RE x IRR) in case of a normalfirm,

Since k = IRR the above can be simplified as,

MPS = E1 (1 - RE) / (k - RE x k)

= E1 (1 - RE) / k (1 - RE)

= E1 / k

So, MPS = E1 / k

E1 is a return on assets, and hence the MPS will be equal to book value of assets as longas the return equals the discount rate or cost of capital. Hence, we find that MPS is afunction of E1/k or Return on Assets r/k.

The relationship can be established for r > k, r = k, and r < k, as we did in Walter’sModel. You will find that the optimal policy does not change by analyzing the same withexample given under Walter's Model.

III. Miller and Modigliani (MM) Theory

While the earlier two theories - Walter's Model and Gordon's Model - laid emphasis onmaximization of shareholders' wealth, Miller and Modigliani (MM) assert that given theinvestment decision of the firm, the dividend payout ratio does not affect the wealth ofthe shareholders. Their contention is that the value of firm is solely determined by thefirm's investment policy and earning power on its assets, and that the split-up betweendividend and retained earnings is irrelevant and has no significance.

The critical assumption of MM is that the rate of return 'r' for a share which ispurchased at time '0' is equal to the dividend received at time 1 plus the capitalgain/losses on the same. Converting into an equation, we get:

r = D1 + (P1 - P0)

P0

where,

r = Internal Rate of Return

D1 = Dividend at the end of period 1

P1 = Market price per share at period 1

P0 = Initial purchase price

Reclassifying the above, we get

r x P0 = D1 + P1 - P0

r x P0 + P0 = D1 + P1

P0 (1 + r) = D1 + P1

P0 = (D1 + P1) / (1 + r)

Since IRR (r) is equal to the cost of capital (CoC) under the assumptions, we can saythat,

P0 = (D1 + P1) / (1 + CoC)

The above is the value for one share. If the firm has 'n' number of shares, we get the totalvalue of the shares of the firm as,

V = nP0 = n(D1 + P1) / (1 + CoC)

One of the basic assumptions in both Walter's and Gordon's Models is that no externalfinancing is envisaged. But MM theory allows external financing. The crux of the MMtheory is that the effect of dividend payment on shareholders' wealth is offset exactly byother means of financing. When the firm has made its investment decision, it mustdecide whether to retain earnings or to pay dividends or sell new shares in order tofinance the investments. The decline in market price of share on account of increasedshares offsets the payment of dividend exactly.

Let us see how this is brought out by the MM model:

nP0 = n(D1 + P1) / (1 + CoC)

If the firm decides to issue 'm' new shares at time 1 at a price P1, the total value of sharesthen will become nP0 + mP1.

If we want to know the value of the new shares at time 0, then the value = nP0 + mP1/(1+ CoC)

This value is to be equated to the overall value at time 1.

At time 1, the number of shares are (n + m), and the dividends paid would have beenonly for 'n' shares. The overall equation then will be:

mP1 nD1 + (n+m) P1

nP0 + ------------ = -----------------------

(1 + CoC) (1 + CoC)

Simplifying, we get value as,

nD1 + (m+n)P1 - mP1

nP0 = -----------------------------

(1 + CoC)

The additional investment can be either financed by retained earnings or by new sharesor by both, as per MM's assumptions. The amount of new shares mP1 will then be equalto (Investment - Retained earnings) or,

mP1 = I1 - (X1 - nD1), where X1 = profits, I1 = Investment

mP1 = I1 - X1 + nD1

Substituting for mP1 in the previous equation, we get,

nD1 + (m+n)P1 - (I1 - X1 + nD1)

nP0 = ------------------------------------------

(1 + CoC)

(m+n)P1 - (I1 - X1)

nP0 = ------------------------

(1 + CoC)

From the above, we find that the term D1 cancels out. MM assumes that the other termsX1, I1, (n + m) P1 and CoC are assumed to be independent of D1.

MM Model thus concludes that the current value of the firm is independent of itscurrent dividend policy. What is gained by the shareholder in increased dividend isoffset exactly by the decline in the terminal value of share. The Model also concludesthat nP0 is unaffected not only by current dividend decisions but by future dividenddecisions as well. Thus the shareholders are indifferent between retention of earningsand the payment of dividends in all future periods.

MM Model also asserts that the dividend irrelevance is not affected even if the firmraises external funds by issuing debt instead of shares, as the real cost of debt is thesame as the real cost of equity financing. In case of debt financing, their conclusion isthe same with regard to leverage. Even when the assumption of complete certainty isdropped, they still conclude that dividend policy continues to be irrelevant, as theyattribute it to the familiar arbitrage argument. The shareholders' wealth is unaffected bycurrent and future dividend decisions. It depends entirely upon the expected futureearnings stream of the firm.

Criticism: MM Theory of dividend irrelevance works out well under a set oftheoretical assumptions. But these are hardly valid and unrealistic in practice, especiallyin the Indian context. We find the capital markets hardly perfect. MM theory loses therelevance here. Internal and external financing are not equivalent and dividend policydoes affect the perception of shareholders. The following are the major criticisms leveledagainst the MM theory:

1. Taxes: The assumption that taxes do not exist, is only a theoretical possibility. InIndia complicated tax laws exist. From the viewpoint of the shareholder, capital gains ispreferable than dividend income because: (i) the capital gains tax is lower than the taxon dividends, and (ii) capital gains arise only when the shares are actually sold. Thevalue of the share goes up if the entire profits are retained rather than getting externalfinancing.

2. Existence of floatation and transaction Costs: MM's assumption is that thewealth of shareholders does not change whether the firm uses internal financing orexternal financing. But in practice there are always underwriting and brokerage costswhen new shares are issued, whereas there are no such costs when the profits areretained. Similarly, the shareholder has to pay a brokerage fee when he decides to sellthe shares.

3. The discount rate 'r' and Cost of Capital 'CoC' are assumed to be equal. Inreality, both differ and investors would always like to maximise their earnings by goingin for different set of portfolios.

4. MM contends that the dividend policy continues to be irrelevant whetherthe market is certain or uncertain. This has been contradicted by Gordon. Heasserts that uncertainty increases with time span. This implies that risk increases as wellas the discount rate. As such, shareholders would prefer immediate dividends than afuture stream of dividends to avoid risk.

5. The last criticism is about the informational content regarding dividends; MMassumes that this does not affect their contention of irrelevance. But the fact is thatinformation regarding dividends does have an impact on the share prices because theycommunicate information regarding the profitability of the firm. If a firm which has astable dividend policy, deviates and changes the ratio, then the shareholders andinvestors might believe that the management is announcing a change in the expectedfuture profitability of the firm. Accordingly, the price of the share might change.

Illustration 1: The earnings per share of a company are Rs. 8 and the rate ofcapitalisation applicable to the company is 10%. The company has before it an option ofadopting a payout ratio of 25% or 50% or 75%. Using Walter's formula of dividendpayout, compute the market value of the company's share if the productivity of retainedearnings is (i) 15% (ii) 10%, and (iii) 5%.

Solution:

Given EPS = 8, CoC = 10%

Market value of the company's share under different payout options:

(i) If productivity of retained earnings is 15% (IRR = 15%)

For payout ratio 0f 25% (DPS = 25% of EPS = 25% x Rs.8 = Rs.2),

Market Value of Share, MPS

IRR 0.15

DPS + -------- (EPS – DPS) 2 + ------ (8 - 2)

CoC 0.10

= -------------------------------------- = ---------------------------- = 11 / 0.10 =Rs.110

CoC 0.10



IRR 0.15

DPS + -------- (EPS – DPS) 4 + ------ (8 - 4)

CoC 0.10

= --------------------------------------- = -------------------------- = 10 / 0.10 =Rs.100

CoC 0.10



IRR 0.15

DPS + -------- (EPS – DPS) 6 + ------ (8 - 6)

CoC 0.10

= -------------------------------------- = -------------------------- = 9 / 0.10 =Rs.90

CoC 0.10

(ii) If productivity of retained earnings is 10% (IRR = 10%)



IRR 0.10

DPS + -------- (EPS – DPS) 2 + ------ (8 - 2)

CoC 0.10

= -------------------------------------- = -------------------------- = 8 / 0.10 =Rs.80

CoC 0.10



IRR 0.10

DPS + -------- (EPS – DPS) 4 + ------ (8 - 4)

CoC 0.10

= ------------------------------------- = --------------------------- = 8 / 0.10 =Rs.80

CoC 0.10



IRR 0.10

DPS + -------- (EPS – DPS) 6 + ------ (8 - 6)

CoC 0.10

= -------------------------------------- = --------------------------- = 8 / 0.10 =Rs.80

CoC 0.10

(iii) If productivity of retained earnings is 5% (IRR = 5%)



IRR 0.05

DPS + -------- (EPS – DPS) 2 + ------ (8 - 2)

CoC 0.10

= ------------------------------------ = ------------------------- = 5 / 0.10 = Rs.50

CoC 0.10



IRR 0.05

DPS + -------- (EPS – DPS) 4 + ------ (8 - 4)

CoC 0.10

= ------------------------------------- = ------------------------- = 6 / 0.10 = Rs.60

CoC 0.10



IRR 0.05

DPS + -------- (EPS – DPS) 6 + ------ (8 - 6)

CoC 0.10

= --------------------------------- = ---------------------------- = 7 / 0.10 = Rs.70

CoC 0.10

Illustration 2: Textool Ltd. has 80,000 shares outstanding. The current market priceof these shares is Rs.15 each. The company hopes to make a net income of Rs.2,40,000during the year ending on March 31, 1995 and it belongs to a risk class for which theappropriate capitalisation rate has been estimated to be 20%. The company's board isconsidering a dividend of Rs.2 per share for the current year that began on April 1, 1995.

Assuming no taxes, answer questions listed below on the basis of the Modigliani-Millerdividend valuation model:

(a) What will be the price of the share at the end of March 31, 1995 (i) if the dividend ispaid, and (ii) if the dividend is not paid?

(b) How many new shares must the company issue if the dividend is paid and thecompany needs Rs. 5,60,000 for an approved investment expenditure during the year?

Solution:

Given, n = 80,000 shares; P0 = Rs.15; X1 = Rs.2,40,000; CoC = 20%; D1 = Rs.2 pershare

(a) (i) If the dividend is paid

According to MM Model, current market price per share P0 = (D1 + P1) / (1 + CoC)

15 = (2 + P1) / (1 + 0.20)

15 (1.2) = 2 + P1

P1 = 18 - 2 = Rs.16 = Price of the share at the end of the period, ending March 31, 1995

(a) (ii) If the dividend is not paid

15 = (0 + P1) / (1 + 0.20)

15 (1.2) = P1

P1 = Rs.18

(b) Dividend is paid, and price of the new share is Rs. 16

Given P1 = Rs.16, Investment I1 = Rs. 5,60,000 and Net income X1 = Rs.2,40,000

According to MM Model, the total value of new shares,

mP1 = I1 - (X1 - nD1), where m is the number of new shares issued

m x Rs.16 = 5,60,000 - (2,40,000 - (80,000 shares x Rs.2))

16m = 4,80,000

m = 3000 shares

REVIEW QUESTIONS

1. What are the various theories of dividend policy?

2. Critically evaluate MM theory. What do you feel about the relevance of the theory inthe Indian context?

3. Compare and contrast dividend theories for (a) growth firm (b) normal firm, and (c)declining firm

4. What are the assumptions which underly Gordon's model of dividend effect? Doesdividend policy affect the value of the firm under Gordon's model?

5. What is the informational content of dividend payments? How does it affect the sharevalue?

PRACTICAL PROBLEM

1. The earnings per share of the face value of equity Rs.100 of PQR Ltd. is Rs.20. It hasan internal rate of return of 25% of EPS. Capitalisation of its risk class is 12.5%. IfWalter's model is used,

(a) What should be the optium payout ratio?

(b) What would be the market price per share if the payout ratio is zero?

(c) How shall the market price of the share be affected if more than zero payout isemployed?

(d) Suppose the company has a payout of 25% of EPS, what would be the price pershare?

[Ans: (a) zero, (b) Rs. 320, (c) The optimum payout ratio for growth firm is zero. For anormal firm one dividend policy is as good as the other. The optimum payout ratio fordeclining firm is 100%, (d) Rs. 280]

SUGGESTED READINGS




4. Rathnam, P.V.: Financial Advisor, Allahabad, Kitab Mahal.


- End of Chapter -

LESSON - 21

RETAINED EARNINGS

Learning Objectives


· Know the significance of retained earnings· Understand the factors affecting size of relative earnings· Detail the various kinds of reserves and surplus· Ascertain the financial significance of depreciation funds/polices

Lesson Outline

· Retention of Earnings· Factors Affecting Size of Retained Earnings· Advantages and Disadvantages· Reserves and its kinds· Surplus and its main classes· Financial Significance of Depreciation Funds/Policies

From the financial viewpoint, the earnings of a business enterprise for any one year arechannelised into three main directions:

(i) The government's share in the profits through income tax,

(ii) The portion to the shareholders as cash dividends; and

(iii) The residual amount retained in the business.

Dividend and retained earnings are controlled by the decisions of corporatemanagement. They decide how much profit should be paid to shareholders in the formof dividend and how much to be retained in the business. The higher the dividend rate,the lower the quantum of profits retained in the business. The management has to strikea balance between the decision in such a manner that neither the continuous flow ofbusiness operations is interrupted nor the shareholders' requirements of steadydividend payment remain unsatisfied.

RETENTION OF EARNINGS

Business enterprises try to save a part of their current earnings for meeting futurefinancial needs of expansions, modernisation, rationalisation and replacementprogrammes. The main feature of retained earnings is that it is an internal source offinance and emanates from profits not distributed to shareholders as dividends. Theother names of retained earnings are 'internal financing', 'self-financing' or 'ploughingback of profits'. The process of creating savings in the form of reserves and surpluses forits utilisation in the business is technically referred to ploughing back of profits.

Features and Significance of Retained Earnings

(i) The main feature of retained earnings is that it is an internal source of finance. Thismethod of financing avoids any long-term debt and does not dilute the ownership.

(ii) Retained earnings for expansion, modernisation etc. is an ideal arrangement fromthe point of view of corporate management because there is no immediate pressure topay a return on this portion of the funds, though it does have a cost which the firm hasto bear. Also this source can be used without creating charge on assets of the company.

(iii) Retained earnings augment the capital base of the business. This puts the companyin a better position to borrow more funds.

(iv) Retained earnings can be utilised for purposes of paying-off the old debts of thecompany and paving a way for greater amount of new funds.

(v) Decision to retain earnings has direct and indirect advantages for the shareholders.Retention of earnings offers the benefit of tax-saving to shareholders. With increasedretention of earnings, the shareholder's equity magnifies. Better creditworthiness of thebusiness leads to higher share prices and future growth prosperity.

(vi) Greater reliance on the use of retained earnings also helps reducing the burden onthe financial system of the country.

Factors Affecting Size of Retained Earnings

The amount of earnings that may be retained in the business is affected by many factors,such as the characteristics of the industry and company, level of profits of the company,management policies about depreciation, dividends policy, and taxation policy.

(i) Characteristics of industry and company: The policy relating to retention ofearnings varies not only between industries, but even among companies within the sameindustry, and sometimes within a company from time to time. Growth industries andgrowth companies are usually characterised with low payout and high retention rates.The reasons are obvious. The more rapid the growth, the greater the demand foradditional funds for expansion. The higher the profitability, the greater the temptationto retain funds, but this is with the basic dividend policy.

(ii) Level of profits of the company: Notwithstanding anything else, larger the levelof profits, greater the amount of earnings available for retention. However, the size ofprofits is a function of factors such as the demand of product, cost of production anddistribution, price, structure of the products, degree of competition in the market,general price level etc.

(iii) Management policy regarding depreciation: At the very outset, it may becategorically specified that depreciation is not a source of funds, however, the inclusionof depreciation expense in the profit and loss statement reduces the net income andhence the income tax and to that extent the funds are available with the business. This isbecause in the present face of ever-rising prices, larger amount of depreciation in initialyears will have greater time value. This is possible with the adoption of the accelerateddepreciation policy. The straight line method of depreciation, on the other hand, doesnot make available larger amounts of funds with the business in the initial life of theasset but charges it uniformly.

(iv) Dividend policy: One of the vital factors affecting the magnitude of retainedearnings is the dividend policy followed by the management. There is an inverserelationship between the payout ratio and retention of earnings. A liberal dividendpolicy would reduce the amount of retained earnings.

(v) Taxation Policy: The higher the rate of corporate tax (corporate tax rate is fixed,but the rates are different for different companies), the smaller the amount of fundsavailable for retention. The rate of corporate tax is higher in case of closely heldcompanies, and is also called the 'rate of distribution of profit'. Such companies,therefore, are in a less privileged position to retain bigger amount of earnings. Atpresent, there exists no provision to encourage retention of corporate earnings exceptthe provision of depreciation being allowed as tax deductable expense.

ADVANTAGES of Retained Earnings

The advantage of retention of earnings or self-financing for the convenience of study,can be classified under three groups

(i) The Corporation,

(ii) The Shareholders, and

(iii) The Country

(i) Advantages to the Corporation

a. Provides a cushion to absorb the shocks of business vicissitudes

b. Ease in financing schemes of rationalism

c. No dependence on ‘fair-weather friends’

d. Helps in stabilizing the dividend policy

e. Deficiencies of depreciation can be made good

f. Easy retirement of bonds or debentures

(ii) Advantages to the Shareholders

a. Safety of investment

b. Rise in the market value of securities

c. Profit by retaining the shares

d. Evasion of super tax

(iii) Advantage to the Country

a. Aids in capital formation

b. Greater, better and cheaper production is facilitated

c. Smooth and continuous functioning of enterprises

d. Quick financing of rationalization schemes

DANGERS / DISADVANTAGES of Excessive Retention of Earnings

The proceedings description might give the impression that retention is alwaysbeneficial to shareholders, company and the nation. This is not to so. Excessiveretention of earnings and their reckless utilization is detrimental to the interest of all:

(i) To Shareholders

a. It results in foregoing dividends for a long period and to a large extent

b. The corporate management may enjoy the accumulated earnings to finance the needof the company in which they are interested even though shareholders may have interest

in them, thus bringing little or no gain to them. Shareholders are benefited out of thissource only when management invests the amount of retained earnings in projectscontributing to their wealth, i.e., the return on projects is greater than the cost involvedin retained earnings.

(ii) To the Company

a. If the accumulated earnings are indiscriminately used for the issue of bonus shares, itmay result in over-capitalisation of the company, with its negative consequences likereduced future dividends, reduced share prices, manipulation etc. The company'sfinancial stability may be threatened.

b. Excessive retention of earnings by one company in relation to its competitors may,over a long period of time, result in occupying monopoly position in the market. Likeover-capitalisation, monopoly position has its own evil consequences for consumers andsociety.

c. Excessive retention of earnings also increases the manipulative powers of thecompany management. For instance, the management may manipulate share prices. Byreducing the rate of dividend, in the first instance, it may cause downfall of prices in themarket and using this opportunity to buy shares at reduced prices. Subsequently, ahigher rate of dividend may be declared causing an increase in share prices and thenusing the same opportunity to sell them at increased prices.

(iii) To the Nation

Excessive retention of earnings may not do any social good also. Retained earnings willnot be used for capital formation and in socially profitable investments. Use of retainedearnings for manipulative purposes will certainly upset the financial system of thecountry.

RESERVES

Meaning: "Precaution is better than cure" is a common sense maxim. On the sameprinciple, 'provisions' should be made in business also for all possible contingencies.According to Companies Act 1956, the expression 'provision' shall mean "any amountwritten-off or retained by way of providing for depreciation, renewals or diminution invalue of assets, retained by way of providing for any known liability of which the amountcannot be determined with substantial accuracy".

The term 'reserves' has not been specifically defined in the Act, but it refers to "thatamount which has been provided for any purpose other than those mentioned above". Ithas been stated that any amount retained by way of providing for any known liability isin excess of the amount which, in the opinion of the directors, is reasonably necessaryfor the purpose, and the excess shall be treated for this purpose as a reserve and not as aprovision.

Kinds: Reserves may be general or specific.

General Reserve is that part of the profits of the company which is set aside formeeting any future emergency. Its various purposes may be;

(i) to stabilise the economic condition of the company,

(ii) to meet the increasing demands of the business,

(iii) to meet casual losses, or

(iv) to conceal the real profits of the company.

In the last case they are known as 'Secret Reserves'.

Specific Reserves are usually created out of profits of capital nature. Such reservescannot be utilised for dividend distribution; their main objective is to stabilise theeconomic condition of the company.

Reserve can be classified into three categories:

(i) Valuation Reserves

(ii) Liability Reserves, or

(iii) Proprietary reserves.

Valuation Reserves are used to restore the integrity of investment when assets havesuffered a loss in value. They are also known as 'specific reserves'.

Proprietary Reserves comprise a number of reserve accounts like reserve fordividends and general reserve.

Liability Reserves are provided to take into account the liabilities arising out ofcurrent operations like reserve for taxes or reserve for pensions, etc.

Liability reserve is more like valuation reserve than proprietary reserve. Valuationreserve is a matter of necessity while proprietary reserve is usually a matter of financialprudence. Valuation reserve is a charge against P & L account while proprietary reserveis an appropriation of profits. Proprietary reserves help in increasing the equity of theshareholders in the company.


SURPLUS

The term 'surplus' represents the undistributed earnings of the company, i.e., thebalance of profits that remain after paying the dividends. Surplus is regarded as awelcome sign by the management. It reflects upon the sound earning capacity of thecompany. Surplus can be divided into three main classes:

(a) Earned Surplus: It is created by the net profits from operations after meeting allthe expenses therefrom. Sometimes, past accumulated profits are also transferred toearned surplus account. Different revenue reserves are also, sometimes, transferred tosuch surplus account.

(b) Capital Surplus: Such surplus is that which is created out of capital gains andnon-recurring receipts. It is also known as 'paid-in-surplus'.

(c) Revaluation Surplus: These surpluses arise from revalution of assets. Theappreciation in the value of fixed assets can be transferred to this surplus account. Thisis particularly done in the periods of rising prices or when the outlook for future isbright.

Uses of Surplus: The accumulated surpluses can be utilised by the company for avariety of purposes / uses, for example,

(i) for reducing the value of fixed and working capital,

(ii) for writing-off intangible assets like goodwill, preliminary expenses, reorganisationexpenses, etc.,

(iii) for equalising the rate of dividend payment but it is possible only if

· they are actually realised in cash,· they are not likely to affect the liquidity position of the company adversely,· they remain after revaluation of all assets and liabilities of a company, and· the Articles of Association of the company permit such distribution.

(iv) for absorbing the shocks of business cycles,

(v) for making up the deficiencies of loss,

(vi) for financing schemes of betterment. For instance, obsolescence may be more rapidthan anticipated or the deteriorated economic conditions may prevent the collection ofdebts. Under such circumstances, the deficiency can be made good out of accumulatedsurplus.

Financial Significance of Depreciation Funds/Policies

The significance of depreciation funds can be discussed with reference to certainmanagement's decisions:

(i) Internal Investment Decision: The provision of depreciation in accountingreports does not in any way affect investment decision implied by the replacement of anasset. Depreciation is taken into consideration indirectly by comparing the cashproceeds generated by asset with the cost thereof.

(ii) Measuring Performance: As the performance is generally measured by eitherincome or return on investment, both of which depend on the method of depreciationaccounting. The straight line depreciation gives reasonably good measure of income incase the revenues and maintenance requirements are constant throughout the life of theasset, but it distorts the return on investment, which would increase with a decrease inthe book value of the asset due to depreciation.

(iii) Fund generation: Generally, it is thought that depreciation is a source of funds.It is not the function of depreciation accounting to provide funds for replacement; fundsmust come from the revenues of the business. The charge for depreciation neitherincreases nor decreases the amount available to, say, purchase equipment. Even themaking of charges to income and setting up of reserves for depreciation give noassurance regarding the availability of funds for replacement, unless they are in someway earmarked for the purpose.

(iv) Make or Buy Decisions: In a make or buy decision, a relevant cost would onethat could be avoided if the part was not made but bought. It would not be relevant costif it would be incurred irrespective of the decision of making or buying. The depreciationof the factory building cannot be avoided by the elimination of one phase of productionand so it would not be relevant in the make or buy decision.

(v) Pricing Decisions: A firm is expected to produce at a point where its marginalcost equals marginal revenue, and to fix a price equal to the average revenue that willsell the appropriate quantum of output. In this context, depreciation is not taken intoaccount in arriving at decisions regarding price fixation. In spite of the fact that themanager may set the price as dictated by competition, he is bound to recover not onlythe fixed costs but also make a profit, if he is skilful in market manipulations throughtimely pricing decisions.

Factors Complicating Depreciation Policy:

A decision regarding depreciation method becomes complex due to the followingconsiderations:

(a) Tax implication: In India the Income Tax law prescribes a method of depreciationi.e., the Diminishing Balance Method. If a company adopts the Straight Line methodthen it will have to declare a different income for taxation purposes as opposed to theincome reckoned for accounting purposes.

(b) Impact on dividend distribution: The company cannot pay dividends exceptout of profits. Profit means the surplus left after providing for depreciation under any ofthe recognised methods. If the management chooses the straight line method, thedistributable surplus in the earlier years would be larger. This would enable themanagement to declare dividend more easily than if they follow the diminishing balancemethod.

(c) The cash flow implication: Cash flow is the difference between sales revenueand cash cost. If the depreciation figure is less, the quantum of profit would be more,and vice versa. Thus the profit plus depreciation has its influence on the quantum ofdistributable profit, and hence on the quantum of dividends. It has already been stalledthat the quantum of cash flow from operations is not to be affected by a change in themethod of depreciation.

(d) Depreciation and changing price levels: Depreciation is the process ofallocation of the historical cost over a period of years. Another objective of depreciationis building up of adequate funds to replace the asset at the end of its full service. Ifdepreciation is calculated on the estimated replacement cost of the asset, then thisimportant objective could be met. But this would lead to arbitrary and highly volatiledepreciation charges in each year.

Factors that Affect the Choice of Method:

The most widely used methods of providing for depreciation are the Straight LineMethod and the Reducing Balance Method, but the factors that affect the choice ofmethods are as follows:

(a) The passage of time - predominantly recognised by the Straight Line Method.

(b) The use of the asset - predominantly recognised by the Product Method.

(c) The rapid deterioration of assets as, for example, loose tools, where the RevaluationMethod may be used.

(d) The effect of associated procedures, such as costing methods which can aid thecalculation of depreciation by, for example, the Production Method.

(e) The possible onset of obsolescence and, therefore, the early write-off of the majorportion of cost by using, for example, the Reducing Balance Method.

(f) Company Connection Influence: The Sum-of-Years Digits method is rarely used inGreat Britain but widely used in America. A subsidiary in this country may be requiredto follow the American practice.

(g) The Effect of Maintenance Expenditure: To equalise product costs, an attempt maybe made to match low maintenance costs with high depreciation or vice versa in any oneaccounting period.

(h) The intention to provide funds for the business at the end of the anticipated assetlife, as a result of setting aside the depreciation provision, e.g., use of the Sinking Fundor Endowment Policy Method.

(i) The need to recognise that funds invested in the asset should be providing a return,e.g., use of the Annuity Method.

(j) The effect of taxation: For tax computation, the rates used for tax purposes may beadopted by the company.

It is important to choose a method which results in a fair allocation to the accountingperiod and to product cost. It is possible, for example, to have misleading product costdata, if two identical products are produced on two different machines, and onemachine is fully depreciated while the other machine is not. In this situation, a differentdepreciation allocation may be made in the costing records from the one adopted for thefinancial accounts. Alternatively, the depreciation may be treated as a fixed cost andexcluded from product cost, e.g., where marginal costing is used.

REVIEW QUESTIONS

1. What is meant by Reserves and Surplus?2. Why are reserves created and how do they serve in stabilising profits and value of

the firm?3. What are the factors affecting size of retained earnings?4. State the advantages of retained earnings as a source of finance viz. Self financing

from the view of a nation, shareholders and the company.5. What are the dangers inherent in excessive retention of earnings?6. "The success of a business concern depends in no small a measure upon the way

in which its earnings are computed, distributed and retained" - Comment.7. Write an essay on the correct policy about allocation of a company's earnings to

depreciation reserves and dividends.8. Explain the financial significance of depreciation policies and methods.

SUGGESTED READINGS

1. Pandey, I. M.: Financial Management, New Delhi, Vikas Publishing House.


- End of Chapter -

LESSON - 22

MERGERS AND ACQUISITIONS

Learning Objectives


· Understand the meaning of merger, take-over, etc.· Know the different kinds of mergers.· Identify the circumstances which influence merger of companies.· Specify the regulations/guidelines for take-over and merger.· List out recent mergers and acquisitions in India.

Lesson Outline

· Concept of Merger and Acquisition· Classification of Mergers - Operating Mergers versus Financial Mergers· Circumstances which influence merger of Companies - Financial and Non-

financial factors· Major Mergers in Indian Corporate Sector· Regulation of Mergers/Take-overs by SEBI· Role of Financial Institution in Mergers and Take-overs· Acquisitions of Companies in Indian Corporate Sector· Tender Offer - Defensive Strategies· Issues to be considered in Mergers and Acquisitions.· Leveraged Buy-Out· Illustrative Examples

CONCEPT OF MERGER AND ACQUISITION

A company may grow internally, or it may go externally through acquisitions. Theobjective of the firm in either case is to maximise existing shareholders' wealth. Acompany can acquire another company through merger, take-over, consolidation etc. Amerger is a combination of two companies where only one survives. The merged

company goes out of (corporate) existence, leaving its assets and liabilities to theacquiring corporation. Consider the merger of Tata Fertilizers Ltd (TFL) with TataChemical Limited (TCL), the promoting company. Under the scheme of merger, TFLshareholders were offered 17 shares of TCL (market value per share was Rs. 114), forevery 100 shares of TFL held by them. Further, TFL's cumulative convertible preference(CCP) shareholders, who may not want to accept shares in exchange, were given theoption of cash payment of Rs. 15 for every share they held. In this merger, TCL is anacquiring company, which survives after the merger, whereas TFL is being the acquiredcompany, which ceases to exist after the merger.

A merger is different from a consolidation or amalgamation, which involves thecombination of two or more companies, whereby an entirely new company is formed.All the old companies cease to exist, and their equity shares (common stock) areexchanged for shares of the new company. For example, Hindustan Computer Ltd(HCL), Hindustan Instruments Ltd (HIL), Indian Software Company Ltd (ISCL) andIndian Reprographics Ltd (RFL) were amalgamated in April 1986 into a new companycalled HCL Ltd. In this amalgamation, all the four amalgamated companies lost theircorporate identities and formed a new company known as HCL Ltd. When twocompanies of about same size combine, they usually consolidate; on the other hand,when the two companies differ significantly in size, usually a merger is involved.Though it is important to understand the distinction, the terms 'merger' and'consolidation' tend to be used interchangeably to describe coming together /combination of two companies.

The term take-over means the acquisition by one person or group of persons or acompany of sufficient shares in another company to give the purchaser control of thatother company. A take-over in this sense differs from merger, as the company which istaken-over by the purchaser remains in existence, while in merger one of the twocompanies goes out of existence. Thus, take-over tends to denote the situation whereone business offers to buy out the ownership of another, often against the wishes of theBoard of Directors or groups of shareholders. The dividing line between the two isindistinct. A number of situations which are presented as mergers are effectively take-over bids. The Directors of the taken-over company, being unable to control effectivelythe course of events in their business, are glad that the other business is willing topreserve their self-esteem by presenting the take-over operation as merger.

The primary motivation for mergers is to increase the value of combined enterprise. Ifcompanies A and B merge to form company C, and if C's value exceeds that of A and Btaken separately, then synergy is said to exist. Synergistic effects can arise from threesources:

(i) Operating economies resulting from economies of scale in production or distribution,

(ii) Financial economies, including a higher Price-Earnings ratio or a lower cost of debt,or both, and

(iii) Increased market power due to reduced competition.

Operating and financial economies are socially desirable, but mergers that reducecompetition are both undesirable and illegal.

CLASSIFICATION OF MERGERS

Economists classify mergers into three groups:

(a) Horizontal Mergers: When two or more companies producing the same goods oroffering the same services decide to merge, it becomes a horizontal merger. Thehorizontal merger involves reduction in the number of competing companies in theeffected markets; for example, the emergence of Associated Cement Companies (ACC)Limited when small cement plants all over the country decided to merge into onecompany; the National Textile Corporation (NTC) resulting from the merger of severalsick units manufacturing textile products into one corporation; merger of SundaramClayton Limited's (SCL) moped division with TVS Suzuki Limited (TSL); and take-overof Universal Luggage Company by Blowplast Company are other examples forhorizontal mergers.

(b) Vertical Mergers: A vertical merger or integration is a merger between twocompanies manufacturing different products but having customer-supplier relationship,wherein the product of one company is used as raw materials by the other company. Themerger between Tata Iron and Steel Company Ltd and Indian Tube Company Ltd is avertical merger.

(c) Conglomerate Mergers: Pure conglomerate merger occurs where one companytakes over another company in a completely different industry, with no importantcommon factors between them in production, marketing, research and development ortechnology. Such mergers result in no reduction in competition in the industriesconcerned. An example of this type of merger is between Mahindra and MahindraLimited and Indian Aluminum Company Limited.

Operating Mergers versus Financial Mergers

From the standpoint of financial analysis, there are two basic types of mergers:

1. Operating mergers, in which the operations of two companies are integrated with theexpectation of operating economies for obtaining synergistic effects. The primarybenefit from an operating merger is high expected profits. For example, the combinedcompany may be able to reduce overheads and thereby increase profits.

2. Pure financial mergers, in which the merged companies will not operate as a singleunit, and from which no operating economies are expected. The expected benefits offinancial mergers are more varied. In one case, the target company may have nofinancial leverage, so the acquiring firm may plan to buy the company, pay for it byissuing debt, and gain market value from the capital structure change. In anotherinstance, one of the firms may be so small that its stock is illiquid, and its Price-Earningsratio is low. In such a case the stock will have a low value, and it may represent a bargain

purchase for the acquirer value. In other instances, one firm may have excessiveliquidity, large annual cash flows, and unused debt capacity, while another firm mayneed financial resources to take advantage of growth opportunities.

In any type of merger, parties such as the shareholders of the company, the creditors,the employees, the government through monopoly commissions, the lending financialinstitutions, the stock exchange, high courts etc., get involved. In a decision to allowmerger of public limited companies, the interest of minority shareholders and the publicinterest in general should always be considered before the necessary permission tomerge is granted by the authorities concerned. These parties should evaluate theproposal of merger in proper perspective considering carefully the following factorsaffecting the mergers:

(i) Capacity to influence its market share,

(ii) Efficiency of the merged enterprise,

(iii) Regional imbalance and the employment,

(iv) Effects on balance of payment, and

(v) Public interest.

Financial and Managerial Considerations

Amalgamation is the blending of two or more existing undertakings, the shareholders ofeach company becoming substantial shareholders in the company which is to carry onthe blended undertakings. The term 'amalgamation' has not been defined in theCompanies Act. It is an arrangement whereby the assets of two or more companiesbecome vested in or under the control of one company. Amalgamation comes into playwhen two companies are joined to form a third company or one is absorbed into orblended with another. Amalgamation generally takes place between companies whichare associated with one another in some form or other e.g. common shareholders, unityof management, common line of business, location of activities etc. But amalgamationbetween two companies which have nothing in common can also take place and this hasbecome equally popular in the present emphasis on diversification and insulationagainst economic, socio-political vicissitudes besides uncertainties of nature. The overallconsiderations of business and the needs of socio-economic changes including of scale,industrial and trade policies of the state may also influence the merger of companieswith a view to achieving long term economic and financial benefit, both for thecompanies concerned and the shareholders.

CIRCUMSTANCES THAT INFLUENCE MERGERS

(a) Gap between corporate objectives and achievements: Despite reasonableinternal growth, management might find a clear gap between expectations andrealisations either due to time constraint, want of special managerial skills, productive

capacity, technology, research and development etc. Merger of companies may facilitatecompanies to grow from a higher take-off point and record incremental sales volume,marshall effectively the available resources and ensure optimum returns.

(b) The need for diversification: With a view to ensuring greater stability in theearnings and working capital management and to get over the limitation of managerialknow-how, product and production technology, marketing skills and other key factors,amalgamation may provide the answer for exchange of all the readymade skills of thecompanies concerned, so that the new emerging management may adopt them toadvantage. With the transplanting of new skills, the new management will also berevitalised and the company poised for further accelerated growth.

(c) Spreading the risk: A small company is exposed to relatively more risk inembarking upon a new product line. Initial and potential losses may be top high whencompared to capital base. Combination with a larger company would spread the risk.

(d) Elimination of unhealthy competition: Two companies running identicalbusinesses can merge together to avoid competition and save huge money oncompetitive advertisements.

(e) Related lines of business: Where activities of companies are complimentary toone another, merger can help reduce cost of products. Different companies dealing withproduct at different stages of production, all of which ultimately result in the productionof one or more major items or products can also merge together under a commonownership.

(f) Long gestation period: A capital intensive company with a long gestation periodcan advantageously increase its debt capacity by merging with another non capitalintensive company, especially when the latter company is a cash rich company and theidle cash can be profitably invested.

(g) Shareholder's net worth: Shareholders of a closely held company can reasonablyexpect a better return upon the company merging with a widely held company besidesensuring enough liquidity and feasibility of altering their investment portfolio. Furtherthe earning per share of the amalgamating company is bound to improve and futureearnings ensured.

(h) Tax benefits: The various tax benefits that accrue from amalgamation formadditional incentives.

(i) Non-financial factors: Apart from the financial factors, the following non-financial factors have also to play a part in merger proposals:

a. Role and compensation of the earlier management over the new oramalgamated company,

b. Continuation and promotion of the existing products,

c. Opportunity to enter new markets,

d. Bargaining capacity after merger,

e. Safeguards for future growth,

f. Other gains to the amalgamating company,

g. Other gains to the amalgamated company

(j) Qualitative factors: In a merger proposal, the amalgamated company not onlytakes over the physical assets and liabilities of the amalgamating company but also itsexperience, organisation, proven performance, skilled staff, goodwill etc.

(k) Other circumstances:

a. Seasonal or cyclical companies can merge with either non-seasonal or othercompanies for various reasons like funds management etc.

b. For sick companies, perhaps, amalgamation with a successful company is a practicalproposition.

c. For successful companies, amalgamation would help securing certain potential taxincentives apart from providing for external expansion.

d. Small companies can merge with other small companies if they have necessarymanagerial talent and competence in addition to ensuring funds flow.

e.Closely held companies may merge with widely held companies in order to takeadvantage of the tax benefits. Even foreign companies can merge and make theamalgamated company an Indian company to ensure the tax benefits, by first convertingthe foreign branch into an Indian company as a subsidiary of the foreign company,which in turn can be merged with an Indian company, subject to the restriction imposedby other legislations like MRTP., FERA, etc.

Illustration

Firm A is studying the possible acquisition of Firm B by way of a merger. The followingdata is available:

Firm A:

After-tax earnings = Rs. 10,00,000

No. of equity shares = 2,00,000

Market price per share = Rs.75

Firm B:

After-tax earnings = Rs. 3,00,000

No. of equity shares = 50,000

Market price per share = Rs.60

(i) If the merger goes through by exchange of equity shares and the exchange ratio is setaccording to the current market prices, what is new earning per share for Firm A?

(ii) Firm B wants to be sure that its earning per share is not diminished by the merger.What exchange ratio is relevant to achieve the objective?

Solution:

(i) According to current market prices, B's position will be as follows:

Value of B's shares will be equal to value of A's shares, when 5 shares of Firm B @ Rs.60are matched with 4 shares of Firm A:

5 x Rs.60 = 4 x Rs.75 = Rs.300

i.e. for every 5 shares of B, 4 shares of A will be exchanged.

In total, the Firm B will get (50,000 shares x Rs. 4 / Rs.5) = 40,000 shares of A

New EPS = Rs.10,00,000 + Rs. 3,00,000

2,00,000 shares + 40,000 shares

= Rs. 5.417 = Rs. 5.42

(ii) By adopting the above method, B's EPS will come down to Rs. 5.42

Present EPS of B is Rs. 3,00,000 = Rs.6

50,000 shares

Present EPS of A is Rs. 10, 00,000 = Rs. 5

2,00,000 shares

Hence, B should get 6 shares for every 5 shares of A, i.e.

(50,000 shares x Rs. 6 / Rs. 5) = 60,000 shares of A

New EPS of B will be Rs. 10,00,000 + Rs.3,00,000 = Rs. 5 per share.

2,00,000 shares + 60,000 shares

Firm B, by getting 60,000 shares of A as against its own 50,000 shares, the objectiveachieved is:

60,000 x 5 = Rs. 30, 00,000

EPS = Rs. 3,00,000 = Rs. 6

50,000 shares

Source: Economic Times, July 15, 1993.

Merger Process in India: The process of amalgamation is regulated by theCompanies Act, 1956. The following procedure for the amalgamation is normallyfollowed:

Examination of object clause

Intimation to Stock Exchange

Approval of Amalgamation Draft

Making Application in the High Court

Drafting of notice and explanatory statements, and its dispatch

Filing an affidavit in court

Holding of meeting of shareholders and creditors

Petition to the court for confirmation

Passing of orders by High Court

Transfer of the assets and liabilities

Issue of shares and debentures

Historical Perspective: In India, the whole business of mergers and takeovers till the1970s was at a low key, though profitable affair: discussions were generally conductedacross the board and negotiated settlements reached amongst the parties concerned. Inthe negotiated settlement, shareholders other than the controlling interests had no realsay, though in the case of mergers they were required to vote for or against the mergerresolution. The enormous clout wielded by the financial institutions came to light whenthe famous raid of DCM Ltd. and Escorts Ltd. was launched by Swaraj Paul in the early1980s. Given the enormous amount of floating short term funds held by institutions,industrialists realised that an institutional vote could make or mar their future.Consequently, a demand was made to curtail their power.

Though the role of financial institutions in take-over battles is rightly interpreted asconnivance between political powers and industrialists, it must be borne in mind thatfinancial institutions are vested with the responsibility of moderating the stockexchanges. Therefore, it is a matter for them to deal in large quantities of shares andown large proportions of the share capital.

Financing the Acquisition (Method used in India)

The three widely adopted methods are:

(i) using asset based financials to finance the acquisition of a division,

(ii) buying of shares from the promoters by paying cash or paying through own shares,and

(iii) paying own shares in exchange for the company.

REGULATION OF TAKE-OVERS

Basically the framework for regulating takeovers must seek to:

(i) impart transparency to the process,

(ii) protect the interest of the shareholders, and

(iii) facilitate the realisation of economic gains.

(i) Transparency of the Process: A takeover affects the interests of many partiesand constituents, such as the contending acquirers, shareholders, employees,customers, suppliers, and others. Hence, it should be conducted in an open, transparentmanner. If the process is transparent, take-overs will be viewed favourably by allconcerned and regarded as a legitimate device in the market for corporate control.

(ii) Interest of Shareholders: In a take-over, the 'controlling block', which oftentends to be between 10 percent and 40 percent, is usually acquired from a single seller(occasionally it may be acquired from many sellers through market purchases).Typically the 'controlling block' is bought at a 'negotiated' price, which is higher than theprevailing market price. The Securities and Exchange Board of India (SEBI) has comeout with some guidelines on Corporate Takeovers. The essential thrust of theseguidelines is to make takeovers as transparent as possible in order to protect targetcompanies and individual shareholders. As per the guidelines, if a person who holdsshares in a company has agreed to acquire further shares through negotiations, whichwhen taken together with the shares already held by him, would carry more than 10% ofthe voting capital, he has to make a public announcement of an offer to the remainingshareholders of the company, before he acquires those additional shares.

(iii) Realisation of Economic Gains: The primary economic rationale for take-overs should be to improve the efficiency of operations and promote better utilisation ofresources. In order to facilitate the realisation of these economic gains, the acquirermust enjoy a reasonable degree of latitude for infusion of funds, restructuring ofoperations, liquidation of non-viable division, widening of product range, redeploymentof resources, etc.

ROLE OF FINANCIAL INSTITUTIONS

Financial institutions, thanks to their substantial equity holding in a large number ofcompanies, often hold the balance of power. Without their support, the acquirer may

not be able to enjoy control. Hence, they have a crucial role to play. Ideally, they shouldserve as guardians of larger public interest and ensure that:

(a) the process of take-over is open and transparent,

(b) the potential acquirers operate on level ground,

(c) the take-over is likely to produce economic gains,

(d) the interest of shareholders and other constituents is reasonably protected, and

(e) no undue concentration of market power arises as a sequel of take-over.

TENDER OFFER

A tender offer is a formal offer to purchase a given number of a company's shares at aspecific price. In a tender offer, a company wants to acquire another company and asksthe shareholders of the target company to "tender" their shares in exchange for aspecific price. The price is generally quoted at a premium i.e., above the market price, inorder to induce the shareholders to tender their shares. Tender offer is one of the waysof acquiring control of another company.

Tender offer can be done in two circumstances:

First, it can be negotiated directly through the management. The acquiring companyrequests the management of the target company to get its approval. When themanagement of the target company does not oblige, then the acquiring company canrequest directly the shareholders by means of the tender offer.

Second, the acquiring company can directly request the shareholders of the targetcompany to "tender" their shares at a specific price. The shareholders are informed ofthe offer through announcement in the financial press or through direct communicationindividually.

In USA, the tender offers have been used for a number of years, but the pace has beenintensified rapidly since 1955, whereas in India, there have been no such tender offerstill recently. In September 1989, Tata Tea Ltd. (TTL), the largest integrated tea companyin India, had made an open offer for controlling interest to the shareholders of theConsolidated Coffee Ltd. (CCL). TTL's Chairman, Darbari Seth, offered one share in TTLand Rs.100 in cash (which is equivalent of Rs. 140) for a CCL share, which was thenquoting at Rs. 88 on Madras Stock Exchange. TTL's decision is not only novel in theIndian corporate sector but also a trend setter. TTL had notified in the financial pressabout its intention to buyout some tea estates and solicited offers from the shareholdersconcerned.

The exchange price for "tender" shares may be either purely cash or purely shares of theacquiring company. Sometimes, the exchange consideration for tender shares may bepartly by cash and partly by shares of the acquiring company. In a number of cases, themanagement of the target company resists such tender offers. There are many reasonsfor this resistance:

(i) The acquiring firm may fail to understand the culture and problems of the targetcompany,

(ii) Future plans may not be in the interest of target company's shareholders,

(iii) Tender offer or exchange ratio is too low to accept, or

(iv) Acquiring company may replace the present management with a new management.

Defense Strategies

There are a number of tactics and devices to defend the tender offer and avoid beingtaken over by another company. The important defensive tactics are:

a. Divestiture (spin off): The target company disposes some of its operations or partof the business in the form of a newly created company.

b. Crown Jewels: Disposal of profitable divisions / asset coveted by the acquirer, thusmaking the target unattractive.

c. Blank Check: Authorising issuance of new shares, usually preferred at thediscretion of the Board of Directors. Its purpose is to vote down a hostile take-overattempt.

d. Poison Pill: Taking on a large debt, usually at exorbitant terms, making theacquisition less attractive. Scorched earth is an extreme form of this tactic.

e. Pac-man: This is similar to the popular video game - each company tries to gobbleup the other. The target seeks to acquire the predator, adding to accounting and legalconfusion.

f. Shark Repellent: Amending the Memorandum or Articles to make a takeovercomplex and costly, thereby discouraging it.

g. Green Mail: Threatening fight for control of the firm, but with the ultimateobjective of raising the market price of shares and selling them at a premium.

h. White Knight: Inducing a cash rich ally to out-bid the predator and avert atakeover.

i. Gray Knight: Enlisting the services of friendly company to purchase the shares ofthe predator, keeping him busy with defending his own company.

ISSUES TO BE CONSIDERED IN MERGERS AND ACQUISITIONS

From the above discussion, it is clear that the management of the company that is takingover another company, should carefully examine the following aspects before a finaldecision is made:

1. How does the merger help the parent company? Does it add to the existing strengths?Does it provide an assured source of raw materials? Does it provide forward integration?Does it help in optimal utilisation of the existing resources?

2. Why should they take over this particular unit, and not some other unit? What are itsunique features? How do they mesh-in with the existing features of the parentcompany?

3. Why is the present management selling out? Is the unit inherently alright? Are thereany basic problems, which are not open to easy solution?

4. What kind of post-merger problems are likely to arise? Is the parent company fullyprepared to tackle them?

5. How would the financial institutions react to the proposal? What new conditions arethey likely to impose?

6. What would be the impact on the share prices of the parent company?

7. What would be the impact on sales turnover, and profitability of the parent companyafter the take-over and merger?

8. What is the right price for the unit? How should it be paid? What should be theexchange ratio between the shares of the parent company and the merger company?

Many merchant bankers have impressive shopping lists of companies available for sale.Some of these bankers are extremely persuasive and sophisticated in their match-making practices. Even when you are paying through your nose, you may be under theillusion that it is a steal. Be careful and be on the alert when you are dealing with themerchant bankers, specialising in take-over deals. It is possible that your company maybe raided by a hostile take-over specialist. In the West, merchant bankers have devisedschemes which help the existing managements to acquire another company.

LEVERAGED BUY-OUTS

During the 1980s, a new scheme of corporate restructuring became extremely popular inthe USA and the Western Europe. This new scheme came to be known as leveragedbuyout (LBO). As the name implies, an LBO has two major aspects:

(i) Using the LBO, the management buys out the entire shareholding of the companyfrom the public and gets it delisted.

(ii) For buying shares on such a massive scale, the management takes a loan and thusleverages the transaction.


The LBO package is usually designed and structured by investment or merchantbankers. LBOs are a mixed bag with some advantages and disadvantages, as indicatedbelow:

Advantages:

1. If the public shareholders get a value higher than the market price (close to thebreak-up value) they are benefited, at least, in the short run.

2. The owner-managers and/or the professional managers can run the companieswithout any fear of losing control from a hostile take-over.

3. LBOs help to restructure the companies, basically weeding out inefficient andincompetent managements.

Disadvantages:

1. As an LBO usually results in a very high proportion of debt, servicing of the debtbecomes a great financial strain for the company in the post-LBO period.

2. Since the management resorts to asset-stripping and jettisoning of the subsidiaries toreduce the debt burden after an LBO, it might weaken the company in the long run.

3. Continuity and stability will be adversely affected when bankers and stock marketexperts start running manufacturing enterprises. The management focus tends to shiftto short term.

Some Policy Issues: LBOs give rise to some major policy issues as listed below:

1. Joint-stock companies which go public and get listed on the stock exchanges promotea wide dispersal of share ownership. LBOs tend to result in the reverse, namely,concentration of share ownership and economic power.

2. LBOs involve considerable debt-financing which works both ways. When theoperational profits are high, a high debt-equity ratio results in high earnings per share.When the operational profits are stagnating or low, a high debt-equity ratio is not in theinterest of the equity owners.

3. Financing an LBO transaction by way of so-called junk bonds (i.e. high-yield bonds)may lead to reckless financing affecting the long-term stability of interest ratestructures. Default rates in junk bonds are quite high.

4. LBOs and junk bonds help managements as well as raiders. Thus they tend to disturbthe equilibrium by rocking the boat rather too often.

REVIEW QUESTIONS

1. Define 'Merger' and state the primary motives for mergers.

2. Distinguish between operating mergers and pure financial mergers.

3. Examine several recent mergers and point out the principal motives for merging ineach case.

4. Examine a recent merger in which at least part of the payment made to the sellerwas in the form of stock. Use stock market prices to obtain an estimate of the gain fromthe merger and the cost of the merger.

5. Explain the distinction between a tax-free and a taxable merger. State thecircumstances in which you would expect buyer and seller to agree to a taxable merger.

6. Do you have any rational explanation for the great fluctuations in aggregate mergeractivity and the apparent relationship between merger activity and stock prices?

7. Explain the various issues to be considered in Mergers and Acquisitions decisions.

8. Give brief summary of SEBI guidelines on merger of companies in India.

9. What is a tender offer? State the defensive strategies adopted to defend the tenderoffer.

10. What is meant by Leveraged Buy-out? State its advantages and disadvantages in thepresent Indian context.

PRACTICAL PROBLEMS

1. Firm E is studying the possible acquisition of Firm F by way of merger. The followingdata is available in respect of the firms.

Firm E Firm F

Earnings after tax (Rs.) 2,00,000 60,000

No. of Equity shares 40,000 10,000

Market value per share (Rs.) 15 12

(i) If the merger goes through by exchange of equity share and the exchanges ratio isbased on the current market prices, what is the new earnings per share for Firm E?

(ii) Firm F wants to be sure that its earnings available to the shareholders will not bediminished by the merger. What should be the exchange ratio in that case?

[Ans.: (i) Rs. 5.42, (ii) 6 new shares for every 5 existing shares]

2. The following data concern companies A and B:

Company A Company B

Earnings after tax Rs. 1,40,000 Rs. 37,500

Equity shares outstanding 20,000 7,500

Earnings Per Share Rs.7 Rs. 5

Price Earnings Ratio 10 8

Market price Rs.70 Rs. 40

Company A is the acquiring company, exchanging its one share for every 1.5 shares ofCompany B. Assume that Company A expects to have the same earnings and P/E ratiosafter the merger as before (no synergy effect), show the extent of gain accruing to theshareholders of two companies as a result of the merger. Are they better or worse offthan they were before the merger?

SUGGESTED READINGS

1. Brealey, R. and Myers, S.: Principles of Corporate Finance, New York, McGraw HillCo.

2. Scharf, Charles, A.: Acquisitions, Mergers, Sales & Takeovers: A Hand Book,Eaglewood Cliffs, N.J., Prentice Hall Inc.

- End of Chapter -

LESSON - 23

BUSINESS FAILURES AND REVIVAL

Learning Objectives


· know the meaning of incipient sickness, weak unit, and sick unit· understand the causes for sickness leading to business failures· detail the steps for rehabilitation of sick companies under S.I.C. Act· ascertain the objectives and activities of B.I.F.R.

Lesson Outline

· The Traditional Sickness - Incipient Sickness· Weak Unit - Sick Unit - Sick Company· Reason for Industrial Sickness - Internal and External· Detection of Sickness - Early Warning Signals

· Revival Measures - under S.I.C. Act· Role of B.I.F.R.

Industrial sickness is spreading very fast. There are over three lakh sick units in thesmall scale industries sector and over 1,000 in the medium and large scale sector. OverRs. 10,000 crores of banks and financial institutions funds are being locked up in theseunits. There are two common patterns of sickness in industrial units:

(a) The Traditional Sickness - Life Cycle Theory: Companies go through a life-cycle with typical phases like entrepreneurial stage, growth stage, maturity stage anddecline stage. The old jute mills and textile mills became chronically sick followed thislife-cycle pattern. These mills were not modernised, technology was not upgraded. Dueto rising costs, the operations of these units became unviable. The units had no moneyto replace their worn-out assets. Eventually the units became sick and some of themwere taken over by the Jute Corporation and National Textile Corporation. Successfulcompanies introduce new products and take up new projects at the maturity stage toavoid the decline. Thus they introduce another growth cycle.

(b) Incipient Sickness: The second type of sickness hits the new projects, which arenot properly conceived, executed and managed. The unit struggles for three to fouryears and then turns sick. Typically such a new project suffers from time overrun andcost overrun. By the time the project is ready, the working capital margin is erodedeither partly or totally. Due to the problems of learning curves, the productivity is low inthe first one or two years. The market-seeding operation takes much more time thanoriginally planned. The company gets into a severe cashflow problem. Usually thebanker takes away his umbrella at this crucial time, and another corporate patient isborn.


Industrial Sick Units

RBI Definition

According to the Reserve Bank of India, a unit may be considered sick, if it has incurredcash losses for one year and; in the judgment of the Bank, it is likely to continue to incur

cash losses for the current year as well as the following year, and the unit has animbalance in its financial structure such as current ratio of less than 1:1 and worseningdebt-equality ratio, i.e., the ratio of total outside liabilities to net worth.

A small scale unit is sick when its account with banks are irregular continuously for sixto nine months, the erosion of capital takes place at a rate more than 10% per annum,there is continuing default in the payment to the creditors and the unit has remainedclosed for the previous six months.

The definition of sick units adopted by the term lending financial institutions is basedon the criterion of continuous cash losses, default in debt servicing requirements andirregularities in meeting statutory and other liabilities.

Thus, an industrial unit is classified as sick by term-lending institutions after taking intoaccount the following symptoms:

(i) Continuous default in meeting four consecutive half-yearly installments of interest orprincipal in respect of the institutional loans;

(ii) Continuous cash losses for a period of 2 years or continued erosion in the net worthby 50% or more; and

(iii) mounting arrears on account of statutory or other liabilities for a period of one ortwo years.

Weak Units

As against the SSI (small scale industry) units, there are categories of non-SSI sick unitswhich do not come under the purview of the Sick Industrial Companies (SpecialProvisions) Act 1985. The Reserve Bank of India has advised the banks to take remedialmeasures to facilitate the detection of sickness at an early stage for these units, whenthey become 'weak', before they turn 'sick'. An industrial unit is called a weak unit at theend of any accounting year, if it has:

(i) accumulated losses equal to or exceeding 50% of its peak net worth in theimmediately preceding five accounting years,

(ii) a current ratio of less than 1:1, and

(iii) suffered a cash loss in the immediately preceding accounting year.

Sick Industries (Special Provisions) Act 1985:

According to this Act, a sick unit means, "A company (being a company registered fornot less than 7 years) which has at the end of any financial year accumulated lossesequal to or exceeding its entire net worth and has also suffered cash losses in suchfinancial year and the financial year immediately preceding such financial year".

Reasons for Industries Sickness

When a unit succeeds, the management takes full credit. When a unit fails and becomessick, the management usually blames the environmental factors including the banks andfinancial institutions. Objective analysis indicates the following reasons for industrialsickness:

1. Internal Factors

(i) Inexperienced entrepreneurs

(ii) Disputes among the promoters' groups/partners

(iii) Wrong technology and obsolete technology

(iv) Antiquated (outdated) equipment

(v) Uneconomical size

(vi) Improper balancing of production facilities

(vii) Lack of adequate margins for working capital

(viii) Poor management practices

2. External Factors

(i) Limited market potential

(ii) Shrinking demand for the product manufactured

(iii) Cut-throat competition in the industry

(iv) Lack of assured supply of raw materials

(v) Militant trade unions and multiple unions

(vi) Unexpected levies and tax burdens

(vii) Power cuts, frequent load shedding

(viii) Heavy interest burden

(ix) Inadequate working capital facilities

(x) Competition from the unorganized sector

(xi) Erratic imports - Emergence of cheap substitutes

(xii) Dumping practices by foreign companies

(xiii) Change in macro-economic Policies.

Detection of Sickness

The old adage 'prevention is better than cure' is especially true in the case of industrialsickness. The major problem in India is the sickness of a unit is detected at a very latestage, when the net worth is eroded and rehabilitation becomes very difficult. Recentstudies on industrial sickness have showed that even six years before attaining the stageof cash loss, the profitability index of the sick companies showed marginal decline,followed by sustained decline during the period of 3 years preceding the cash lossperiod, and then it showed continuous and significant cash loss during the subsequentperiod. Thus, if the sickness is detected at early stages using some important ratios,sickness can be prevented.

Early warning signals or Symptoms of a Sick Unit

These are some of the more important early warning signs of impending sickness in acompany:

· Stagnant declining sales· Continuing losses· Erosion of working capital margins· Irregularity in bank working capital limits· High operating costs· Uneconomic levels of operations· Chronic cash shortages· Accumulation of non-moving inventories· Sticky debtors· Pressing creditors· Unsatisfactory financial ratios· Fall in share prices

Revival Measures

1. Pre-requisites for New Management

a. A New Chief: A chief brings a new perception of reality. He initiates thedevelopment of new strategies and implementation of new methods. He tends to haveleadership and motivational skills. His ability to be flexible, to make rapid decisions, andto work under stress, allows him to turn around the company. Above all, he brings avision.

b. Central Financial Control: Introduction of strong financial control through theestablishment of cash-flow forecasts, budgets, manufacturing overheads, and a tightcontrol over both capital and revenue expenditure are very crucial.

c. New Marketing Focus: If the company lacks competitiveness in one or more of itsproduct lines, it is time to rethink the overall product-market focus. Add (delete)product lines; add (delete) customers and markets and begin a focused sales effort. Newfocus includes eliminating unprofitable lines and customers, emphasising only theprofitable core. (If the core itself is not profitable, then recovery chances are slim).

d. Improved Marketing: Improved marketing begins with a detailed well executedmarketing plan, and recruiting new sales representatives, since this always leads toincrease in sales volume. It is possible that the present sales force is capable of doingbetter with the right motivation and direction.

e. Pricing: Pricing is most important during a turnaround, because profits are moresensitive to price. A given increase in price will have a greater impact on profit than thesame % increase in volume or reduction in cost. However prices must be increased whenthe variable costs are not covered by the selling price. When firms see their sales volumedecreasing, they lower their prices. But as soon as the firm lowers its prices, thecompetitor lowers theirs and thus no further sales volume can be obtained. Thus becareful when lowering prices.

f. Asset Reduction: Integral part of a turnaround is asset reduction. In severefinancial crisis, asset reduction is the only viable alternative. A positive cash-flow is themost important priority for survival. Reduction in working capital requirement ispossible through the reduction in the days the debtors are due, and in reduction ofinventory levels.

g. Cost Reduction: Cost reduction strategy must be aimed at improving the firm's costposition vis-a-vis the competitors'. Studies have shown that in a loss making situation,profits are more sensitive to cost-reduction than to price increases. Costs are alsoreduced through control on purchases and plant utilisation.

h. Debt Re-Structuring: A firm that is in a turnaround situation and in a cash crisisusually has a high level of debt to equity. Cash-flow generation strategies, particularlyasset reduction strategies, should be used to reduce borrowings. It is common forcompanies to restructure debts by asking principal creditors, such as banks, to convertinterest and principal payments into equity. Convert short-term debt to long-term debtor settling for a lower amount now, as a full and final settlement for all borrowings.

2. Cost-Reduction Strategies

a. Raw-Material Costs: The easiest way to do this is to reduce the amount used bychanging the manufacturing processes. For example, engineering companies study whateach component is supposed to do and whether there are substitutes and redundancies,both in product and process engineering.

b. Labour Costs: In developed nations, accepting wage cuts is quite common. But inIndia, it is even absurd to think that white- and blue-collar workers will accept thistemporary solution. Management has to rely on increased labour productivity for areduction in labour costs. Changes in management style, introduction of incentivepayout, and changes in production methods can increase productivity. Total labourcosts can be lowered by encouraging early retirement, voluntary retirement and nothiring when persons leave. Cutting or reducing over-time and re-scheduling work andpaid holidays can lower labour costs. For white-collar workers, freeze all pay increases.

c. Reduction of overhead Costs: For reducing the manufacturing costs, reduce thesize of operation by eliminating a part of the process, and improve efficiency within theexisting operation. In summary, successful cost reduction is possible when there arechanges in established methods of operation, changes in the organisational culture andattitude of management and staff.

d. Marketing and Revenue Improvement: The first thing to do is to make a list ofwhat you are selling - land, building, machinery, inventory, who is the potentially thebest type of purchaser and what is it worth to him. This exercise defines a direction thatthe company will follow to sell its assets most profitably.

e. Reduce Inventories: Immediately stop new purchasing, cancel outstanding orders,and return goods to suppliers. Instead of holding stocks, order more frequently. Deals

and other understandings between the suppliers and the purchase departmentpersonnel often exist. It is wise to change suppliers and not rely on same old ones.Surplus raw-materials could be sold and work-in-progress inventories should bereduced through better scheduling, better manufacturing methods.

f. Reducing Debtors: Identify outstanding accounts and stop all deliveries to them.Contact customers personally, rather than through the sales force. Check the solvencyand trading practices of your customers. An insolvent debtor could be the final blow forthe firm. Companies have been known to use bill discounting facilities and begin toestablish the same terms that the competitors are offering, not more, not less.

g. Delay Creditors: Delay the time in which creditors get paid. Try to persuade themto continue to provide the firm with supplies and wait for payment.

h. Concentrate on Few Products and Markets: In a recovery situation, it is thebest to concentrate on few products and a few customers. Selecting products toconcentrate on should be those that provide a sales volume and have a good growth rate.Products that offer a good contribution margin, and have short manufacturing timeshould be selected. It is wise to limit the range of products offered during theturnaround situation. If too many products are there, it is difficult to pay attention to allof them, causing inventories to build-up and thus affecting cashflow.

Customers should be selected on the basis of profitability earned, and days outstandingon the account. It is not always wise to focus on the largest customer. If volume isrequired and the largest customer is profitable then it is alright, otherwise, he is also theonly one who is most capable of exploiting the firm's situation. Once the product andcustomer decisions have been made, other marketing steps are taken.

Planning, monitoring each customer and salesperson, along with products and pricemust be done. Evaluate and replace the sales reps if required. Assign profit centreresponsibility and develop an ongoing profit improvement plan to insure maximumoperational efficiency.

i. Changing Prices: Price increases means raising list prices, lowering discounts orboth. Price and profitability have a great relationship:

(a) Raising prices: Products that already have a high margin can stand a furtherprice increase more easily than products with lower margins. Infrequentlypurchased consumer goods tend to be less price-sensitive. If there are fewersources of supply, there are fewer comparable products on the market, and thusprice increases are easier. Products with high switching costs and specialisedbuyers also lead to price inelasticity. The Indian consumer is often used to priceincrease due to high inflation. If prices have been steady for the past few months,it is not unreasonable to raise prices. The greatest resistance against raising pricescomes, not from the customer, but from the sales force, because they have to workharder with increased prices.

b) Discounts: Discounts work like magic for the wholesalers and retailers. It ismore important for a firm to have a competitive discount structure than acompetitive list price. Once a decision is made, communicate the importance tothe sales force and the need to change prices.

3. What the crisis manager should do: Gain Management Control

Appoint 2 new persons - good Finance Director and a good Chief Accountant. After that,the crisis manager must spend time:

a) understanding all legal cases, formalities that the company has or will have toface in the near future;

b) developing a cash-flow forecast - current month's, next quarter's and the wholeyear's, and understand the current cash position. Receipts from debtors, amountpaid to creditors, amount of salary and wages, tax and dividend payments andcapital items (receipts and payments). Consideration must be given to loanrepayments, the next peak demand for cash, and the seasonal build of inventory.

c) doing inventory control - identify old or obsolete items and either dispose themor write them off. Keep a firm control over purchases, and compare usage levelsbefore new purchases.

d) doing expenditure controls - make a policy that all capital expenditure over Rs.X will require the manager's approval. Limit all revenue expenditures, liketemporary employment and the recruitment of staff. There should be no newrecruitment of labour. All pay increases shall be temporarily frozen and any priceincreases from suppliers should be rejected. In this way revenue expenditure canbe controlled.

4. Communication with outsiders

a. Banks - Keep them informed at all times regarding new plans, actions taken andresults obtained. Restructure debt and/or obtain additional financing.

b. Unions - Meet the Union leaders and seek their cooperation. Urgency of situationmust be outlined clearly, win their confidence and support.

5. Assess Management Quality and replace if needed. As a rule, do not fire someonefrom his job if the job is crucial for day-to-day operation and there is no competentreplacement available immediately.

6. Evaluate the Business

Remember Pareto’s 80:20 principles:

80% or all profits come from 20% of the products.

80% of the work is done by 20% of the employees.

80% of problems get created by 20% of the workers.

80% of the problems get solved by attending to 20% of the business.

a. Finance: Calculate the percentage of all expenditure to sales, financial ratios andlook for any trend. Compare the company with the industry standards; comparehistorical cash-flows to determine how the firm has arrived in the current cash-flowcrisis.

b. Marketing: Undertake a sales analysis by product customer, for trends on salesvolume and seasonal patterns; profit-to-contribution for major selling products. Identifypositive and negative products or product lines. Customer analysis includes gross salesfor each customer, days outstanding, returns, complaints and profitability for individualcustomers

c. Operational: Plant utilisation, departmental efficiency reports, breakdown andmaintenance reports are of great value to the crisis manager.

d. Personnel: A record of the name and designation of each employee - years worked,legal costs for dismissal, qualification, background etc., is useful.

7. Improve the Budgetary System

The budget and forecasts as a vehicle for control sales forecasts must be developed andproperly monitored. The sales forecast must specify what product or product line will besold to which customer and in what geographical territory. Above all, solicit the co-operation from the department heads during the process of development andimplementation of these forecasts.

Revival under Sick Industries Companies (Special Provisions) Act 1985

For providing an integrated approach to deal effectively with the problem of industrialsickness, a special legislation called or Sick Industries Companies (Special Provisions)Act (SICA) was passed in the year 1985. Under the SICA, Board For Industrial andFinancial Reconstruction (BIFR) was set up in the year 1987, as a body of experts fortimely defection of sickness in industrial companies and for expeditious determinationof preventive, ameliorative, remedial and other measures.

Objectives of BIFR

(i) To fully utilise the productive industrial assets,

(ii) To afford maximum protection of employment

(iii) To optimise use of investible funds locked up in sick units.

(iv) To realise the amounts of banks and financial institutions etc, from non-viable sickunits through liquidation in cases where there is no hope of revival.

Machinery Under SICA

The provisions of SICA arc sought to be implemented through BIFR which is the heartand soul of SICA, assisted by an operating agency which acts as hand tool of BIFR bycarrying out investigations and preparing schemes for revival. BIFR acts as a quasijudicial body, i.e. independent of executive influence. In addition to the abovementioned authorities, Appellate Authority for Industrial and Financial Reconstruction(AAIFR) is also constituted under SICA, which acts as a judicial body and hears appealsagainst the orders of BIFR. SICA excludes the Civil Courts jurisdiction against any orderpassed by BIFR or AAIFR i.e., any order passed by BIFR or AAIFR cannot be challengedin any other civil courts. So AAIFR has been given exclusive jurisdiction as per SICA.

Operating Agency

Any public financial institution specified in Sec. 3 (1) of SIC Act i.e., (ICICI, IFCI, IDBI,IRBI, SFCs, Banks etc.) can be appointed as an Operating Agency by BIFR.

Constitution of BIFR

BIFR consists of a chairman appointed by Central Government for a term of 5 years, andnot less than 2 or more than 14 members. A member must be qualified to be the judge ofHigh Court or persons of ability, integrity and standing who have special knowledge andprofessional experience of not less than 15 years, in fields of science, technology,banking, industry, law, economics, industrial finance, industrial reconstruction etc. Thefirst team of 6 members was formed on 12-1-1987 with Mr. R. Ganapathy, as itsChairman.

Procedural Steps

1. Identification of a sick company : It may be either by reference or uponinformation received from outside.

(a) The Act imposes responsibility on Board of Directors to intimate in a prescribedformat to BIFR within 60 days of finalisation of accounts, if it qualifies as Sick Companyas per definition of SICA.

(b) Reference to BIFR by State Government, Central Government, scheduled bank orany public financial institution which has interest.

(c) Identification of a sick unit by BIFR itself.

2. Inquiry by BIFR : The inquiry by Operating Agency or BIFR must be completed in60 days. For the purpose of conducting inquiry, BIFR has got the right to appointspecial directors, if necessary. As soon as the case is taken up for study, all the legal

proceedings and contracts (like winding up of company, execution of decree againstproperties of company, etc.) stand suspended.

3. Consideration for revival of sick unit shall be decided on the basis of extensivestudy of all the variables like management policies, labour unrest, availability of rawmaterials, finance, etc.

4. After an indepth study, BIFR decides if there is any possibility of making thecompany's networth positive in a reasonable time. If so, the company is given achance to make it positive, and has got the right to extend the time limit, if the companyrequests for some more time and passes a fresh order.

5. If the company fails to do so, the Operating Agency prepares a scheme providingeither for ameliorative, remedial or other measures for revival of the company within 90days of issue of order. There is freedom of action to the Operating Agency while framingthe scheme. The scheme may be reconstruction, rehabilitation or revival.

6. Finally, the revival package is sent by BIFR to the sick company and mayincorporate any changes as suggested by the sick company, if necessary.

7. Any scheme is sanctioned by BIFR after circulating a draft copy to all the personswho have some interest in the company like Operating Agencies, creditors, transferee ofan industrial concern etc., before giving a final approval to it.

Sometimes, merger of a sick unit with a healthy unit may be resorted to, due tosynergistic advantages that may be available. Uneconomic divisions of a unit andsurplus assets may be sold in order to mobilise funds.

Where the unit is under a heavy financial burden, a package of reliefs and concessions isworked out providing for adequate working capital.

Thus, by adopting various strategies, the BIFR attempts at reviving viable units, whilethe unviable ones are allowed to die.

Difficulties encountered by BIFR

During its working of more than seven years, BIFR has experienced various difficultiesin the process of taking measures for rehabilitation of sick units referred to it. Some ofsuch difficulties are listed below:

(i) Although the promoters of the sick units are quite anxious to get their unit declaredas a sick industrial company to get protection against their creditors, they submit theirrevival plans to BIFR/Operating Agencies with a lot of delay. Even after sanction ofrevival schemes by BIFR, promoters, in many cases, do not comply with the envisagedterms and conditions including induction of their contribution.

(ii) In case of units belonging to large industrial groups, BIFR has observed that thefinancial institutions and the banks lack coordination amongst them and do not exertrequisite pressure on such groups to take care of their sick units. BIFR on its part insistson larger promoter's contribution and keeps the reliefs within RBI parameters in suchcases.

(iii) One of the major obstacles in the smooth process of rehabilitation is the inadequatecooperation extended by the State level financial institutions, foreign banks and privatebanks. These agencies, in many cases, refuse to give even the normal reliefs andadditional assistance envisaged in the rehabilitation packages.

(iv) Several State governments, particularly the less industrialised ones, do notcooperate in the required degree. They do not take decisions and seek repeatedadjournments of the BIFR hearings. They either do not send their representatives in thehearings or send junior officers who are not able to commit on behalf of the Stategovernments.

(v) BIFR has observed that workers in most cases give maximum sacrifices whencompared to their intrinsic capacity. They also agree for rationalisation and wage freezeif considered necessary for revival of the sick units. However, of late, tendency has beennoticed in some cases for labour to renege on the agreements and raise demands forwage hikes, etc.

(vi) While the work of financial institutions as operating agency has been found by BIFRto be, by and large, satisfactory, the designated commercial banks generally displayshyness to take up the operating agency work. Most of the commercial banks are notfully equipped for multi-disciplinary approach required for conducting a techno-economic study.

REVIEW QUESTIONS

1. Explain the causes for industrial sickness, leading to business failures.

2. What are the early financial and non-financial symptoms of sick units?

3. Explain (a) incipient sickness (b) weak units (c) chronic sickness

4. Suggest suitable revival measures for rehabilitating sick industrial concerns.

5. Explain role of and procedure for rehabilitating sick industrial company under BIFRscheme of SIC Act, 1985.

SUGGESTED READINGS

1. Bidani S.N. and Mitra, P.K.: Industrial Sickness, New Delhi, Vision Books.

2. Saravanavel, P.: Management Control Systems, Bombay, Himalaya PublishingHouse.

3. Srivastava, S.S. and Yadav, R.A.: Management and Monitoring of IndustiralSickness, New Delhi, Concept Publishing Company.

- End of Chapter -

LESSON - 24

VALUATION OF SHARES

Learning Objectives


· Know the different concepts of valuation· Understand the necessity for and relevance of valuator· Ascertain the general and specific factors influencing the valuation of shares· Explain and evaluate the different methods of valuation of shares.· Calculate fair market value of shares

Lesson Outline

· Concept of Value· Valuation of Shares - Equity and Preference· Factors influencing the valuation of shares· Necessity for Valuation· Methods of Valuation - Asset Backing Method - Earning Capacity Method· Fair Market Value

As observed in Lesson 1, the objective of a firm is to maximise shareholder's wealth.Further, it was explained that the shareholder's wealth is represented by the product ofnumber of shares and the current market price per share. Given the number of sharesthat the shareholder owns, the higher the stock price per share, the greater will be theshareholder's wealth. Thus, the financial objective of a firm is to maximise the marketvalue per share in the market. To maximise the stock price, we have to develop a

valuation model and identify the variables that determine the stock price. Generallyspeaking, the value of the firm depends upon two things: (i) the rate of return and (ii)the element of risk. As the return and risk characteristics of a firm are influenced by thethree financial decisions, namely, (i) Investment decisions, (ii) Financing decision, and(iii) Dividend decision.

Valuation Concepts

The term 'value' has been used to convey a variety of meanings. The different meaningsof value are useful for different purposes. The various concepts of value are discussedbelow:

1. Present Value: A business enterprise keeps or uses various assets because theygenerate cash inflows. Value is the function of cash inflows and their timing and risk.When cash inflows are discounted at the required rate of return to account for theirtiming and risk, we get the value or the present value of the asset. In financial decisionmaking, such as valuation of securities, the present value concept is relevant.

2. Going Concern Value: In the valuation process the valuation of shares is done onthe going concern basis. In a going concern, we assess the value of an existing mixture ofassets which provide a stream of income. The going concern value is the price which afirm could realise if it is sold as an operating business. The going concern value willalways be higher than the liquidation value. The difference between these two valueswill be due to value of organisation, reputation etc. We may command goodwill if theconcern is sold as a going concern.

3. Liquidation Value: If a firm decides to go out of business it will sell its assets.After terminating the business, the amount which will be realised from sale of assets isknown as liquidation value. Since the business will be terminated, the organisation willbe valueless and intangibles will not fetch any price. The liquidation value will be thelowest value of a firm. Generally, the true value of the firm will be greater than theliquidation value.

The liquidation value is useful from the creditors' point of view. If the concern isrunning then creditors will be paid out of cash inflows. On the other hand if the concernis terminated, the creditors will be paid out of the amount realised from various assets.The creditors will try to ensure that the realisable value of the assets is more than theirclaims so that they get fully paid.

4. Replacement Value: The assets are shown on historical cost in the balance sheet.This cost may not be relevant in the present context. This problem may be solved byshowing assets on replacement value basis. Replacement value is the cost which a firmwill have to spend if it were to replace the assets under present conditions.

Though replacement value method is an improvement over book value concept but stillit has certain limitations. It is very difficult to ascertain the present value of similarassets which the firm is using. It may so happen that this type of assets may no longer be

manufactured as present. This will create a problem of finding out the replacement costof the assets. Moreover, it is not certain that the assets of business would be worth itsreplacement cost. The value of intangibles is also ignored in this method.

5. Market Value: The market value of an asset or security is the value at which it canbe sold at present. It is argued that actual market prices are appraisals of knowledgeablebuyers and sellers-who are willing to support their opinions with cash. Market price is adefinite measure that can readily be applied to a particular situation and it minimisesthe subjectivity of other methods in favour of a known yardstick of value.


6. Book Value: The book value of assets can be ascertained from the firm's balancesheet which is prepared according to the accounting concepts and conventions. Theassets are shown in the balance sheet at cost less depreciation. No account is taken forthe real value of the assets, which may change with the passage of time. The assets aregenerally recorded at cost. In case the convention of conservatism is used then assets areshown at cost or market price whichever is less. The convention of conservatism isfollowed for current assets only not for fixed assets. The value of intangibles is alsoincluded in the assets. The debts are shown on the outstanding values and no account istaken for interest or payment of principal amount. The book value' per share can be

determined by dividing the common shareholders' equity (capital plus reserves andsurpluses) by the number of shares outstanding.

Factors influencing the share value

The factors influencing the valuation of shares can be classified as general factors andspecific factors.

General Factors: These factors are those which have an overall effect on the price ofshares in general:

(i) Government's fiscal and monetary policies - Bank rate, direct and indirect taxes,

(ii) Political stability in the country,

(iii) Economic climate i.e., depression or boom,

(iv) Industrial Policy of the Government,

(v) International political and economic climate also influence the market value ofshares. No country's economy is so isolated that it is immune to changes in other partsof the world.

Specific Factors : These factors are those which apply to the particular company andto the industry in which the company is operating:

(i) The present position and future prospects of the industry of which the company is apart.

(ii) The amount and trend of dividends paid and expected, future dividends, taking intoconsideration the dividend cover and the yield compared with similar equity shares.

(iii) Announcement by companies themselves may affect prices, for instance, if acompany increases or does not pay interim dividend.

(iv) The capital structure of the company, which will lead to the study of financialleverage i.e. the proportion of debt to equity.

(v) An analysis of the company's cash flow to determine its ability to service fixedcharges.

(vi) The amount and trend of the company's profits and the net earnings i,e, the profitsavailable for distribution to the equity shareholders' after meeting all prior charges,expressed as a percentage of the market value of the equity share capital.

(vii) The set up of the management to ensure that the company has got a competent andbroad-based, board of directors and also has within it persons of sufficient standing withadequate technical, financial and business experience.

(viii) The net assets according to the balance sheet of the company

(ix) Whether there is an active market in the equity shares and the amount of the "turn"i.e. the difference between the higher and lower prices as quoted on the stock exchange.

(x) The possibility of bonus or rights issues.

Necessity for valuation

The necessity for valuation of shares arises inter alia in the following circumstances.

(i) Assessments under the Wealth Tax or Gift Tax Acts.

(ii) Purchase of a block of shares which may or may not give the holder thereof acontrolling interest in the company.

(iii) Purchase of shares by employees of the company where the retention of such sharesis limited to the period of their employment.

(iv) Formulations of schemes like amalgamation, absorption, etc.

(v) Acquisition of interest of disentitling shareholders under a scheme of reconstruction.

(vi) Compensating shareholders on the acquisition of their shares by the Governmentunder a scheme of nationalisation.

(vii) Conversion of shares, say preference share, debentures/loan into equity.

(viii)Advancing a loan on the security of shares.

(ix) Resolving a deadlock in the management of a private limited company on the basisof the controlling block of shares being given to either of the parties.

(x) Valuation of securities for Balance Sheet of trust and finance companies.

Relevance of Valuation

Valuation by expert is generally called for when parties involved in the transaction/deal,etc., fail to arrive at a mutually acceptable value or the agreements or Articles ofAssociation, etc., do not provide for valuation by experts. For isolated transactions ofrelatively small-blocks of shares which are quoted on the stock exchanges, generally, theruling stock exchange price provides the basis. But valuation by valuer becomesnecessary when: (i) Shares are unquoted, (ii) Shares relate to private limited companies,

(iii)Courts so direct, (iv) Articles of Association or relevant agreements so provide,(v)Large blocks of shares is under transfer, and (vi) Statutes as require (like Wealth Tax,Gift Tax Act).

Limitation of Stock Exchange Prices as a Basis for Valuation: Stock exchangeis a place where shares and stocks are exchanged by the process of purchase and sale,generally through brokers, who transact the business on a commission basis on behalf oftheir clients. It may be stated that stock exchange price is a price pure and simple andnot a value based on valuation. Stock exchange price is, basically, determined on theinteractions of demand and supply and business cycles and may not reflect a reasonedvaluation on principal considerations of yield and safety of capital.

METHODS OF VALUATION

The different methods of valuing shares may be broadly classified into –

1. Asset backing method,2. Earning capacity valuation method.3. Imputed Market price of shares.

1. Asset Backing Method : This method is concerned with the asset backing per shareand may be based either (a) on the view that the company is a going concern, or (b) onthe fact that the company is being liquidated.

(a) Company as a going concern: If this view is accepted, there are two approaches(i)to value the shares on the net tangible assets basis (excluding the good will) (ii) tovalue the shares on the net tangible assets plus an amount for goodwill.

Net Tangible Assets Backing (excluding the Goodwill): Under this method, it isnecessary to estimate net tangible assets of the company (Net Tangible Assets=Assets-Liabilities)in order to value the shares. In valuing the figures by this method care mustbe exercised to ensure that the figures representing the assets are sound that intangibleassets and preliminary expenses are eliminated and all liabilities are taken into account.

Where both types of shares are issued by a company, the shares would be valued asunder:

(1) If preference shares have priority as to capital and dividend, then the preferenceshares are to be valued at par.

(2) After the preference shareholders are paid, die net tangible assets are divided by thenumber of equity shares to calculate the value of each shares. If at the time of valuationthere is an uncalled capital, then the uncalled equity share capital be added with the nettangible assets in order to value the shares fully paid up. The valuation of shares for theshareholder who have calls in arrears will be valued as a percentage on their paid upvalue with the nominal value of shares.

(3) If the preference shares are non-participating and rank equally with the equityshares, then the value per share would be in proportion of the paid up capital.

Illustration 1

The following is the summarised Balance Sheet of XYZ Company Ltd. as at December31, 1994.

For purposes of valuation of shares fixed assets are to be depreciated by 10 per cent andinvestments are to be revalued at Rs. 10,80,000. Debtors will realise Rs.12, 14,000.Interest on Debentures is accrued due for 9 months and preference dividend for 1994 isalso due; neither of these has been provided for in the Balance Sheet. Calculate the valueof each Equity Share.

Solution

Valuation of Shares of XYZ Company Ltd. By the Net Assets Method

Asset Backing (including Goodwill):

In many cases goodwill may be worth the figure at which it is stated in the, balance sheetor if there is no book value for goodwill, it may nevertheless exist. Further even if thereis a book value, the actual value of goodwill may be considerably higher than the bookvalue. It is generally considered that the value of fixed assets of the company depend ontheir ability to earn profits i.e., on the goodwill attaching to them. In such a casegoodwill should be included with other tangible assets for valuation purposes. Thevarious methods of valuing the goodwill are:

i. Capitalisation of expected future net profits or earningii. Assessment based on turnover,

iii. Super Profits method, andiv. Annuity Method.

Illustration 2

Calculate Goodwill as per (a)Annuity Method(b)Five Years purchase of Super Profitsmethod; and (c) Capitalisation of super profits methods from the details hereunder

The profits included non-recurring profits on an average basis of Rs. 1,000. Out ofwhich it was deemed that even non-recurring profits had a tendency of appearing at therate of Rs.600 p.a.

Solution

Normal rate of profit 10% of 1,50,000 = Rs. 15,000

Average net profit for 5 years

= (14,400+15,400+16,900+17,400+17,900) ¸ 5 = Rs.16,400

Super Profit = 1 6,400-600(non-recurring)= 15,800

15,800-15,000 = Rs. 800

Value of goodwill

(a) Annuity Method = Rs.800 x 3.78(present value factor) =Rs.3,024

(b) Five years purchase of super profits=800 x 5 = Rs.4,000

(c) Capitalisation of supper profit method:

Weakness of Assets Based Approach:

This method has its own weaknesses:

1. There is no uniform method for assessing book value of assets. Such a value isinfluenced by policies of the companies on the one hand and accounting practices on theother.

2. There is no uniformity in assessing depreciation which is an essential ingredient ofvaluation of assets.

3. Goodwill and patents count a lot in valuation but in so far as accounting practice goes,there is considerable lack of standardisation in this regard,

4. It is usually very difficult or rather impossible to exactly bring at par and compare thevalue of securities of one company with another.

5. Every company has certain conventions about valuing assets rather than followingany logic and this influences valuation.

6. Usually the understandings do not take fixed assets at current value, but at old costswhich is quite deceptive.

7. This approach also does not give any real idea about earning power of the assetswhich is another consideration in valuation.

Advantages of the approach:

This approach has certain advantages as well.

This approach has proved very useful in so far as investing companies, insurancecompanies and banks are concerned and in the case of such companies whose assets arelargely liquid, provided such an approach is not exclusively expanded upon.

(1) Asset backing where company is being liquidated (Realisable ValueApproach)

Asset backing method is sound if liquidation is contemplated though realisable valueshould be taken into account. When realisation is imminent, it is desirable to construct astatement of affairs supported, by independent valuations of the fixed assets such asland and buildings, plant and goodwill. Provision should also be made for the cost ofliquidation and thus some indication may be obtained as to how much per shares maybe payable to members.

(2) Earning Capacity Valuation Method

Capitalisation of earnings approach for valuation of shares is based on the assumptionthat a shareholder values earning power on the one hand and income rather thanphysical assets on the other. This method is also known as the Yield method. Under

this method, the valuation depends upon the comparison of the company's earningcapacity and the normal rate of interest or dividend that is current on outsideinvestment. The Earning capacity or yield basis of valuation may take any of thefollowing two forms: (i) valuation based on rate of return, and (ii) valuation based onproductivity factor.

(i) Valuation based on Rate of Return: The term rate of return refers to the returnswhich a share holder earns on his investment. It may further be classified as (a) rate ofreturn and (b) rate of earnings. To ascertain the value of shares based on profit earningcapacity future maintainable profits and rate of interest at which the profits are to becapitalised must be fixed. In arriving at the profit to show the normal earning capacitygenerally the following adjustment are made: (i) Non-recurring items should be allowedfor, (ii)Income tax charges should be appropriated to the particular year in which theyare paid, and (iii) allocation to reserve.

The main purpose for adjustment of profit is the determination of future annualmaintainable profit which must be capable of distribution as dividend. The rate ofinterest for capitalising the average normal profit is fixed upon by the circumstances of aparticular case. In practice a rate of 10% or more may be reasonable.

The following steps may be followed for calculating the value of shares according toyield method:

i. Calculation of average expected future profits.ii. Calculation of expected return by the following equation:

Expected Return = Expected Profits x 100

Equity Capital

iii. Calculation of yield value of share as under:

Value of share= Expected Rate x Paid up value of share

Normal Rate

Conclusion: Of course earning approach has its own advantages, but it cannot bedenied that such an approach has own limitations It is primarily because profits areinfluenced by many factors. Even due to various reasons, the companies having samespan of work, working under same conditions might show different profits. Accordinglythis method determining the value of shares has its own inherited problems.

(ii) Valuation based on Productivity Factor: Productivity factor represents theearning power of the company in relation to the value of the assets employed for suchearning. The factor is applied to the net worth of the company on the valuation date toarrive at the projected earnings of the company. The projected earnings after necessaryadjustments are multiplied by the appropriate capitalisation factor to arrive at the valueof the company’s business. Total value is divided by the number of equity shares toascertain the value of each share. The productivity factor-based valuation is merely amethod for ascertaining a reliable figure of future profits. The steps involved in such amethod of valuation can be enumerated as follows:

(a) Average net worth of the business is ascertained by taking a number of years whoseresults are relevant to the future. It will be appropriate to determine the average networth of each year on the basis of net worth of the business at the commencement andat close of each of the accounting years under consideration. The average net worth ofthe business of the period under study would be calculated on the basis of the averagenet worth calculated as above for each of the accounting years.

(b) Net worth of the business on the valuation date is ascertained.

(c) Average profit earned for the period under consideration is ascertained on ihe basisof the profits earned by the business during the period by. simple or weighted averagemethod as may be considered appropriate.

(d) The productivity factor is found out as follows:

Average profit x 100

Average net worth

(e) The productivity factor calculated as above is applied to the net worth of the businessin future.

(f) The projected income so calculated is adjusted further by making of appropriationsfor replacement, tax, rehabilitation of plant and equipments, underutilisation ofproductive capacity, effects of restriction on monopoly and divided on preferenceshares. Thus, the profits available for the equity shareholders are ascertained.

(g) The normal rate of return for the company is ascertained keeping in view nature andsize of the undertaking.

(h) Appropriate capitalisation factor or multiplier based on normal rate of return isascertained, as explained earlier

i. The capitalisation factor obtained as above is applied to adjusted projected profitavailable for the equity shareholders to ascertain the capitalised value of theundertaking.

Illustration 3

The following figure relate to a company which has Rs. 10,00,000 in Equity Shares andRs. 3,00,000 in 9 per cent Preference Shares, all of Rs. 100 each:

Average Net Worth Adjusted Taxed

(excludinginvestment) Profit

1992 Rs. 18,60,000 Rs. 1,90,000

1993 21,50,000 2,10,000

1994 21,90,000 2,50,000

The company has investments worth Rs 2.80,000 (at market value) on the valuationdate, the yield in respect of which has been excluded in arriving at the adjusted tax profitfigures. It is customary for similar types of companies to set aside 25 percent of taxedprofit for rehabilitation and replacement purposes. On the valuation date, the net worth(excluding investments) amounts to Rs. 22,50,000. The normal rate of return expectedis 9 percent. The company has paid dividends consistently within a range of 8 per centto 10 per cent on equity shares over the previous seven years and it expects to maintainthe same.

You are required to ascertain the value of each equity share on the basis of productivity,applying suitable weighted averaging.

Solution

Computation of Productivity Factor

(Profit as a percentage of Capital employed)

(3)Valuation of Shares on the basis of Actual Market Price

Market price method is one of the old methods for the valuation of shares. In fact thereare many economists and analysts who attach more importance to this rather than anyother method. According to them, valuation of share is related to actual market priceand the prices at which transactions take place in the market indicate the value of theshares. The real value is the verdict of the market.

Those who support this are of the view that this price is determined by the investors andas such can be depended upon. Being a readily available measure can also be applied toa particular situation. It is this method which minimises subjectivity, which is thecharacteristic of other methods.

But the approach has its own problems as well. It is difficult to assess the marketbecause there are many fluctuations in its market and market is linked with manyfactors. Sometimes fluctuations can be both violent as well as extreme, which mightdisturb the whole system. Under such a situation it becomes doubtful whether at all it isdesirable to depend on this method, which is so undependable. Then another problemwith this method is that much of the speculative activity is going on in the market whichdisturbs share valuation. Those who are working in the market manipulate share pricesin a manner which suits their convenience.

There are other problems involved in so far as market price is concerned. One sucpimportant problem is that for many shares market quotations are not available and assuch their value is not listed in the share market. In the case of such companies itbecomes difficult to find out value of the shares. Trading in such shares becomes ratherdeceptive both for the buyers as well as the investors. If any undertaking decides torelease some additional shares then in the case of any such share, share market willsuddenly come down, as it shall not he-possible for the market to bear its pressure.

Still another difficulty with this method is that in many cases market price is influencednot by real but by artificial means and when the market is under the influence of suchmeans then there is bound to be deception. Then comes the problem of shares of closelyheld company. Obviously the shares of such a company are not reflected through themarket. In many cases shares of such companies in the market might go up or comedown when the members of the family themselves begin to trade in the market andpurchase or sell shares to attract or detract the attention of some others concerned withit.

Fair Market Value: There are many problems in so far as market value is concerned.Though the method might seem very acceptable, yet it is not because it is linked withmany problems. In order to avoid some of the problems the idea of Fair Market Value,has been evolved. This value is based on the assumption that there are both willingbuyers as well as sellers in the market and that each is quite well informed. It is alsobelieved that each such buyer and seller is quite rational. Accordingly, under this notionit is believed that whole market will smoothly and rationality work. But as we know suchan idea is difficult to follow in practice because in the market there are neither readybuyers nor ready sellers and equally also in the market all the buyers and sellers are notrational or quite well informed.

Illustration 4

Mr.Ram Nath intends to invests Rs.66,000 in Equity Shares of a limited Company andseeks your advise as to the maximum number of shares he can expect to acquire basedon a fair value of the shares to be determined by you. The following information isavailable:

Average net profit of the business is Rs. 1,50,000. Expected normal yield is 8% in case ofsuch equity shares. It is observed that net assets on revaluation are worth Rs. 1,40,000more than the amount at which they are stated in the books. Goodwill is to be calculatedat 5 years purchase of super profits, if any. Ignore taxation.

Solution

1. Value on Yield basis:

Normal yield is 8%

Value of Equity Share = 1 .20 x 100 = Rs. 15

8

or

Actual Yield = 1.20 x 100= 12%

10

Value of Equity Share = 12% x Rs.10 per share = Rs,15

8%

No. of Equity Shares that he can acquire = 66,000 = 4,400 Shares

15

2. Intrinsic Value including goodwill;

Rs.

3. Fair Value = 15.00 + 13.20 = 14.10

2

No. of Equity Shares that he can acquire = 66,000 = 4,680 Shares

14.10

Illustration 5

You are asked to value shares as on 31st March 1995 of a private Company engaged inengineering business, with a view to floating it as a Public Company. The followinginformation is extracted from the audited accounts:

The audited Balance Sheet as at 31st March, 1995 showed the following position.

In lieu of salary to Managing Director, the Public Company would incur director's fees ofRs.l8,000 per annum. Income Tax may be assumed at 60%.

You are required to value shares.

Solution

Valuation of Equity shares on net assets basis:

Valuation of Preference Shares

In India preference shares have a priority as to payment of dividend and repayment ofcapital over equity shares in the event of company's winding up. They are taken ascumulative but non-participating unless otherwise stated. Their valuation is generallyon "Dividend Basis" according to the following formula:

Paid-up value x Average maintainable Dividend rate

Normal rate of return

For example, if the paid-up value of a preference share is Rs.80, average dividend rate12 per cent, normal rate of return 10 per cent the value of a preference share would beRs. 96 (m i.e. Rs. 80 x 12/10).

In case the dividend on cumulative preference shares is in arrears, the present value ofsuch arrears of dividend (if there is a possibility of their payment) should be added tothe value of a preference share calculated as above.

The dividend basis for valuation of preference shares is useful only in those cases wherethe preference share capital does not has adequate assets backing and the company is agoing concern. In case the preference share capital does not have adequate assetsbacking or the company is going into liquidation it will be appropriate to valuepreference shares according to the net assets method.

In case of participating preference shares of companies in liquidation, it will beappropriate to take into account the share in the surplus assets remaining after paymentto the equity shareholders.

Illustration 6

A company has net assets of Rs 1 lakh before payment to the shareholders. The sharecapital consists of 5,000 equity shares of Rs. 10 each and 2,000 preference shares of Rs,10 each. The preference shares are entitled to share 25 per cent of the surplus assetsremaining after payment to the equity shareholders. Calculate the value of a preferenceshare.

Solution

Illustration 7

The following figures are extracted from the books of M/s Prosperous Limited.

On a fair valuation of all the assets of the company it is found that they have anappreciation of Rs. 75,000.

The articles of association provided that, in case of liquidation the preferenceshareholders will have a further claim to the extent of 10 per cent of the surplus assets.Ascertain the value of each preference and equity share, assuming liquidation. Ignoreexpenses of winding up.

Solution

Valuation of Preference and Equity Shares of M/s Prosperous Ltd.

Note: It is to be noted that values in the question are to be determined assumingliquidation. In such a case the surplus is to be distributed among the equityshareholders according to the nominal value of the shares held by them (equal in thiscase). Uncalled capital is an asset of the company and, ii one presumes that uncalledmoney has been called up the truth of the statement made above will be self-evident. Itwill be incorrect to distribute the surplus in the ratio of paid-up amounts.

REVIEW QUESTIONS

1. Briefly discuss some of the important purposes and methods of valuation of shares.

2. What do you understand by asset based approach to valuation? What are the mainproblems involved in this approach?

3. Critically evaluate capitalisation of earnings approach for the valuation of shares.

4. Explain the method of valuation of shares on the basis of actual market price. Statethe main objections to this method.

5. Describe two methods of valuation of shares and discuss which method in your view,most appropriate in valuing a minority and majority shareholding.

6. What are facts that influence the valuation of shares for the purpose ofamalgamation/merger of companies? Discuss with illustrations.

PRACTICAL PROBLEMS

1. From the following figures calculate the value of a share of Rs yield on capitalemployed basis and (ii) dividend basis, the market expectation being 12 %

2. Mr. Ashok wants to invest Rs. 32,000 in equity shares of a Company, The followingparticulars are available:

The company is three years old and has earned an aggregate net profit of Rs. 9lakhs. Theequity shares may yield 15%, If the net assets are re-valued, the value thereof is Rs.1,40,000 more than the value stated in the books. What is the maximum number ofshares Mr. Ashok can purchase based on fair value of the shares?

[Ans.: Fair value = Rs. 14, No of shares to be purchased on the basis of fair value 2,286Equity Shares]

3. Mr. X, who desires to invest Rs. 33,000 in equity shares in public limited company,seeks your advice as to the fair value of the shares. The following information is madeavailable:

Issued and Paid-up Capital Rs.

6 per cent Preference shares of Rs. 100 each 5,50,000

Equity shares of Rs. 100 each 3,50,000

9,00,000

Average net profit of the business in Rs. 75,000. Expected normal yield is 8 per cent incase of such equity shares. It is observed that the net assets on revaluation are worth Rs.70,000 more than the amounts at which they are stated in the books. Goodwill is to becalculated at 5 year's purchase of the super profits, if any, (Ignore income-tax).

Give your working of the fair value of equity shares and determine the number of shareswhich Mr. X should purchase.

[Ans. Goodwill Rs. 42,000; Intrinsic value Rs. 13.20; Value on yield basis: EPS basedRs. 15 and Rate of Earnings basis Rs. 12.50 No. of shares to be purchased 2,340]

4. The Balance Sheets of two companies A Ltd. and B Ltd. as on 31 March, 1994 are:

(Rs.Lakh)

A Ltd. proposes to take over B Ltd. For this purpose the assets were revalued as:

Fixed Assets Rs. 6.15 lakhs

Stock 1.00 lakhs

Debtors 1.05 lakhs

The additional factor to be considered is that B Ltd. is an industry which is not licensedunder the current policy of the Government. Hence, there is an advantage as an existingunit. For this premium of Rs. 5 lakhs is assessed.

Calculate and suggest a share valuation of B for the takeover and suggest a fair exchangeratio of shares.

[Ans. Break-up value of both more or less the same; Exchange Ratio 1:1]

SUGGESTED READINGS

1. Chowdhury : Management Accounting, Ludhiana. Kalyani Publishers.

2. Rathnam, P.V. : Financial Adviser, Allahabad, Kitab Mahal.

3. Saravanavel, P. : Financial Management,New Delhi, Dhanpat Rai & Sons

- End Of Chapter -

Date post:	27-Dec-2015
Category:	Documents
Upload:	sm-friend
View:	124 times
Download:	8 times

Financial Management

Documents