FINANCIAL MANAGEMENT

Unit -1

Financial Management: An introduction - Concept, Nature, Evolution and

Significance - Finance functions - Risk return trade off - Maximization and

minimization vs. optimization.

Unit - 2

Long Term Capital Resources: Equity and debt sources - Equity shares,

Preference shares and Debentures - Uses - Significance of convertible issues and

right issues - Borrowings from term lending institutions - Institutional frame work -

Types of assistance - General procedure and conditions - Public deposits - Meaning,

scope and regulations.

Unit-3

Working Capital: Concept and types - Determinants - Financing approaches -

Sources of working capital - Financing working capital Financing by commercial

banks - Types of assistance - Working capital gap -Recommendations of Tandon

Committee and Chore Committee reports.

Unit-4

Capital Budgeting: Concept - Significance - Methods of evaluation of capital

investments - Payback, Average Return, NPV, 1RR, Decision free Simulation.

Sensitivity and CAPM methods.

Unit-5

Capital Structure Planning; Determinants of capital structure - Optimum

capital structure - Capital structure theories – Significance and limitations -Cost of

capital: Concepts - Cost of debt, equity, preference share capital and retained

earning - weighted average cost.

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Unit – 6

Management of Current Assets: Forecasting of current assets needs -

Management of cash and liquidity - Objectives - budgeting - Planning the optimum

level of cash - Inventory model, stochastic model - Model of Miller and Orr -

Payment and collection practices -Management of receivables -Credit policy -

Credit period - Credit terms - Collection policies - Control of receivables - Inventory

management - Meaning and importance - Inventory costs - Inventory levels -

Inventory management techniques - Stock out cost determination techniques.

Unit-7

Dividend Theories: Valuation under Gordon and Walter Theories -Dividend

irrelevance under MM Theory - Assumptions and limitations -Dividend policy:

Different policies and practices - Factors affecting dividend decision.

UNIT-I

FINANCIAL MANAGEMENT - FUNCTIONS & GOALS

In this unit you will learn, concept of financial management, nature of

financial management, evolution of financial management, significance of financial

management, functions of financial management, goals of financial management,

risk return -trade off and aspects of maximization, minimization and optimization in

financial management.

INTRODUCTION

Of the different factors of production, capital is very crucial. Capital is

otherwise called finance.

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Finance is one of the requisites for all human endeavours -personal, business

or government. Finance refers to the money resources -owned or borrowed

available to individuals, businesses or governments for their operations. Ours is a

money economy and every person, individual or otherwise, needs finance and

mobilizes finance. As every other resource, finance is not unlimited. Printing

currency notes or minting coins would only add to the money supply resulting in

inflation and reduced value of oney. So, more money circulation would not mean

more finance availability.

ctually, finance is monetized form of capital, and capital is the savings (S)

available for investment. Amount of savings depends on income (Y) and

consumption (C). There are certain macroeconomic equations:

Y = C + S ; Y = C + I and S = I

When savings become available for investment, capital formation takes

place. Capital, thus formed, is finance. Finance has two sides, just as a coin. One

side is concerned with assets and the other with liability. The assets side

represents investments and the liability side represents sources and types of

finances depended.

That is to say, finance is a scarce resource. Consequently, no one has

unlimited access to finance nor can afford frittering away the resources unwisely.

Both mobilizing and investing financial resources have to be managed properly.

Hence, financial management has emerged as a priority function for all concerned.

There are three branches of financial management Personal, business and

government financial management Personal financial management deals with how

individuals, you and I, manage our finances. Business financial management deals

with how business undertakings manage their finances. Government financial

management known as public finance, deals with how governments manage their

finances. In this paper, we are however dealing with business financial

management only.

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1.1 DEFINITIONS AND CONCEPT OF FINANCIAL MANAGEMENT

What is meant by financial management? Very simple indeed. Financial

management is management principles and practices applied to finance. Howard

and Upton view that financial management is the application of general

management functions to the area of financial decision making. General

management functions include planning, execution and control. Financial decision

making includes decisions as to size of investment, sources of capital, extent of

use of different sources of capital and extent of retention of profit or dividend

payout ratio. Financial management, is therefore, planning, execution and control

of investment of money resources, raising of such resources and retention of

profit/payment of dividend.

Howard and Upton define financial management as "that administrative area

or set of administrative functions in an organisation which have to do with the

management of the flow of cash so that the organisation will have the means to

carry out its objectives as satisfactorily as possible and at the same time meets its

obligations as they become due.

Bonneville and Dewey interpret that financing consists in the raising,

providing and managing all the money, capital or funds of any kind to be used in

connection with the business.

According to James C Van Home and John M. Wachowicz financial

management is concerned with acquisition, financing and management of assets

with some overall goal in mind.

Osbon defines financial management as the "process of acquiring and

utilising funds by a business”.

Considering all these views, financial management may be defined as that

part of management which is concerned mainly with raising funds in the most

economic and suitable manner, using these funds as profitably as possible;

planning future operations, and controlling current performances and future

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developments through financial accounting, cost accounting, budgeting, statistics

and other means. Financial management provides the best guide for future

resource allocations. It designs and implements certain financial plans, investment

plans and value addition plans.

1.2 NATURE OF FINANCIAL MANAGEMENT

Nature of financial management is concerned with its functions, its goals,

trade-off with conflicting goals, its indispensability, its systems, its relation with

other subsystems in the firm, its environment, its relationship with other

disciplines, the procedural aspects and its equation with other divisions within the

organisation.

i) Financial Management is an integral part of overall management. Financial

considerations are involved in all business decisions. Acquisition,

maintenance, removal or replacement of assets, employee compensation,

sources and costs of different capital, production, marketing, finance and

personnel decisions, almost all decisions for that matter have financial

implications. So financial management is pervasive throughout the

organisation.

ii) The central focus of financial management is valuation of the firm. That is

financial decisions are directed at increasing/maximization/ optimizing the

value of the firm. Weston and Brigham depict the above orientation in

Figure 1.1.

Fig. 1.1 Orientation of Financial Management

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iii) Financial management essentially involves risk-return trade-off Decisions

on investment involve choosing of types of assets which generate returns

accompanied by risks. Generally higher the risk, returns might be higher

and vice versa. So, the financial manager has to decide the level of risk

the firm can assume and satisfy with the accompanying return. Similarly,

cheaper sources of capital have other disadvantages. So to avail the

benefit of the low cost funds, the firm has to put up with certain costs,

disadvantages or risks, so, risk-return trade-off is there throughout. Fig

1,1 implies this aspect of financial management also.

iv) Financial management affects the survival, growth and vitality of the firm.

Finance is said to be the life blood of'business. It is to business, what

blood is to us. The amount, type, sources, conditions and cost of finance

squarely influence the functioning of the unit.

v) Finance functions, i.e., investment, rising of capital, distribution of profit,

are performed in all firms - business or non-business, big or small,

proprietary or corporate undertakings. Yes, financial management is a

concern of every concern.

vi) Financial management is a sub-system of the business system which has

other subsystems like production, marketing, etc., In systems

arrangement financial sub-system is to be well-coordinated with others

and other sub-systems well matched with the financial subsystem.

vii) Financial management of a business is influenced by the external legal

and economic environment. The investor preferences, stock market

conditions, legal constraint or using a particular type of funds or on

investing in a particular type of activity, etc., affect financial decisions, of

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the business. Financial management is, therefore, highly

influenced/constrained by external environment.

viii) Financial management is related to other disciplines like accounting,

economics, taxation operations research, mathematics, statistics etc., It

draws heavily from these disciplines. The relationship between financial

management and supportive disciplines is depicted in figure 1.2. given

below.

Fig. 1.2. Relationships between Finance and other disciplines

ix) There are some procedural finance functions - like record keeping, credit

appraisal and collection, inventory replenishment and issue, etc., These

are routinized and are normally delegated to bottom management.

x) The nature of finance function is influenced by the special characteristic of

the business. In a predominantly technology oriented business, it is R & D

functions which get more dominance, in a consumer fashion product

business it is marketing and marketing research which get more priority

and so on. Here, finance assumes a low profile importance. But one

should forget that the strength of a chain depends on its weakest link.

1.3 EVOLUTION OF FINANCIAL MANAGEMENT

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Finance, as capital, was part of the economics discipline for a long time. So,

financial management until the beginning of the 20th century was not considered

as a separate entity and was very much a pan of economics.

In the 1920s, liquidity management and raising of capital assumed

importance. The book, 'FINANCIAL POLICY OF CORPORATIONS' written by Arthur

Stone Dewing in 1920 was a scholarly text on financing and liquidity management,

i.e., cash management and raising of capital in 1920s.

In the 1930s tfoere was the Great Depression, i.e., all round price decline,

business failures and declining business. This forced the business to be extremely

concerned with solvency, survival, reorganisation and so on. Financial Management

emphasized on solvency management and on debt-equity proportions. Besides

external control on businesses became more pronounced.

Till early 1950s financial management was concerned with maintaining the

financial chastity of the business. Conservatism, investor/lender related protective

covenants/information processing, issue management, etc. were the prime

concerns. It was an outsider-looking-in function.

From the middle of 1950s financial management turned into an insider-

looking-in function. That is, the emphasis shifted to utilization of funds from rising

of funds. So, choice of investment, capital investment appraisals, etc., assumed

importance. Objective criteria for commitment of funds in individual assets were

evolved.

Towards the close of the 1950s Modigliani and Miller even argued that

sources of capital were irrelevant and only the investment decisions were relevant.

Such was the total turn in the emphasis of financial management.

In the 1960s portfolio management of assets gained importance. In the

selection of investment opportunities portfolio approach was adopted, certain

combinations of assets give more overall return given the risk or give a certain

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return for a reduced risk. So, selection of such combination of investments gained

eminence.

In the 1970s the capital asset pricing model (CAPM), arbitrage pricing model

(APM), option pricing model (OPM), etc., were developed - all concerned with how

to choose financial assets. In the 1980s further advances in financial management

were found. Conjunction of personal taxation with corporate taxation, financial

signaling, efficient market hypothesis, etc., were some newer dimensions of

corporate financial decision paradigm. Further Merger and Acquisition (M&A)

became an important corporate strategy.

The 1990s, saw the era of financial globalization. Capital moved West to

East, North to South and so on. So, global financial management, global

investment management, foreign exchange risk manage lent, etc., become more

important topics.

In late 1990s and 2000s, corporate governance got preeminence and

financial disclosure and related norms are being great concerns of financial

management. The dawn of 21st Century is heralding a new era of financial

management with cyber support.

The developments till mid 1950s are branded as classical financial

management. This dealt with cash management, cash flow management, raising

capital, debt-equity norms, issue management, solvency management and the like.

The developments since mid - 1950s and upto 1980s, are branded as modem

financial management. The emphasis is on asset management, portfolio approach,

capital asset pricing model, financial signaling, efficient mark*, hypothesis and so

on. The developments since the 1990s may be called po^ modern financial

management with great degree of global financial integral m net supported

finances and so on.

1.4 SIGNIFICANCE OF FINANCIAL MANAGEMENT

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Financial management is a very important function of overall business

management. The reasons are laid down here.

i) Financial Management covers a very large spectrum of activities of a

business. True, whatever a business does it has a financial implication.

Hence its pervasiveness and significance. Finance knowledge is a must

for all irrespective of position, place, portfolio and what not.

ii) Financial Management influences the profitability or return on investment

of a business. Yes, the choice of capital investment decisively affect the

profitability of an undertaking.

iii) Financial Management affects the solvency position of a business.

Solvency refers to ability to service debts paying interest and repaying

principal as these become due. Profitability and nature of debts - both

concerns of financial management, govern the solvency aspect. Hence

the significance of financial management

iv) Financial Management affects the liquidity position of a business.

Liquidity refers to ability to repay short term loans. Efficient cash

management, cash flow management and management of relations with

the banker influence the level of liquidity. All these factors are aspects of

financial management.

v) Financial Management affects cost of capital. Able financial managers

find and use less cost sources, which in turn contributes to profitability. In

using fixed cost instruments of capital, the efficacy of sound financial

management would be known well. Variable cost instruments of capital

are the order of the day. Finance savvy persons go for such instruments.

vi) Financial Management, if well steered can ward off difficulties such as

restrictive covenants imposed by lenders of capital, inflexibility in capital

structure, dilution of management control on the affairs of the business

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and so on. Failure to do so, has landed many firms in difficulties and

financial mess.

vii) Good financial management enables a business to command capital

resources flowing into the business. There is always capital available at

attractive terms, if business finance is handled well. Even overseas

capital can be easily mobilized, if sound financial management is

ensured.

viii) Market value of the business can be increased through efficient and

effective financial management. As share and stock are quoted at high

prices, more funds, when needed, can be mobilized easily either thro1

public and/or rights offers.

ix) Efficient financial management is necessary for the survival, growth,

expansion and diversification of a business.

x) Financial Management significantly influences the business's credit

rating, employee commitment, suppliers' confidence, customers'

patronage and the like.

xi) Financial Management is an exercise on optimizing costs given revenues,

or optimizing revenues given costs. This is vital to ensure purposeful

resource allocation.

xii) Today financial management has global dimensions with opportunity to

mop up resources and put up investments across borders. Global trend in

finance is better learnt by all.

The significance of financial management can be well appreciated if

one considers the analogy. Finance is what blood is to living beings. Financial

management is what the blood circulation system is to living beings. The functions

of heart, veins, arteries, etc., in maintaining the circulation of blood are life's worth

to living beings. So is the worth of financial management to a business.

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1.5 FINANCE FUNCTIONS

Finance functions simply refer to functions of financial management.

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The functions of financial management are divergent. Several

classifications are used. Here are presented the functions of financial management

as noted by eminent authors. Figure 1.3 gives the details.

Fig. 13 Functions of Financial Management

Authors 1 2 3 4

Robert W

Johnson

Financial

Planning

and

control

Raising of

funds

Investing

funds

Meeting special

problems

Grunwald

Nemmars

Investmen

t of funds

Providing

liquid assets

Generating

earnings

Maximizing

market value of

the firm

Van Home &

Wachowicz

Investmen

t function

Financial

function

Dividend

function

Earnest W.

Walker

Financial

planning

Financial co-

ordination

Financial

control

Weston&

Jrigham

Financial

planning

and

control

Fixed asset

and working

capital

managemen

t

Capital

structure

decisions

Individual

financing

episodes

Well. The above figure presents the functions of financial management,

or finance functions shortly, as perceived by the different authors. Let us look at

them in a more analytical way. Finance functions are classified on two dimensions -

managerial" and operative. The managerial financial functions include planning,

organisation, direction, coordination and control of the operative functions. The

operative functions include investment function, financing function and dividend

function. We have a matrix of functions as given in Fig. 1.4.

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Fig. 1.4 : Matrix of Financial Functions

Operative

FunctionsManagerial Functions

Planning Organizing DirectionCo-

ordinationControl

Investment

and asset

management

Size and

types

Financing and

liability

management

Structure

and cost

Dividend

payout

management

and internal

financing

Impact on

value and

liquidity

Each one of the operative functions has got to be planned, organized,

directed, coordinated and controlled. Investment function is concerned with the

asset to be acquired. Fixed and current assets are needed. Commitment of funds in

them is dealt by investment function. Financing function is concerned with the

capital sources to be tapped. Equity and debt funds are available. The mix of them

is dealt by financing function. We may put this way. The investment function deals

with the 'asset side' of balance sheet and financing function with the 'liabilities

side' of balance sheet. Dividend function deals with how much of profit to be

distributed as dividend and how much be retained. Evidently, each of the operative

functions involves a host of dimensions as to size, variety, proportions, timing,

sourcing and so on requiring a total managerial approach to decide each on each

dimension. Hence the interplay of managerial and operative functions.

Now a more detailed account of each of the operative functions is

attempted.

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a) Investment and Asset Management Function

A detailed discussion on investment function of financial management

is taken up. This function essentially covers the following:

i) the total amount to be committed in assets

ii) the proportion of fixed to current assets

iii) the mix of fixed assets to be acquired

iv) the timing, sourcing and acquisition of fixed assets

v) the evaluation of capital investments as to risk and return features

vi) the mix of current assets

vii) the management of each item of current assets to optimize liquidity and

return

viii) the effecting of a healthy portfolio of assets

Actually the above aspects of investment function are concerned with

much pregnant issues with which financial management is concerned. The first

aspect deals with the size of the firm, the second and third deal with the level of

risk the business is willing to assume, the fourth with appraisal of investment as to

their profitability, pay back period, etc., the fifth with actual execution of

investment decisions, the sixth with the liquidity of the business, the seventh with

structural and circulatory aspects of current assets and the eighth with the overall

balancing of various investments held by the business taking into account

competing and divergent claims.

Investment function is, concerned capital budgeting and current asset

management. Capital budgeting deals with fixed assets management. Investment

appraisal, capital rationing, and acquisition, maintenance, replacement and

renewal of fixed assets come under fixed assets management. Inventory

management, receivables management, marketable securities management, cash

management and working capital administration come under current assets

management. (You will learn every one of these in the subsequent lessons). A good

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deal of planning, organisation, coordination and control is needed in every decision

area.

b) Financing and Liability Management Function

The financing function refers to raising necessary iunds for backing up

the investment function. Financing function is dealing the capital structure of the

business and covers the following:

i) determination of total capital to be raised

ii) determination of the debt-equity ratio or the proportion of debt to equity

capital and the mix of long term and short-term capital.

iii) determination of the level of fixed-change funds like bonds, debentures,

loans, etc.

iv) determination of the sources of borrowing - development banks, public or

private

v) determination of the securities/charges to be given

vi) determination of the cost of capital

vii) determination of the extent of lease financing

viii) determination of the degree of sensitivity of earnings per share to

earnings before interest and taxation

ix) determination of the method of raising capital-public issue or private

placement; under-writing and brokerage, rights issue and the like

x) the legal restrictions, if any, on the scale, form, timing and other aspects

of raising capital

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Like investment function, financing function also affects the liquidity

(less short term debt means more liquidity), solvency (more equity means more

solvency), profitability (low cost capital means more profitability), flexibility of

capital structure (more equity, more flexibility), control on business (more debt and

less equity mean more concentration of control on the affairs of the business) and

so on. That is, financing function is equally influencing the fortunes of the business.

But authors like Modigliani and Miller would argue that financing function is not all

mat relevant requiring our deep concern. Any capital mix or structure is equally

good or bad as any other. (You will learn more of these in subsequent lessons). Lot

of managerial planning and control ate needed in the financing function.

c) Dividend Payout Management Function

The third and last, but not the least important, function of financial

management is dividend function. The fruits of the carefully executed earlier two

functions are the profits. How the profits are to be utilized, is the concern of the

dividend function. How much of the profits to be distributed as dividends to the

shareholders? In other words, what should be the pay-out ratio? What should be

the retention ratio? Dividend payment is necessary, for shareholders expect a

return on their shareholding for they can invest / spend the dividend income; for

maintaining or enhancing the value of the shares in the market, for dividend

declaration has a financial signaling effect and so on. Retaining the profits ane

ouging back the same in the business itself may become necessary because; the

>mpany can invest more profitably than the shareholders; the company can get

established and can modernize, diversify and expand using the retained profits;

the share holders are expecting capital gain rather than current income; and

because the cost of raising new capital form the public is costlier and time

consuming. So, there are conflicting issues in paying dividend as well as in

retaining the earnings. A well thought out plan of action is called for. Hence the

significance of the dividend function. (You will learn more on this function in the

last lesson).

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There is another classification of finance functions. Treasurer functions

and controller function are the two types. Treasurer's responsibilities include asset

management, capital budgeting, bank-institutional relationship, credit

management, dividend disbursement, investor's relations, insurance risk

management, tax analysis, etc. The controller deals with accounting, data

processing, budgeting, internal control, government reporting, etc.

1.6 GOALS OF FINANCIAL MANAGEMENT

Goals provide the foundation for any managerial activity. They ai the ends

toward which all activities are directed. The purpose and direction of an

organisation are seen in its goals. Goals act as motivators, serve as the standards

for measuring performance, help in coordination of multiplicity of tasks, help in

identifying inter-departmental relationships and so on. Simply put, goals are what

you aim at So, goals have to be specific and quantitative. Generally, goals are

multiple. Financial management may pursue different goals such as increasing

profit by 20% every year, reducing cost of capital by 1%, maintaining the debt-

equity ratio at 3:2 and so on. Let us examine all these in detail.

1.6.1 Types of Goals

The goals can be classified in many ways. Official goals, operative goals and

operational goals are one classification. Official goals are the general aims of the

organisation. Maximization of return on investment and market value per share

may be tenned as official goals. Operative goals indicate what the organisation is

really attempting to do. They are focused and help in choice making. Expected

return on investment, cost of capital, debt-equity norms, eic dong with time

horizon are specified or their acceptable ranges/limits are static keeping in view

the official goals. The operational goals are more directed quantitative and

verifiable. The scale, mix and timing of specific form of finance are detailed. The

official, operative and operational goals are structured with a pyramidal shape, the

official goals at the top (concerned with the top executives), operative goals at the

middle (concerned with middle management) and operational goals at the base.

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The goals can be classified in a functional way. Return related goals,

solvency related goals, liquidity related goals, valuation related goals, risk related

goals, cost related goals and so on. Return related goals refer to the aims on

minimum, average and, maximum returns. What should be the minimum return

from a project in order to accept the same, what should be average return the firm

should settle for and what is the maximum return possible (for risk increases with

return). Similarly, goals as to solvency, liquidity, market value etc., can be thought

of You have to state to what extent the stated goal factor is important and be

actively pursued/and the extent of the goal factor required; the minimum, average

and the maximum levels be specified. The different goals of financial management

are given below in Table 1.1.

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1.6.1.1 Profit Maximization

Profit maximization is a stated goal of financial management. Profit is

the excess of revenue over expenses. Profit maximization is therefore maximizing

revenue given the expenses, or minimising expenses given the revenue or a

simultaneous maximization of revenue and minimization of expenses. Revenue

maximization is possible through pricing and scale strategies. By increasing the

selling price one may achieve revenue maximization, assuming demand does not

fall by a commensurate scale. By increasing quantity sold by exploiting the price-

elasticity of the demand factor, revenue can be maximized. Expenses minimization

depends on variability of costs with volume, cost consciousness and market

conditions for inputs. So, a mix of factors is called for profit maximization.

This objective is a favoured one for the following reasons:

1st profit is a measure of success in business. Higher the profit greater is the

degree of success. 2nd profit is a measure of performance. Performance efficiency is

indicated by the quantum of profit, 3rd profit making is essential for the growth and

survival of any undertaking. Only protit making business can think of tomorrow and

beyond. It can only think of renewal and replacement of its equipment and can go

for modernization and diversification. Profit is an engine doing away the odds

threatening the survival of the business. 4th profit making is the basic purpose of

business. It is accepted by society. A losing concern is a social burden. The sick

business undertakings cause a heavy burden to all concerned, we know. So, profit

criterion brings to the light operational inefficiency. You cannot conceal your

inefficiency, if profit is made the criterion of efficiency. 5th profit making is not a sin.

Profit motive is a socially desirable goal, as long as your means are good.

However, profit maximization is net very much favoured. Certain limitations are

pointed out. First, concept of profit is vague. There are several concepts of profit

like gross profit, profit before tax, profit after tax, net profit, divisible profit and so

on. So the reference to the profit has to be clear. Second, profit maximization in

the long-run or in the short-run is to be stated clearly. Long-run or in the short-run

profit orientations differ in the nature, emphasis and strategies. Third, profit

maximization does not consider the scale factors. Size of business and level of

profit have to be related. Otherwise no sensible interpretation of performance or

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efficiency is possible. Fourth, profit has to be related to the time factor. Inflation

eats up money value. A rupee today is worthier today than tomorrow and day

after. Time value of money is not considered in profit maximization. Consider the

case of three businesses making same absolute profits over a 3 year time span

given below.

Year Unit-1 Unit-2 Unit-3

Rs. Rs. Rs.

1 20,000 40,000 5,000

2 20,000 15,000 15,000

3 20,000 5,000 40,000

Total 60,000 60,000 60,000

The profit maximization objective would not differentiate among the three

business. But, evidently, unit-2 is the best of the three, followed by Unit-1 and Unit-

3 in that order. Fifth, profit maximization might lead to unfair means being

adopted. The 'end' through and 'means' is no good. Ethics is business dealings may

be undermined any this is not good. So, profit maximization is not accepted as a

flawless goal.

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1.6.1.2 Profitability Maximization

Profit as an absolute figure conveys less and conceals more. Profit must be

related to either sales, capacity utilisation, production or capital invested. Profit

when expressed in relation to the above size or scale factors it acquires greater

meaning. When so expressed, the relative profit is known as profitability. Profit per

rupee sales, profit per unit production, profit per rupee investment, etc., are more

specific. Hence, the superiority of this goal to the profit maximization goal.

Further profit per rupee investment or return on investment, (ROI) is a

comprehensive measure. ROI = Return or Profit / Average Capital invested. This

can be written as:

Profit

X

Sales

Sales Investment

Profit divided by sales measures the profit per rupee of sales and sales

divided by investment measures the number of times the capital is turned over.

The former is an index of profit earning capacity and the latter is an index of

activeness of the business. Maximization of profitability (ROI) is possible through

either the former or the latter or both.

The favourable scores of this objective are the same as those of the profit

maximization objective. The unfavourable scores of this objective again are the

same as those of the profit maximization objective except one aspect. Profit

maximization goal does not relate profit to any base. But profitability maximization

relates profit to sales and/or investment. Hence it is a relative measure. So it is

better than profit maximization goal on this score. But as other limitations

continue, this objective too gets only a 'qualified' report as to its desirability.

1.6.13 EPS Maximization

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Maximization EPS involves maximizing earnings after tax given the number

of outstanding equity shares. This goal is similar to profitability maximization in

respect of merits and demands. It is very specific both as to the type of profit and

the base to which it is compared. One disadvantage is that EPS maximization may

lead to value depletion too, because effect of dividend policy on value is totally

discarded.

1.6.1.4 Liquidity Maximization

Liquidity refers to the ability of a business to honour its short-term liabilities

as and when these become due. This ability depends on: the ratio of current assets

to current liabilities, the maturity patterns of currents assets and 'the current

liabilities, the composition of current assets, the quality of non-cash current assets;

the relations with the short-term creditors; the relations with bankers and the like.

A higher current ratio, a perfect match between the maturity of current assets and

current liabilities, a well balanced composition of current assets, healthy and

'moving1 current assets, i.e., those that can be converted into liquid assets with

much ease and no loss, understanding creditors and ready to help bankers would

help maintaining a high-liquidity level for a business. All these are not easy to

obtain and these involve costs and risks.

How far is it a good goal? It is a good goal, though not a wholesome one.

Every business has to generate sufficient liquidity to meet its day-to-day

obligations. Last, the business would suffer. A liquidity rich business can exploit

some rare opportunities like buying inventory in large quantity when price is lower,

lend to the call money borrowers when the interest rate is high, retire short-term-

creditors taking advantage of cash discounts and so on. So many benefits accrue.

But, high liquidity might result in idle cash resources and this should be avoided.

Yes, excess liquidity and profitability move in the opposite directions, they are

conflicting goals and have to be balanced.

1.6.1.5 Solvency Maximization

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Solvency is long run liquidity. Liquidity is short-run solvency. The business

has to pursue the goal of solvency maximization. Solvency is the capacity of the

business to meet all its long-term liabilities. The earning capacity of the business,

the ratio of profit before interest and tax to interest, the ratio of cash flow to debt

amortization, the equity-debt ratio and the proprietary ratio influence the solvency

of a business. Higher the above ratios greater is the solvency and vice-versa

Is this a significant goal? Yes, Solvency is a guarantee for continued

operation, which in turn is necessary for survival, growth and expansion. Borrowed

capital is a significant source of finance. Its cost is less; it gives tax leverage; So,

equity earnings increase; so market valuation increases. So, wealth maximization

is enabled through borrowed capital. But to use borrowed capital, solvency

management is essential. You have to decide the extent to which you can use debt

capital and ensure that the cost of debt capital is minimum. Higher dependence

and higher cost (higher than the ROI) would spell doom to the business. If the cost

is less, (cost is the post tax interest rate), and your earnings are stable, a higher

debt may not be difficult for servicing. Solvency maximization is increasing your

ability to service increasing debt and does not mean using less debt capital.

Increasing the debt service ability would require generating more and stable cash

flows through the operations of the business. Ultimately, the nature of investments

and business ventures influence solvency.

You would now understand that liquidity maximization and solvency

maximization emerge to a large extent from wealth maximization

objective.

1.6.1.6 Flexibility Maximization

Flexibility means freedom to act in one's own way. The finance manager

must enjoy a good degree of freedom. This is possible when more equity capital is

used, there are no restrictive covenants and exit options are available.

1.6.1.7 Minimization of Risk

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So far, maximization financial goals were dealt with. Now, if we turn the coin,

the minimization goals come to light. Minimization of risk is one of the goals. Risk

refers to fluctuation, instability or variations in what we cherish to obtain.

Variations in sales, profit, capacity utilisation, liquidity, solvency, market value and

the like are referred to risk. Business risk and financial risk are prominent among

different risks. Business risk refers to variation in profitability while financial risk

refers to variation in debt servicing capacity. The business risk, alternatively, refers

to variations in expected returns. Greater the variations, greater the business risk.

Risk minimization also does not mean taking no risk at all. It means minimizing risk

given the return and given the risk maximizing return. Risk reduction is possible by

going in for a mix of risk-free and risky investments. A portfolio of investments with

risky and risk-free investments, could help reducing business risk. So,

diversification of investments, as against concentration, helps in reducing business

risk.

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Financial risk arises when you depend more on high-geared capital structure and

your cash flows and profits before interest and tax (PBJT) vary. To minimize

financial risk, the quantum of debt capital be limited to the serviceable level, which

depends on the minimum level of PBJT and the cash flow. Of course, debt payment

scheduling and rescheduling may help in financial risk reduction and the creditor

must be agreeing to such schedules/reschedules. Here; too, a portfolio of debt

capital can be thought of to reduce risk.

1.6.1.8 Minimization of Cost of Capital

Minimization of cost of capital is a laudable goal of financial management.

Capital is a scarce resource, A price has to be paid to obtain the same. The

minimum return expected by equity investors, the interest payable to debt capital

providers, the discount for prompt payment of dues, etc., are the costs of different

forms of capital. The different sources of capital - equity, preference share capital,

long term debt, short-term debt and retained earnings, have different costs. In

theory, equity is the costliest source. Preference share capital and retained

earnings cost less than equity. The debt capital costs less, besides there is the tax

advantage. So, to minimize cost you have to use more debt and less of other forms

of capital. Using more debt to reduce cost is however is beset with some problems,

viz., you take heavy financial risk, create charge on assets and so on. Some even

argue, that more debt means more risk of insolvency and bankruptcy cost arises.

So, debt capital has, besides the actual cost, another dimension of cost - the

hidden cost. So, minimizing cost of capital means minimizing the total of actual and

hidden costs.

This is a good goal. Minimization of capital cost increases the value of the

firm. If the overall cost of capital is less, the firm can take up even marginal

projects and make good returns and serve the society as well. But, it should avoid

the temptation to fritter away scarce capital. Capital should be directed into

productive and profitable avenues only.

1,6.1.9. Minimization of dilution of control:

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Control on the business affairs is, generally, the prerogative of the equity

shareholders. As the Board holds a substantial equity it wants to preserve its hold

on the affairs of the business. The non-controlling shareholders too, in heir financial

pursuit, want no dilution of their enjoinment of fruits of equity ownership. Dilation

takes place when you increase the capital base. By seeking debt capital control

dilation is minimized. Also, by rights issue of equity dilation of control can be

minimized.

It is evident, minimization of dilution of control is essentially a financing -mix

decision and the latter's relevance and significance had been already dealt with.

But you cannot minimize dilution beyond a point, for providers of debt capital,

directly or indirectly, affect business decisions. The convertibility clause is a shot in

the arm for those creditors. Yes, controlling power has to be distributed. Especially,

in Indian context one need not be a 51% owner to exercise full control. Even with

as little as 26% or 30% equity holding maximum control can be exercised. This is

bad. So, such control better is not controlled. So, there is need and score for

sharing of controlling power. The present scenario is a fulfillment of the above.

1.6.1.10. Wealth maximization:

Wealth maximization means maximization of networth of the business, i.e.

the market valuation of a business. In other words, increasing the market valuation

of equity share is what is pursued here. This objective is considered to be superior

and wholesome. The pros and cons of this goal are analysed below.

Taking the positive side of this goal, we may mention that this objective takes into

account the time value of money. The basic valuation model followed discounts the

future earnings, i.e. the cash flows, at the firm's cost of capital or the expected

return. The discounted cash inflow and outflow are matched and the investment or

project is taken up only when the former exceeds the latter. Let the cash inflows be

expressed by CFi, CF2, CFs.... CFn, where the subscripts l,2,3...n are periods when

cash flows realised. Let, the cash investment at time zero be T. The present value

i.e. the discounted value of CFi, CFi, CF3..., CFto at the discount rate V is given by:

n

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∑ CFt / (1+r)t or

t=1

CF + CF2 + CF + …….. + CF

(1+r)1 (1+r)2 (1+r)3 (1+r)n

The value addition is given by PV - I. By adopting this methodology the firm

gives adequate consideration to time value of money, the short-run and long-run

income as the return throughout the entire life span of the project is considered

and so on.

The term cash flow used here is capable of only one interpretation, unlike the

term profit. Cash inflow refers to profit after interest and tax but before

depreciation. Otherwise put, profit after tax and interest as increased by

depreciation. Cash outflow is the investment. Salvage value of investment, at its

present value can be reduced from investment or added to inflow. So, the cash

flow concept used in wealth maximization is a very clear concept.

This goal considers the risk factor in financial decision, while the earlier two

goals are silent as though risk factor is absent. Not only risk is there and it is

increasing witH the level of return generally. So, by ignoring risk, you cannot

maximize profit for ever Wealth maximization objective give credence to the whole

scheme of financial evaluation by incorporating risk factor in evaluation. This

incorporation is done through enhanced discounting rate if need be. The cash flows

for normal-risk projects are discounted at the firm's cost of capital, whereas risky

projects are discounted at a higher than cost of capital rate so that the discounted

cash inflows are deflated, and the chance of taking up the project is reduced. Cash

flows - inflows and outflows are matched. So, one is related to the other: i.e. there

is the relativity criterion too. So, wealth maximization goal comes clear off all the

limitations all the goals mentioned above. Hence, wealth maximization goal is

considered a superior goal. This is accepted by all participants in the business

system.

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The profit, profitability, liquidity, solvency and flexibility maximization goals

and risk, cost and dilution of control minimization goals lead to reaping of wealth

maximization goal. Wealth maximization is, therefore, a super-ordinate goal.

1.6.1.11. Maximization of economic value added

A modern concept of finance goal is emerging now, called as maximization or

economic value added (EVA). EVA = NGPAT - CCC, where, EVA is economic value

added, NGPAT is net generating profit after tax but before interest and dividend

and CCC is cost of combined capital. CCC = Interest paid on debt capital plus fair

remuneration on equity. EVA is simply put excess of profit over all expenses,

including expenses towards fair remuneration paid/payable on equity fond.

1.7. RISK-RETURN LINKAGE AND TRADE-OFF

Risk is the uncertainties or fluctuations in expected gain or benefit. Return is

the gain of reward. Risk and return are linked, in a probabilistic way. Higher risk

may give you more return and vice versa. There is no certainty relationship. If mat

were so, the concept of risk gets vanished. You put your money with nationalised

banks in different schemes. Your return at the maximum would be 10% or so, but

you are sure this return would be given to you with no hitch or hindrance. So there

is no fluctuation in your earnings from your deposits with these banks. So, there is

no risk, but your return is minimum. You put your money in debentures of ‘AAA’

rated company. A 12% interest may be promised. You may not run any risk, but

the Government guarantee is not there as in the case of bank deposits. So some

risk is there. Hence a 2% extra return. You take some risk and there is additional

return. You put your money in a BBB plus company's debentures and you are

promised 13% return. Yes, you take more risk than in the case of your investment

in an *AAA' company and hence the added return. In these two cases referred to

above you take the risk. But returns are only promised. If promises are not fulfilled,

higher returns have not resulted. Hence, the probabilistic but direct relationship

between risk and return.

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As risk and return move in the same direction, a trade-off has to be effected.

What is the level of risk you want to take? Then the return is specified What is the

return you want to earn? Then the risk is given. If you decide one, the other is

given and you can't have any bargain over that. You decide one and take the other

as given. If you reduce the level of risk, this is accomplished by a reduction in

return too and vice versa. So, every unit of return has a price - i.e. the risk. You pay

the price - i.e. assume the extra risk and get the extra return and vice versa. This

exchange arithmetic is referred to risk-return trade-off.

All financial decisions involve risk-return trade-off. Consider these. More

liquidity means less risk of running out of cash. You keep more liquid cash. Result

more barren assets and less return. So, less risk - less return situation arises. More

solvency means less risk, because you possibly use less debt capital. Less debt

means more overall cost of capital, for you have used less of low cost debt capital

and more of high cost equity capital. More overall cost of capita) means reduced

return. So, again less risk and less return situation results. When high risk is

involved, high return is expected

This relationship is put into an equation of risk and return. Rf + Rp, where,

E(R) is expected return, Rf is risk-tree return as in the case return on good bonds

and Rp is risk premium, i.e. additional return expected for any additional dose of

risk assumed and Rp varies with risk level.

1.8 MAXJMISATION-MINIMISATION-OPTIMISATION-SATISFICING

So far the goals of financial management were dealt either in terms of

maximization or minimization, as the case may be. Now the reality of these

maximization and minimization may be required into, and alternative approaches

to them, if need be, evolved,

Both maximization and minimization are devoid of clear expression or

definition, as these have not definite limits. Hence these are unrealistic. Unrealistic,

not because conceptualization is difficult. We can even conceptualize by

mentioning some bench mark levels or some min-max ranges. But once such levels

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are mentioned, human tendency is to conform to the limits. You may not maximize

return beyond the minimum expected and may not minimize cost below the

maximum acceptable. The divorce between ownership and management in a case

in point. Shareholders are no longer the managers. The interest of shareholders

differ from the interests of the management The principals' interest may not be

realised by the agents, unless the agents' own set of interests are fulfilled. Michael

C.Jensen and William H.Meckling refer to this as the agency cost. Managements

have to be offered incentives - a percentage commission on profit, a fat salary, a

diverse perquisites, stock options and so on But the above are costs reducing the

shareholders' lot. So cost get escalated instead of getting reduced and returns gets

reduced instead of getting escalated. Even assuming the management is a

reasonable one, i.e., not interested in fat salary nor varied perks, as humans their

judgments are subject to human errors. So maximization of benefits and

minimization of costs cannot be taken for granted. So, in reality these approaches

to setting goals of financial management are unrealistic. But Eugene F.Fama would

tell that the above approach is normative in nature, like the official goal. Toward

these maxima and minima the organisation has to move. They are merely

directional and not decisional

Optimization is yet another approach. This is definable, objective and

measurable too. Optimization is getting the best solution, having regard to all

constraints. Inventory management, receivable management, resource

management, liquidity management, etc., involve very many situations where

optimizing techniques are used. The Economic Order Quantity (EOQ) technique is a

versatile optimizing model. Similarly, waiting line theory, linear programming,

assignment models, etc., can be used in financial management in optimizing goal

achievement. Waiting line theory is used finding out whether or not additional

facilities are required to ensure a certain level of service and to reduce costs of

waiting and servicing. Linear programming is used in efficient resource allocations.

Job-machine optimal assignment is facilitated with the use assignment models.

Optimization is but constrained maximization or minimization and that it has the

same limitations of maximization or minimization goals. However, unlike

maximization, constrained maximization is decisional and so is constrained

minimization. So, optimization is a good goal. But it is too ideal to practice.

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Satisfying is another approach. Maximization and minimization are both

Utopia Optimization is prone with constraints. So, satisficing comes. You try to

"satisfy* rather than maximize or minimize or optimize. The satisficing goal is

behaviourally suited and perfectly manageable. You don't search for the 'best', but

get satisfied with the considered 'good*. Often the search cost of the 'best' over

the better or even the good might be more than the additional gains of the 'best'.

So satisficing approach has become a more practical approach.

1.9 SUMMARY

Financial Management is an integral part of business management. As a

discipline it emerged only in the early 20th century. Traditional concept of financial

management confined it to cash management and raising of capital. Modern

financial management, evolved since the middle of 1950s, deals with both raising

and utilisation of capital, portfolio management and so on. Finance functions can

be classified on two dimensions - managerial and operative. Operative functions

include investment, financing and dividend functions. Each of these functions

needs careful managerial planning, execution and control. And that is financial

management.

There is a multiplicity of goals of financial management. Wealth

maximization is a wholesome goal. Maximization of profit, profitability, liquidity and

solvency are other goals. But these are sectional and fragmented. Similarly,

minimization of cost of capital, risk and dilution of control address particular

aspects. Well, all these put together throw much light on the whole gamut of

financial management as such. Now, maximization of economic value added is

added to the list of goals of financial management. Maximisation / minimisation is

but vague as they do not refer to any absolute value. Besides, with ownership

separated from management, maximization of benefitstoainimization of costs is

not possible, behaviourally speaking. Clash of interests of the two parties comes in

the way of realisation of these objectives. Optimization is a viable alternative

approach. But models have to be built, constraints specified and objective function

expressed clearly. Search costs are involved therein. So, satisfying approach - a

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satisfactory goal/a satisfactory level, has become prominent. Of course it does not

mean the best course, but not necessarily less than the optimum.

1.10 SELF ASSESSMENT QUESTIONS

1. Bring out the nature and significance of financial management.

2. Explain the concept, importance and functions of financial management.

3. Discuss the evolution of financial management and bring out the changing

emphasis of finance functions.

4. What are finance functions? Explain them briefly.

5. Distinguish between financing and investment functions.

6. What considerations are involved in dividend decision?

7. Define finance goals. Explain them briefly.

8. Wealth maximization is superior to profit maximization. Discuss.

9. Elucidate risk-return trade-off. Also bring out the nature of relationship

between risk and return.

10. Satisfying approach to goal setting is gaining ground in recent times to

maximizing. Why?

11. Finance goals are multiple and conflicting. How do you resolve the conflict?

12. What is EVA maximization? How is it different from maximization of wealth?

13. What is time value of money? In annual inflation is 8%, what is the present

value of Rs. 11664 receivable after two years?

14. HNOPAT of a firm in a period is Rs.4,50,000. It has equity capital of Rs.

10,00,000 and debt capital of Rs. 5,00,000 with annual interest rate of t2%.

Equity capital needs a return of 18% p.a. Find the EVA for the firm

REFERENCES

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1. Financial Management and Policy - Van Horne

2. Financial Decision Making – Hampton

3. Management of Finance - Weston and Brigham

4. Financial Management - P.Chandra

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UNIT-II

LONG-TERM CAPITAL: TYPES & SOURCES

In this unit you will learn instruments of raising long-term capital (equity

shares, preference shares and debentures), significance of different modes of issue

of capital instruments (public, right and private placement), term lending

institutions and borrowings and public deposits as a means of long-term capital.

INTRODUCTION

Long-term capital is capital with maturity exceeding one year. Long-term

capital is used to fund the acquisition of fixed assets and part of current assets.

Public limited companies meet their long-term financial requirements by issuing

shares and debentures and through borrowing and public deposits. The required

fund is to be mobilized and utilized systematically by the companies.

21 SOURCES OF CAPITAL

Broadly speaking, a company can have two main sources of funds internal

and external. Internal sources refer to sources from within the company External

sources refer to outside sources.

Internal sources consist of depreciation provision, general reserve fund or

free reserve - retained earnings or the saving of the company. External sources

consists of share capital, debenture capital, loans and advances (short term loans

from commercial banks and other creditors, long term loans from finance

corporations and other creditors). Share capital is considered as ownership or

equity capital whereas debentures and loans constitute borrowed or debt capital.

Raising capital through issue of shares, debentures or bonds is known as primary

capital sourcing. Otherwise it is called new issues market.

Long-term sources of finance consist of ownership securities Equity shards

and preference shares) and creditor-ship securities (debentures, borrowing from

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the financing institutions and lease finance). Short-term sources of finance consists

of trade credit, short term loans from banks and financial institutions and public

deposits,

2.2 LONG-TERM CAPITAL INSTRUMENTS

Now, an attempt is made to discuss the long term capital instruments of a

company i.e. shares and debentures.

Corporate securities also known as company securities are said to be the

documentary media of raising capital by the joint stock companies. These are of

two classes: Ownership securities; and Creditor-ship securities.

Ownership Securities

Ownership securities consist of shares issued to the intending investors with

the right to participate in the profit and management of the company. The capital

raised in this way is called 'owned capital*. Equity shares and securities like the

irredeemable preference shares are called ownership securities. Retained earnings

also constitute owned capital.

Creditor-ship Securities

Creditor-ship securities consist of various types of debentures which are

acknowledgements of corporate debts to the respective holders with a right to

receive interest at specified rate and refund of the principal sum at the expiry of

the agreed term. Capital raised through creditor-ship securities is known as

‘borrowed capital’. Debentures, bonds, notes, commercial papers etc. are

instruments of debt or borrowed capital.

2.2.1 Equity Shares

Equity shares are instruments to raise equity capital. The equity share capital

is tie backbone of any company's financial structure. Equity capital represents

ownership capital. Equity shareholders collectively own the company. They enjoy

the reward of ownership and bear the risk of ownership. The equity share capital is

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also termed as the venture capital on account of the risk involved! in it. The equity

shareholders’ liability, unlike the liability of the owner in a proprietary concern and

the partners in a partnership concern, is limited to their capital subscription and

contribution.

In India, under the Companies Act 1956, shares which are not preference

shares are called equity shares. The equity shareholders get dividend after the

payment of dividend to the preference shareholders. Similarly, iif the event of the

winding up of the company, capital is returned to them after the return of capital to

the preference shareholders. The equity shareholders enjoy a statutory right to

vote in the general body meeting and thus exercise their voice in the management

and affairs of the company. They have an unlimited interest in the company's profit

and assets. If the profit of the company is substantial, the equity shareholders may

get good dividend; if not, there may be little or no dividend with reduced or nil

profit The equity shareholders* return of income, i.e. dividend is of fluctuating

character and its magnitude directly depends upon the amount of profit made by a

company in a particular year.

Now a days equity capital is raised through global equity issues. Global

depository receipts (GDRs), American depository receipts (ADRs), etc. are certain

instruments used by Indian companies to overseas capital market tc get equity

capital.

Advantages of Equity Share Capital

i) Equity share capita] constitutes the 'corpus' of the company. It is the

‘heart’ to the business.

ii) It represents permanent capital. Hence, there is no problem of refunding

the capita]. It is repayable only in the event of company's winding up and

that too only after the claims of preference shareholders have been met

in full.

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iii) Equity share capital does not involve any fixed obligation for payment of

dividend. Payment of dividend to equity shareholders depends on the

availability of profit and the discretion of the Board of Directors.

iv) Equity shares do not create any charge on the assets of the company and

the assets may be used as security for further financing.

v) Equity capital is the risk-bearing capital, unlike debt capital which is risk-

burdening.

vi) Equity share capital strengthens the credit worthiness and oorrowmg or

debt capacity of the company. In general, other things being equal, the

larger the equity base, the higher the ability of the company to secure

debt capital.

vii) Equity capital market is now expanding and the global capital market can

be accessed.

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Disadvantages of Equity Shares Capial

i) Cost of issue of equity shares is high as the limited group of risK-seeking

investors need to be attracted and targeted. Equity shaiv attract only

those classes of investors who can take risk. Conservative and cautious

investors do not to subscribe for equity issues, Su underwriting

commission, brokerage costs and other issue expense are high for equity

capital, raising up issue cost.

ii) The cost of servicing equity capital is generally higher than the cos'

issuing preference shares or debenture since on account of higher n the

expectation of the equity shareholders is also high as compared

preference shares or debentures.

iii) Equity dividend is payable from post-tax earnings. Unlike intent paid on

debt capital, dividend is not deductible as an expense from, profit for

taxation purposes. Hence cost of equity is hi«be: Sometimes, dividend tax

is paid, further rising cost of equity share capital.

iv) The issuing of equity capital causes dilution of control of the equji holders.

v) In times of depression dividends on equity shares reach low be which

leads to drastic full in their market values.

vi) Excessive reliance on financing through equity shares reduces the

capacity of the company to trade on equity. The excessive use of equity

shares is liJcely to result in over capitalization of the company.

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2.2.2 Preference Shares

Preference shares are those which carry priority rights in regard to the

payment of dividend and return of capital and at the same time are subject to

certain limitations with regard to voting rights. *

The preference shareholders are entitled to receive the fixed rate of dividend out

of the net profit of the company. Only after the payment of dividend at a fixed rate

is made to the preference shareholders, the balance of profit will be used for

paying dividend to ordinary shares. The rate of dividend on preference shares is

mentioned in the prospectus. Similarly in the event of liquidation the assets

remaining after payment of all debts of the company are first used for returning

the capital contributed by the preference shareholders.

Types of Preference Shares

There are many forms of preference shares. These are:

i) Cumulative preference shares

ii) Non-Cumulative preference shares

iii) Participating preference shares

iv) Non-participating preference shares

v) Convertible preference shares

vi) Non-convertible preference shares

vii) Redeemable preference shares

viii) Non-redeemable preference shares

ix) Cumulative convertible preference shares

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Cumulative and non-cumulative

In the case of cumulative preference shares, the unpaid dividend goes on

accumulating until paid. The unpaid dividends on cumulative preference shares

become payable out of the profit of the company in the subsequent years. Only

after such arrears have been paid off, any dividend can be paid to other classes of

shares. In case of non-cumulative preference shares, the right to claim dividend

lapses if there is no profit in a particular year. Thus, the non-cumulative preference

shareholders are not entitled to claim arrears of dividend. As a result, the dividend

coupon on non-cumulative preference shares is more than that of cumulative

preference shares.

Participating and non-participating

The preference shares which are entitled to participate in the surplus of

profits of the company available for distribution over and above the fixed dividend

are called as participating preference shares. Non-participating preference shares

do not have such rights.

Convertible and convertible

Convertible preference shares are convertible into equity shares as per

norms of issue and conversion. Non-convertible preference shares are not

converted. Convertibility is resorted to enhance attractiveness of the instrument to

prospective investors, who prefer equity to preference shares.

Redeemable and Irredeemable

Redeemable preference shares are those which can be redeemed during the life

time of the company, while irredeemable preference shares can be redeemed only

when the company goes for liquidation.

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Cumulative Convertible

Cumulative convertible preference shares have both the features of

cumulativeness of unpaid dividend and convertibility. These features make the

preference shares more preferred.

Merits of Preference shares

i) The preference shares have the merits of equity shares without their

limitations.

ii) Issue of preference shares does not create any charge against the assets

of the company.

iii) The promoters of the company can retain control over the company by

issuing preference shares, since the preference shareholders have ^>nly

limited voting rights.

iv) In the case of redeemable preference shares, there is the advantage that

the amount can be repaid as soon as the company is in possession of

funds flowing out of profits.

v) Preference shares are entitled to a fixed rate of dividend and the company

many declare higher rates of dividend for the equity shareholders by

trading on equity and enhance market value.

vi) If the assets of the company are not of high value, debenture holders will

not accept them as collateral securities. Hence the company prefers to

tap market with preference shares.

vii) The public deposit of companies in excess of the maximum limit

stipulated by the Reserve Bank can be liquidated by issuing preference

shares.

viii) Preference shares are particularly useful for those investors who want

higher rate of return with comparatively Jower risk.

ix) Preference shares add to the equity base of the company and they

strengthen the financial position of it Additional equity base increases the

ability of the company to borrow in future.

x) Preference shares have variety and diversity, unlike equity shares,

Companies have thus flexibility in choice.

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Demerits of Preference Shares

i) Usually preference shares carry higher rate of dividend than the rate of

interest on debentures.

ii) Compared to debt capital, preference share capital is a very expensive

source of financing because the dividend paid to preference shareholders

is not, unlike debt interest, a tax-deductible expense.

iii) In the case of cumulative preference shares, arrears of dividend

accumulate. It is a permanent burden on the profits of the company.

iv) From the investors point of view, preference shares may be

disadvantageous because they do not carry voting rights. Their interest

may be damaged by a equity shareholders in whose hands the control is

vested.

v) Preference shares have to attraction. Not even 1% of total corporate

capital is raised in this form.

vi) Instead of combining the benefits of equity and debt, preference shar

capital, perhaps combines the banes of equity and debt.

2.2.3 Debentures

A debenture is a document issued by a company as an evidence of a debt

due from the company with or without a charge on the assets of the company. It is

an acknowledgement of the company's indebtedness to its debenture-holders.

Debentures are instruments for raising long term debt capital. Debenture holders

are the creditors of the company.

In India, according to the Companies Act, 1956, the term debenture includes

"debenture stock, bonds and any other securities of a company whether

constituting a charge on the assets of the company or not"

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Debenture-holders are entitled to periodical payment of interest aij agreed

rate. They are also entitled to redemption of their capital as per the agreed terms.

No voting rights are given to debenture-holders. Under section 117 of the

Companies Act, 1956, debentures with voting rights cannot be issued. Usually

debentures are secured by charge on or mortgage of the assets of the company.

Types of debentures

Debentures can be various types. They are:

i) Registered debentures

ii) Bearer debentures or unregistered debentures

iii) Secured debentures

iv) Unsecured debentures

v) Redeemable debentures

vi) Irredeemable debentures

vii) Fully convertible debentures

viii) Non-convertible debentures

ix) Partly convertible debentures

x) Equitable debentures

xi) Legal debentures xii) Preferred debentures

xii) Fixed rate debentures

xiii) Floating rate debentures

xiv) Zero coupon debentures

xv) Foreign currency convertible debentures

Registered debentures : Registered debentures are recorded in a^register of

debenture-holders with full details about the number, value and types of

debentures held by the debenture-holders. The payment of interest and repayment

of capital is made to the debenture-holders whose names are entered duly in the

register of debenture-holders. Registered debentures are not negotiable. Transfer

of ownership of these type of debentures cannot be valid unless the regular

instrument of transfer is sanctioned by the Directors. Registered debentures are

not transferable by mere delivery

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Bearer or Unregistered debentures: The debentures which are payable to the

bearer are called bearer debentures. The names of the debenture-holders are not

recorded in the register of debenture-holders. Bearer debentures are negotiable.

They are transferable by mere delivery and registration of transfer is not

necessary.

Secured debentures: The debentures which are*secured by a mortgage or change

on the whole or a part of the assets of the company are called secure,: debentures.

Unsecured debentures: Unsecured debentures are those which do not cam ...

charge on the assets of the company. These are, also, known as ‘naked’

debentures.

Redeemable debentures: The debentures which are repayable after a certain

period are called redeemable debentures. Redeemable debentures may be bullet-

repayment debentures (i.e. one time be payment) or periodic repayment

debentures.

Irredeemable debentures: The debentures which are not repayable during the

life time of the company are called irredeemable debentures. They are also known

as perpetual debentures. Irredeemable debentures can be redeemed only in the

event of the company's winding up.

Fully convertible debentures: Convertible debentures can be converted intoj

equity shares of the company as per the terms of their issue. Convertible

debenture-holders get an opportunity to become shareholders and to take part inj

the company management at a later stage. Convertibility adds a ‘sweetner’ to thej

debentures and enhance their appeal to risk seeking investors.

Non-Convertible debentures: Non-convcnible debentures are not convertible

Thev remain as debt capital instruments.

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Partly convertible debentures: Partly convertible debentures appeal to

investors who want the benefits of convertibility and non-convertibility in one

instrument.

Equitable debentures: Equitable debentures are those which are secured by

deposit of title deeds of the property with a memorandum in writing to create a

charge.

Debentures: Legal debentures are those in which the legal ownership of property

of the corporation is transferred by a deed to the debemure holders, security for

the loans.

"Referred debentures: Preferred debentures are those which are paid first in the

event of winding up of the company. The debentures have priority over other

Ventures.

“Fixed rate debentures : Fixed rate debentures cany a fixed rate of interest \

Now-a-days this class is not desired by both investors and issuing institutions.

“Floating rate debentures : Floating rate debentures cany floating interest rate

coupons. The rates float over some bench mark rates like bank rate, LIBOR etc.

Zero-coupon debentures: Zero-coupon debentures do not carry periodic interest

coupons. Interest on these is paid on maturity. Hence, these are also called as

deep-discount debentures.

Foreign Currency convertible debentures: Foreign currency convertible

debentures are issued in overseas market in the currency of the country where the

floatation takes place. Later these are converted into equity, either GDR, .VDR or

plain equity.

Merits of debentures

i) Debentures provide runds to the company for a long period without

diluting its control, since debenture holders are not entitled to vote.

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ii) Interest paid to debenture-holders is a charge on income of the company

and is deductible from computable income for income tax purpose

whereas dividends paid on shares are regarded as income and are liable

to corporate income tax. The post-tax cost of debt is thus lowered.

iii) Debentures provide funds to the company for a specific period. Hence, the

company can appropriately adjust its financial plan to suit its

requirements.

iv) Since debentures are generally issued on redeemable basis, the company

can avoid over-capitalisation bv refunding the debt when the financial

needs are no longer felt.

v) In a period of rising prices, debenture issue is advantageous. The burden

of servicing debentures, which entail a fixed monetary commitment for

interest and principal repayment, decreases in real terms as the price

level increases.

vi) Debentures enable the company to take advantage of trading on equity

and thus pay to the equity shareholders dividend at a rate higher than

overall return on investment.

vii) Debentures are suitable to the investors who are cautious and

conservative and who particularly prefer a stable rate of return with

minimum or no risk. Even institutional investors prefer debentures for this

reason

Demerits of Debentures

i) Debenture interest and capital repayment are obligatory payments.

Failure to meet these payment jeopardizes the solvency of the firm.

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ii) In the case of debentures, interest has to be paid to the debenture holders

irrespective of the fact whether the company earns profit or not. It

becomes a great burden on the finances of the company.

iii) Debenture financing enhances the financial risk associated with the firm.

This may increase the cost of equity capital.

iv) When assets of the company get tagged to the debenture holders the

result is that the credit rating of the company in the market comes down

and financial institutions and banks refuse loans to that company.

v) Debentures are particularly not suitable for companies whose earnings

fluctuate considerably. In case of such company raising funds throifgh

debentures may lead to considerable fluctuations in the rate of dividend

payable to the equity shareholders.

2.2.4 Financing through equity snares and debentures - Comparison

A company may prefer equity finance (i) if long gestation period is involved,

(ii) if equity is preferred by the market forces, (iii) if financial risk perception is

high, (iv) if debt capacity is low and (v) dilution of control isn't a problem or does

not rise.

A company may prefer debenture financing as compared to equity shares

financing for the following reasons:

i) Generally the debenture-holders cannot interfere in the management of

the company, since they do hot have voting rights.

ii) Interest on debentures is allowed as a business expense and it is tax

deductible.

iii) Debenture financing is cheaper since the rate of interest payable on it is

lower than die dividend rate of preference shares.

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iv) Debentures can be redeemed in case the company does not need the

funds raised through this source. This is done by placing call option in the

debentures.

v) Generally a company cannot buy its own snares but it can buy its own %

debentures.

vi) Debentures offer variety and in dull market conditions only debenture;

help gaining access to capital market.

2.2.5 Convertible Issues

A convertible issue is a bond or a share of preferred stock that can be

converted at the option of the holder into common stock ot ihe same company.

Once converted into common stock, the stock cannot be exchanged again for

bonds or preferred stock. Issue of convertible preference shares and convertible

debentures are called convertible issues. The convertible preference shares and

convertible debentures are converted into equity shares. The ratio of exchange

between the convertible issues and the equity shares can be stated in terms of

either a conversion price or a conversion ratio.

Significance of convertible issues : The convertible security provides the

investor with a fixed return from a bond (debenture) or with a specified dividend

from preferred stock (preference shares). In addition, the investor gets an option to

convert the security (convertible debentures or preference shares) into equiu

shares and thereby participates in the possibility of capital gains associated with,

being a residual claimant of the company. At the time of issue, the .convertible

security will be priced higher than its conversion value. The difference between the

issue price and the conversion value is known as conversion premium. The

convertible facility provides a measure of flexibility to the capital structure of, the

company to the company which wants a debt capital to short with, butj market

wants equity. So, convertible issues add sweetners to sell debt securities! to the

market which want equity issues.

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Convertible preference shares: The preference shares which carry the right of

conversion into equity shares within a specified period, are called convertible

preference shares. The issue of convertible preference shares must be dulj

authorized by the articles of association of the company.

Convertible debentures: Convertible debentures provide an option to holders to

convert them into equity shares during a specified period at particular price. The

convertible debentures are not likely to have a goc investment appeal, as the rate

of interest for convertible debentures is lesser than the non-convertible

debentures. Convertible debentures help a company to sell future issue of equity

shares at a price higher than the price at which the company's equity shares may

be selling when the convertible, debentures are issuea By convertible debentures,

a company gets relatively cheaper financial resource for business growth.

Debenture interest constitutes tax deductible expenses. So, till the debentures are

converted, the company gets a tax advantage. From the investors* point of view

convertible debentures prove an ideal combination of high yield, low risk and

potential capital appreciation.

2.3 DIFFERENT MOOES OF CAPITAL ISSUES

Capital instruments, namely, shares and debentures can be issued to the

market by adopting any pf the four modes: Public issues, Private placement, Rights

issues and Bonus issues. Let us briefly explain these different modes of issues.

2.3.1 Public Issues

Only public limited companies can adopt this issue when it wants to raise

capital from the general public. The company has to issue a prospectus as per

requirements of the corporate laws in force inviting the public to subscribe to the

securities issued, may be equity shares, preference shares ;or debentures/bonds. A

private company cannot adopt this route to raise capital. The prospectus shall give

an account of the prospects of investment in the company. Convinced public apply

to the company for specified number of shares/debentures paying the application

money, i.e., money payable at the time of application for the shares/debentures

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usually 20 to 30% of the issue price of Jie shares/debentures. A company must

receive subscription for at least 95% of the shares/bonds offered within the

specified days. Otherwise, the issue has to be scrapped. If the public applies for

more than the number of shares/debentures the situation is called over

subscription. In under subscription public ;ribes for less number of

shares/debentures offered by the company. For companies coupled with better

market conditions, over -subscription Its. Prior to issue of shares/debentures and

until the subscription list is open company go on promoting the issue. In the

western countries such kind of iog the issue is called 'road-show'. When there is

over-subscription a

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part of the excess subscription, usual!) upto 15% of the otter, can be retained and

allotment proceeded with. This is called as green-shoe option.

When there is over-subscription, pro-rata allotment (proportionate basis

allotment, i.e., say when there is 200% subscription, for every 200 share applied

100 shares allotted) may be adopted. Alternatively, pro-rata allotment For some

applicant, full scale allotment for some applicants and nil allotment for rest of

applicants can also be followed. Usually the company co-opts authorities from

stock-exchange where listing is done, from securities regulatory bodies (SEBI in

Indian, SEC in USA and so on) etc. in finalizing mode of allotment.

Public issues enable broad-based share-holding. General public's savings

directed into corporate investment. Economy, company and individual

nvestors benefit. The company management does not face the challenge of

dilution of control over the affairs of the company. And good price for the share

and competitive interest rate on debentures are quite possible.

2.3.2 Private Placement

Private placement involves the company issuing security places the same at

the disposal of financial institutions like mutual funds, investment funds >r banks

the entire issue for subscription at the mutually agreed upon pro-rata of interest.

This mode is preferred when the capital market is dull, shy and] depressed

During the late 1990s and early 2010s, Indian companies preferred] private

placement, even the debt issues, as the general public totally deserted the} capital

market since their hopes in the capital market were totally shattered,] Private

placement is inexpensive as no promotion is issued. It is a wholesale} deal.

2.3.3 Right Shares

Whenever an existing company wants to issue new equity shares, the

existing shareholders will be potential buyers of these shares. Generally the

Articles or Memorandum of Association of the Company gives the right to existing

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shareholders to participate in the new equity issues of the company. This right is

known as 'pre-emptive right" and such offered shares are called 4Right shares' or

'Right issue.

A right issue involves selling securities in the primary maricet by issuing

rights to the existing shareholders. When a company issues additional share

capital, it has to be offered in the first instance to the existing shareholders on a

pro rata basis. This is required in India under section 81 of the Companies' Act,

1956. However, the shareholders may by a special resolution forfeit tfcis right,

partially or fully, to enable the company to issue additional capital to public.

Under section 81 of the Companies Act 1956, where at any time after the

expiry of two years from the formation of a company or at any time after the expiry

of one year from the allotment of shares being made for the first ume after its

formation, whichever is earlier, it is proposed to increase the subscribed capital of

the company by allotment of further shares, then such further shares shall be

offered to the persons who, at the date of the offer, are holders of the equity

shares of the company, in proportion as nearly as circumstances admit, to the

capital paid on those shares at that date. Thus the existing shareholders have a

pre-emptive right to subscribe to the new issues made by a company. This right

has at its root in the doctrine that each shareholder is entitled to participate in any

further issue of capital by the ompany equally, so that his interest in the company

is not diluted,

Significance of rights issue

i) The number of rights that a shareholder gets is equal to the number of

shares held by him.

ii) The number rights required to subscribe to an additional share is

determined by the issuing company.

iii) Rights are negotiable. The holder of rights can' sell them fully or partially.

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iv) Rights can be exercised only during a fixed period which is usually less

than thirty days.

v) The price of rights issues is generally quite lower than market price and

that a capital gain is quite certain for the share holders.

vi) Rights issue gives the existing shareholders an opportunity for the

protection of their pro-rata share in the earning and surplus of the

company.

vii) There is more certainty of the shares being sold to the existing

shareholders. If a rights issue is successful it is equal to favourable image

and evaluation of the company's goodwill in the minds of the existing

shareholders.

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2.3.4 Bonus Issues

Bonus issues are capital issues by companies to existing shareholders

whereby no fresh capital is raised but capitalization of accumulated earnings is

done. The shares capital increases, but accumulated earnings fall A company shall,

while issuing bonus shares, ensure the following:

i) The bonus issue is made out of free reserves built out of the genuine

profits and shares premium collected in cash only.

ii) Reserves created by revaluation of fixed assets are not capitalized.

iii) The development rebate reserves or the investment allowance reserve is

considered as free reserve for the purpose of calculation of residual

reserves only.

iv) All contingent liabilities disclosed in the audited accounts which have,

bearing on the net profits, shall be taken into account in the calculation; of

the residua! reserve.

v) The residual reserves after the proposed capitalisation shall be at k 40 per

cent of the increased paid up capital.

vi) 30 per cent of the average profits before tax of the company for previous

three years should yield a rate of dividend on the exj capital base of the

company at 10 per cent.

vii) The capital reserves appearing in the balance sheet of the company as a

result of revaluation of assets or without accrual of cash resources are

capitalized nor taken into account in the computation of the residual

reserves of 40 percent for the purpose of bonus issues.

viii) The declaration of bonus issue, in lieu of dividend is not made.

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ix) The bonus issue is not made unless the partly paid shares, if any existing,

are made fully paid-up.

x) The company - a) has not defaulted in payment of interest or principal in

respect of fixed deposits and interest on existing debentures or principal

on redemption thereof and (b) has sufficient reason to believe that it has

not defaulted in respect of the payment of statutory dues of the

employees such as contribution to provident fund, gratuity on bonus.

xi) A company which announces its bonus issue after the approval of the

board of directors must implement the proposals within a period of six

months from the date of such approval and shall not have the option of

changing the decision.

xii) There should be a provision in the Articles of Association of the Company

for capitalisation of reserves, etc. and if not, the company shall pass a

resolution at its general body meeting making decisions in the Articles of

Association for capitalisation.

xiii) Consequent to the issue of bonus shares if the subscribed and paid-up

capital exceed the authorized share capital, a resolution shall be passed

by the company at its general body meeting for increasing the authorized

capital.

xiv) The company shall get a resolution passed at its generating for bonus

issue and in the said resolution the management's intention regarding the

rate of dividend to be declared in the year immediately after the bonus

issue should be indicated.

xv) No bonus shall be made which will dilute the value or rights of the holders

of debentures, convertible folly or partly.

SEBI General Guidelines for public issues

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i) Subscription list for public issues should be kept open for at least 3

working days and disclosed in the prospectus.

ii) Rights issues shall not be kept open for more than 60 days.

iii) The quantum of issue, whether through a right or public issue, shall not

exceed the amount specified in the prospectus/letter of offer. No

retention of over subscription is permissible under any circumstances,

except the special case of exercise of green-shoe option.

iv) Within 45 days of the closures of an issue a report in a prescribed form

with certificate from the chartered accounts should be forwarded to SEBI

to the lead managers.

v) The gap between the closure dates of various issue e.g. Rights and

Indian public should not exceed 30 days.

vi) SEBI will have right to prescribe further guidelines for modifying the

existing norms to bring about adequate investor protection, enhance the

quality of disclosures and to bring about transparency in the primary

market.

vii) SEBI shall have right to issue necessary clarification to these guidelines

to remove any difficulty in its implementation.

viii) Any violation of the guidelines by the issuers/intermediaries will be]

punishable by prosecution by SEBI under the SEBI Act.

ix) The provisions in the Companies Act, 1956 and other applicable lai shall

be complied with the connection with the issue of shares debentures.

2.4 INSTITUTIONAL FINANCE: FRAMEWORK, FUND TYPES AND

PROCEDURE

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An important pre-requisite for industrial development is the availability

of adequate institutional finance. Government has set up several financial

institutions which provide term loans and also render assistance in several other

forms. Term loans, also referred to as term finance represent a source of debt

finance which is generally repayable over a period of years. Term loans are granted

for purposes such as new projects and for expansion, diversification, modernization

and renovation of existing projects. The security cover for term loans comprises

the existing assets as well as those to be acquired from such loans. Where the total

term-loan required by an industrial unit is too large for a single institution, some

form of participation arrangement is also made on the part of different financial

institutions, known as co-financing or consortium finance or syndicated loans.

Till the middle of 1990s the role of term-loans considerably increased

and in many cases greater reliance has been placed on term-loans vis-a-vis the

owned funds, because of the growth of term lending institutions and growing

participation by commercial banks in term lending as well. Today, the era is

universal banking, where the line of demarcation between short and long term

loans is removed and any institution is prepared to provide fund for any period,

short or long.

Factors responsible for the growth of Term Leading Institutions

A string of institutions had been established in India as an integral; of

the capital market development for the following reasons :

i) Need for higher capital formation: Developing countries suffer by

dearth of term finance due to low rate of capital formation. The gap

between savings and investment is intended to be bridged by the financial

institutions. Institutional investors ensure higher rate of capital formation,

by mopping savings from within and outside the country and extending

capital assistance to industries and trade.

ii) Shyness of Capital: Capital is reluctant to go to new and untried

industries in economically backward areas. In this situation, establishment

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of financial institutions becomes essential to achieve balanced industrial

development of all regions of the nation. Moreover, the financial

institutions undertake pioneering risk by providing necessary long term

capital including seed capital, venture capital and so on.

iii) Venture Capital: Industrial economy continues to change. In a span

10 years, some industries totally become irrelevant and new ones take

the place. It is therefore essential to incubate their businesses on an

ongoing basis. For this venture capital is needed. Financial institutions

provide this form of capital through their own venture capital arms/units.

iv) Need for Promotional Activities: Financial institutions provide

technical and managerial know-how in the formulation and evaluation of j

new industrial projects or investment proposals. Spotting fundable

projects,] shaping up them and supporting the same are thus taken by

financial institutions.

v) Finance for Small Scale Industries: The financial need of si scale

industries, differ from those of large inr stries. Special financi package and

delivery system are needed in this context. Finam institutions like the

SIDBI, fillip the role.

vi) Planned Economic Development: Planned economic develop!

requires large investment in basic and key industries for provi<

instrumental for quick industralisation. The financial institutions

essential to participate actively in the execution of our development to

bring out planned economic development.

vii) Reconstruction Programme: Industrial reconstruction, rehabilit and

modernization are vital in any economy. Funding such programme an

essential task of financial institutions.

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2.4.1 Institutional Framework of Term Lending Institutions

Specialised term finance institutions have been established a country

after independence to meet the specific financial needs of in enterprises. These

institutions help mobilize scarce resources, such as capital technology,

entrepreneurial and managerial talents and channelise them into industrial

activities in accordance with the national priorities. The following list gives an

account of structure of term finance institutions in India.

The following is the list of all - India and State level financial institutions.

a) All-India Institutions

i) Industrial Development Bank of India (1964)

ii) Industrial Finance Corporation of India (1948)

iii) Industrial Credit and Investment Corporation of India Ltd. (1955)

iv) Life Insurance Corporation of India (1956)

v) Unit Trust of India (1964)

vi) General Insurance Corporation of India (1973)

vii) Industrial Reconstruction Bank of India (1985) (Now Industrial Investment

Bank of India.

viii) Small Industries Development Bank of India (1990)

ix) National Bank of Agriculture and Rural Development (1982)

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x) Infrastructure Development Company Ltd. (1997).

xi) Ex-im Bank (1982)

b) State level financial institutions

i) State Financial Corporations

ii) State Industrial Development Corporations

iii) Technical Consultancy Organisations.

A short description of each of these financial institutions follows now:

2.4.1.1 Industrial Development Bank of India

Industrial Development Bank of India (IDBI) established in 1964 was

originally a subsidiary of RBI Parliament 12 years since its inception, IDBI's

ownership was passed on to Government of India in 1976. In 1995, Govt's holding

in IDBI was diluted from 100% to 72%, and public ownership was pushed through.

Further in 2001, Govt share holding in IDBI was scaled down to 58.47%.

Industrial Development Bank of India (IDBI) established on July 1, 1964 is the

principal financial institution for industrial finance in the country Besides providing

direct assistance to medium and large projects and resource support to other

Development Financial Institutions (DFIs), IDBI coordinates the working of other

term lending institutions engaged in financing, promoting or developing industries

and assist in the development of these institutions. IDBI promotes and provides

developmental finances to industries to fill the gaps in the industrial structure in

the country. IDBI also provides technical and administrative assistance, undertakes

market and investment research and; surveys as also techno-economic studies

related to envelopment of industry During the about 4 decades of its service to

industry, IDBI evolved a number i innovative schemes of assistance and undertook

various promotional activities meet the growing needs of industry, IDBI is the first

financial institution in country to get ISO 9000 certification for treasury operations

in 1994 and foi services in 2000.

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Aggregate sanctions by IDBI during the Seventh Five Year Period (1985-86 to

1989-90) amounted to Rs.27,844.1 crore registering a grw of over one and a half

times over Rs. 10,286.6 crore sanctioned during the Sii Plan Period (1980-81 to

1984-85).

As on 31.3.2001, IDBFs total equity was Rs.92 bn, borrow amount to Rs.538

bn and other resources Rs.88 bn. Out of the total resources I Rs.720 bn,

outstanding loans amounted to Rs.493 bn or 70% of funds are in accounts.

Schemes of Direct Assistance

IDBI’s direct assistance to industry is extended mainly under its Project

Finance Scheme and to a limited extent, under the Technical Development

Fund Scheme. Assistance under the Textile Modernisation Fund, Venture Capital

Fund, Technology Upgradation and Equipment Finance for Energy Conservation

Schemes is also covered under the Project Finance Scheme.

i) Project Finance Scheme: Project loans are given in the form of rupee

loans, foreign currency loans, under writing/direct subscription to public

issues of shares/bonds and guarantees for deferred parents. Tbtal

sanctions upto Mar 2001 were Rs.1103 bn, disbursements Rs.640 bn and

outstanding amount Rs. 562 bn.

ii) Non-Project Finance: Non-project finance takes the form of asset credit,

equipment finance, working capital loan, short term credits, equipment

leasing, investment etc., Total sanctions upto March 2001 were Rs.656 bn,

disbursement Rs.517 bn and outstanding amount Rs. 13 bn.

Schemes of Indirect Assistant:

Schemes of indirect finance, include bill rediscounting, bill direct mnting,

refinance, loans to other finance institutions, investments in other trial institutions,

retail finance, seed capital assistance, secondary market rtions, etc.

i) Refinance: The scope of re-finance scheme for modernization covers

loans granted by eligible institutions to small and medium units for

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acquiring instruments for energy audit/monitoring energy consumption. In

view of the high priority accorded to tourism, term loans sanctioned for

financing tourism and tourism related facilities have been made eligible

for irefinance assistance from IDBI In view of the high priority accorded to

JMonal Sericulture Project (NSP) by Government, assistance extended by

SPCs and banks to finance the industry component of NSP has been made

A'gible for refinance assistance on concessional terms. Sanctions upto

2001 March stood at Rs.205 bn, disbursements Rs.161 bn and outstanding

amount Rs. 11 bn.

ii) Bills Finance Schemes: Bills discounting and re-discounting constituted

bill finance. Total sanctions upto March 2001 were Rs.203 bn,

disbursement Rs 148 bn and outstanding amount Fs.25 bn.

IDBI carved out its activities concerning small scale businesses and put them

under the fold of its subsidiary SJDBI in 1990. In 2000, IDBI's shareholding in

SIDBI has been broad based with participation by LIC, GIC, etc.

IDBI was instrumental in establishing technical consultancy organisatinos in

the states of AP, Bihar, J&K, Kerala, North-Eastem States, Orissa, UP and

West Bengal.

iii) Resources Support to other institutions: IDBI supports ICICI, IFCI,

IDBI Bank, IDBI Capital Market Services Ltd., IDBI Infotech, IDBI AMC, IIBI

(Formerly IRBI), IDFC, National Securities Depository, NSTCs, NSE,

NABARD, NEDFC, SIDBI, SFCs. SIDCs, SSIDCs, SHO, TCOs, TFCI, UTI, CARE,

DFffl, Banks, etc. Loans and investment in financial institutions

aggregated upto March 2001 to Rs. 58 bn in sanction, Rs. 53 bn in

disbursements and Rs.28 bn as outstanding amount as on 31.3.01.

2.4.1.2 Industrial Finance Corporation of India

Industrial Finance Corporation of India (IFCI) was set up under the Industrial

Finance Corporation Act in 1948 with the objective of providing medium and long

term financial assistance to the industrial sector. IFCI's functions cover project

financing, financial services and promotional activities. Over the years, apart from

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increase in the volume IFCI's assistance, the scope of its activities has widened. To

give more operational freedom to IFCI, it was converted into a company with effect

from May 1993.

The financing operations of IFCI primarily consist of project finance, financial

services, corporate advisory services etc. Rupee loans, foreign currency loans,

underwriting, direct subscription, guarantees, equipment leasing, suppliers' credit,

buyers' credit, loans to leasing and hire purchase companies, corporate loans,

short-term loans, working capital loans, etc. The promotional activities of IFCI

covers fiinds support for technical consultancy, risk capital, venture capital,

technology development, tourism, housing, development of

securities market, entrepreneurship parks and subsidy support to help

entrepreneurs and enterprises in the village and small industries sector.

Total cumulative assistances (sanctions) under various schemes stood at

Rs.436 bn and disbursement at Rs.413 bn as on 31.3.2001. Outstanding loans as

on 31.3.01 stood at Rs.223 bn.

IFCI has been instrumental in establishing technology consultancy

organizations in Harvana, HP, MP, Punjab and Rajasthan.

IFCI earlier in 1988 floated Risk Capital and Technology Finance Corporation

as its venture capital arm. Later it was converted into IFCI Venture Capital Fund

Ltd. Tourism Finance Corporation of India was floated by IFCI to fund tourism

attitudes.

During 1989-90, IFCI introduced two new schemes viz. Equipment

Credit and Buyers Credit as part of its financial services, in addition to the existing

schemes of equipment financing, equipment leasing, equipment procurement and

suppliers’ credit. Under the Equipment Credit Scheme introduced in July 1989, IFCI

finances the entire cost of the equipment ^jmrchased/fabricated by an existing

actual user-purchaser concern. The cost of ^equipment and the interest payable

are recoverable in 54 equal monthly installments. Under the buyers’ credit scheme

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introduced in July 1989, IFCI a non-revolving line of credit to actual user-purchasers

of machinery/ lipment to enable them to acquire such equipment on deferred

payment basis, scheme also covers equipment directly fabricated by actual users

as also equipment

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IFCFs current business strategy is to concentrate on core snce, focused

lending to established clients, building up strong market-business culture targeting

large/high growth industries, providing shensive lending, innovative pricing of

products/services offered, etc.

Industrial Credit and Investment Corporation of India Ltd.

Industrial Credit and Investment Corporation of India Ltd. (ICICI) was established in

1955 as a public limited company, primarily for financing the exchange component

of industrial projects and for encouraging and assisting industrial development and

investment in the country. The International Bank for Reconstruction and

Development (World Bank) played a key role in its formation. ICICI provides

assistance by way of rupee and foreign currency loans, underwriting and direct

subscriptions to shares/debentures and guarantees. ICICI also provides financial

services to industry by way of deferred credit, equipment leasing, installment sale

and the recently introduced asset credit facility, besides rendering merchant

banking services. Upto March 2001, cumulative sanctions by ICICI amounted to

Rs.2476 bn and disbursements Rs. 1462 bn and outstanding loans as on 31.3.01

stood at Rs.638 bn.

ICICI has number of subsidiaries like ICICI bank, ICICI Capital market, ICICI

Venture Funds Management Co. Ltd., etc. ICICI was instrumental establishing

technical consultancy organizations in the States of Gujarat, Tamil Nadu and

Maharashtra. ICICI has evolved served new products and e vpanded the basket of

financial products to meet charging needs of customer. Its strategy is more

customer focus orientation than product focus orientation.

ICICI provides a complete spectrum of wholesale banking products and

services including project finance, corporate finance, hybrid] financial structures,

treasury services, cashflow based financial products, It finance, equity finance, risk

finance, advisory services, banking services through ICICI bank etc. Medium term

loans to manufacturer sector, structured finance infrastructure, oil, gas and

petrochem sector, loan syndication, IPO manage! etc. its main offerings in 2000-01.

ICICI finances corporate mergers acquisitions to a grand scale are loans to captive

or sole suppliers of large companies was introduced in 2000-01. ICICI does

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securm'sation of certain cl of assets like student fees receivables, road toll

receivables, employee loan, etc;

During 2000-01, ICICI made significant investments in setting a strong retail

business architecture, direct marketing agents, auto fini home financing,

commercial banking, investment banking, non-banking fim investor servicing,

venture capital financing, on-line stock trading, im etc. ICICI was recently reverse

merged with ICICI bank.

2.4.1.4 Life Insurance Corporation of India

Life Insurance Corporation of India (LIC), was set up in 193 the

nationalisation! of life insurance business in the country. It was vested', the

responsibility of exclusively managing the life insurance business until recently

and, in consonance with national priorities and objectives, prudently deploying the

funds of the policy-holders to their best advantage. LIC has made rapid strides in

development of individual as well as group insurance business over the years

thereby extending a measure of social security. Through its landless labour

insurance scheme, it covered even remote rural areas.

Besides investing in Government and other approved securities in the form of

shares, bonds and debentures, LIC extends assistance for development of socially-

oriented sectors and infrastructure facilities like housing, rural electrification, water

supply and sewerage and provides finance to industrial concerns by way of term

loans and underwritingtfirect subscription to shares and debentures. LIC also

extends resource support to term lending institutions by subscribing to their shares

and bonds. Recently, LIC has set up three subsidiaries viz. LJC Mutual Fund, LIC

International and the LIC Housing Finance Limited.

LIC subscription to shares of JDBI was Rs.41 bn, IFCI Rs, 9 bn, ICICI Rs.41 bn,

IIBI Rs 1 .3 bn and other institutions including SIDBI was Rs. 14 bn as on 31.3 2001

LIC’s investment in public sector stood at Rs.1414 bn in joint sector at Rs 22 bn, in

co-op sector at Rs.8 bn and in private sector Rs.228 teas on 31 3 2

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Aggregate investible funds of LIC, consisting of Life insurance {business and

capital redemption insurance business, stood at Rs.1755 bn as on 31.03.2001. Life

insurance business represented 98% of the total investible funds K as at the end of

March 2001, balance 2% accounted by capital and Jeevan Suraksha Schemes.

Investment Pattern

LIC’s total outstanding investments (in Government and other approved

securities, for providing infrastructure facilities, assistance to industry, etc.,) as at

the end of March 2001 stood at Rs. 1755 bn, 20% higher than at the end of March

2000. Investments in Government and other approved ties (Rs.1030 bn) as at the

end of March 2001 were higher by 20% and 58.9% of total investments of LIC

compared to position in 2000. The share of direct assistance to industry was 22%

as at the end of March 2001 as against 20% and 17% as at the end of the

preceding two years.

The cumulative loan sanctions upto 31.3.2001 to corporate sector stood at

Rs.398 bn and disbursements Rs.331 bn. The relevant figures for public-sector

companies were Rs.203 bn and Rs. 177 bn and for private sector Rs. 185 bn

andRs.151 bn.

2.4.1.5 Unit Trust of India

Unit Trust of India (UTI), established in 1964, plays an important: role in

mobilizing savings of the community through sale of units under its various

schemes and channelising them into corporate investments. Over the years, it has

floated 85 schemes, including off-shore country funds, to suit diverse investment

needs of investors. Consequent upon amendment to the UTI, Act, effective April

23,1986, UTI has been extending assistance to the corporate-sector by way of term

loans, bills rediscounting, equipment leasing and hire purchase financing. UTI

manages funds to the tune of Rs.600 bn and caters to 42 million investors as on

31.3 2002.

UTI along with ICICI launched a Venture Capital Fund of Rs,H crore which is

managed by the ICICI Venture Fund Management Company Lt for investment in

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Greenfield projects. UTI International Ld., a 100% subsidy ofj UTI is marketing UTTs

off-shore funds in Europe and USA. India IT Fi India Debt Fund and India Public

Sector Fund were launched overseas, to overseas capital into Indian capital

market. UTI helps NRI investors in a way too.

In June 1990, UTI set up the UTI Institute of Capital (UTHCM) with a view of

promoting advanced professional education, trail and research in the field of

capital markets. The institute located in New Boml is envisaged to be not only a

center for development of Investment specialists! the country but also as regional

center for study of international capital and for opening a window on Indian and

International capital markets. Di the year, UTI, for the first time, acted as a

consultant to study policy issi relating to the development of securities market in

Indonesia.

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Aggregate sanctions by UTI to corporate sector upto 31.3.2001 stood at

Rs.595 bn and disbursement at Rs.443 bn on account of project finance. Non-

project finance figures stood at Rs.88 bn and Rs.80 bn. Both project and non-

project finance together stood at Rs. 683bn and Rs.523 bn respectively for

sanctions and disbursements as on 31,3.2001.

As on 31.3.2001, UTTs instrument in corporate equity shares stood at Rs.403

bn (57.3% of total), pref shares Rs.47 bn (0.7%) debentures Rs.229 bn (32.6%),

Fixed deposits with companies Rs. 9 bn (1.3%), term loans Rs.9 bn (1.3%), deposits

with banks Rs.1.5 bn (0.2%) and govt. securities Rs.46.6 bn (6.6%). Of the UTTs

project finance of Rs.443 bn disbursed utpo 31.3.2001, Rs.121 bn is invested in

public sector companies, Rs.315 bn in private sector companies.

2.4.1.6 General Insurance Corporation of India

General Insurance Corporation of India (GIC) was established in 1973 after

nationalisation of general insurance companies in the country. GIC, along with its

four subsidiaries viz. National Insurance Company Ltd., New India Assurance

Company Ltd., Oriental Fire and General Insurance Company Ltd. and United India

Insurance Company Ltd., operates a number of insurance schemes to cater to the

diverse needs of society, In terms of the provisions of the Insurance Act, 1938, and

in keeping with Government guidelines issues from time to time, GIC is required to

channelise 70% of annual accretions to its investible fluids to socially-oriented

sectors of the economy. GIC also participates in consortium financing of industrial

projects along with other AIFIs find extends assistance by way of term loans and

undenvriting/direct subscriptions to shares/ debentures of new and existing

industrial undertakings.

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GIC’s aggregate sanctions upto the end of March 2001 totaled Rs. 146 bn of which

a sum of Rs.48 bn was disbursed. The figures for project finance stood at Rs.70 bn

and Rs.48 bn for sanction and disbursement. The gate sanctions on non-project

finance stood at Rs.20 bn and disbursements B.6.7 bn as on 31.3.2001.

Investments in loans to financial institutions relegated the Rs.30 bn, cumulative

upto 31.3,2001, sanctions to corporate sector stood at Rs.90 bn and disbursement

Rs.67 bn. The private sector companies accounted for over 75% of total assistance

by UT1.

2.4.1.7 Industrial Investment Bank of India (Formerly

Industrial Reconstruction Bank of India)

Industrial Reconstruction Bank of India (IRBI), established in 1985

under the IRBI Act 1984, after reconstruction of the erstwhile Industrial

Reconstruction Corporation of India, is the principal credit and reconstruction

agency for rehabilitation of sick and closed industrial units. IRBI assists industrial

concerns by grant of term loans and advances, underwriting of stocks, shares,

bonds and debentures and guarantees for loans/deferred payments. The range of

its services includes provision of infrastructure facilities, consultancy, managerial

and merchant banking facilities and making available machinery and other

equipment on a lease or hire-purchase basis.

IRBI was renamed as Industrial Investment Bank of India and] brought

under Companies Act, 1956, since March 17, 1997. With this, IIBI hasj become full

fledged development financial institution with operational flexibilit and financial

autonomy. IIBI finances new projects, modernization wor balancing equipment

needs, correcting in balance in cvTent assets, relievir strain on cash resources,

repayment of pressing liabilities and other activities.

Cumulative sanctions and disbursements of IRBI, upto the end, March

2001, aggregated Rs.96 bn and Rs.90 bn respectively and outstanding on

31.3.2001 was Rs.45 bn. The figures for project finance stood at Rs. 54 bn, Rs bn

and Rs.29 bn. The relevant figures for non-project finance Rs.34 bn, Rs.33 and

Rs.12 bn. Together, the figures for direct finance are Rs.88 bn, Rs.82 on Rs.40 bn.

The Figures for loans & investments in shares/bonds of financij institutions are

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Rs.3.8 bn, Rs.3.7 bn and Rs.1.3 bn. The figures for seconc market operations are

Rs, 4.4 bn, Rs.3.95 bn and Rs.2.96 bn.

2.4.2.8 Infrastructure Development Finance Co. Ltd.

Infrastructure Development Finance Co. Ltd. (IDFC) was boi of the need

for a specialized financial intermediary to professionalise the of infrastructure

development in the country. Incorporated in 1997 with an naid-uo caoital of Rs.

10,000 million, IDFC was conceived as an institute to facilitate the flow of private

finance to commercially viable infrastructure jWojects and help mitigate

commercial and structural risks contained therein, by designing innovative

products and processes.

Operations

IDFC mainly operates in the areas such as energy, telecommunications

& information technology, integrated transportation, urban infrastructure and food

& agri-business infrastructure. IDFC has been assigned lead arranger mandates in

its areas of operations and in its role as policy advisor, it is actively involved in

exercise entailing rationalizing policy and regulatory frameworks that govern

infrastructure sectors. It is involved in identification of best practices, drawing on

the expertise of Policy Advisory Boards and promoting policy dialogue amongst

stakeholders such as Central and State Governments, regulators and investors.

IDFC offers a variety of services to projects in the infrastructure sector,

mezzanine structures and advisory services. Apart from above, IDFC encourages

banks to participate in infrastructure projects through ‘take-out’ financing for a

specific term and at a preferred risk profile, with IDFC taking out the obligation

after a specific period. Using risk participation facilities, IDFC also strengthens links

between financial institutions and infrastructure projects. Further, IDFC, through

guarantees structure, helps promoters raise resources from international markets.

Mutual funds and pension funds being potential Kpces of long-term funds for

infrastructure projects, IDFC intends offering advisory services to these funds to

facilitate and strengthen their connectivity with infrastructure projects.

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During 2000-01, to propel its vision for infrastructure towards reality,

IDFC addressed issues such as conditional lending for power sector, ipetitive

bidding for infrastructure services and issues in transport pricing and icing. IDFC is

also developing its vision for the urban water and sanitation In the power sector,

IDFC has been working with progressive state lents to prepare road maps for

reforms in the policy framework, with a belief that its multi-pronged and focused

approach towards reforming the power would ultimately translate into desired

investment opportunities. With a to develop an alternative to escrow based lending

that restrict privatization of distribution, IDFC financed a 210 MW power project set

up by Karnataka Power Corporation, based on a reform linked multipartite

agreement with various stakeholders in Karnataka, The agreement envisages

privatization of distribution, besides committing state government to financial

discipline and envisaging creation of dedicated power sector fund. Based on the

multipartite agreement in Karnataka, lenders are exploring alternative to escrow

based lending in other states as well.

IDFC has developed a Model Concession Agreement for shadow toll

projects, which was approved by the High Powered Committee of the Government

of India. TDFC also assists private sponsors in structuring projects and negotiating

the concession framework for projects being set up in the roads and ports sectors.

IDFC assisted the Planning Commission in the formulation of Integrated Transport

Policy and is involved with the Expert Committee on Railways as well as a group

constituted to examine the needs of the shipping ndustry.

During the year, IDFC created a decentralized infrastructure and new

technologies group to undertake initiatives such as identification of new

echnologies for application, development of financial models with the help of a

iocal service partner and initiating dialogue with donor agencies, relevant

ministries and multi-lateral agencies to enable and stimulate commercially viable

decentralized development.

During 2000-01, IDFC's total sanctions and disbursements amounted to

Rs. 24,670 million for 31 projects and Rs. 7,620 million for projects, respectively.

This compares favourably with previous year’s performance of Rs. 18,660 million

sanctions for 20 projects and Rs. 6,420 million, disbursements for 11 projects,

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indicating an increase of 32.2% in sanctions and] 18.7% in disbursements in 2000-

01 as against the growth rates of 10.9% am 71.2% in 1999-2000. Up to end March

2001, IDFC sanctioned fmancia assistance to 60 projects aggregating Rs. 63,100

million. Of this, disbursemei including non-funded commitments) were made for 27

projects aggregating Rs. 17,790 million.

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2.4.2.9 NABARD

National Bank for Agriculture and Rural Development (NABARD),

established in July, 1982 under an Act of Parliament, is an apex development bank

for promotion and development of agriculture, small-scale industries, cottage and

village industries, handicrafts and other rural crafts and other allied economic

activities in rural areas. The Bank's objective is to promote integrated rural

development necessary for overall prosperity of rural areas in the country.

NABARD's multi-faceted functions have, besides financing, promotional,

developmental and regulatory dimensions.

Operations

NABARD extends credit support by way of refinance to eligible institutions

viz. State Co-operative Agriculture and Rural Development / Banks (SCARDBs),

State Co-operative Banks (SCBs), Commercial Banks (CBs), Regional Rural Banks

(RRBs) and Scheduled primary (Urban) Co-operative Banks (PCBs) for farm as well

as non-farm sectors (NFS). NABARD provides long-term investment credit to farm

sector for various approved agricultural and allied activities such as minor

irrigation, plantation & horticulture, forestry, land development, farm

mechanization, agricultural equipments, animal husbandry and fisheries. Medium-

term credit facilities are available to SCBs and RRBs for approved agricultural

purpose and short-term credit facilities are extended to SCBs on behalf of District

Central Co-operative Banks (DCCBs) and RRBs for financing seasonal agricultural

operations, marketing of crops, purchase, procurement and distribution of

agricultural fertilizers and other inputs.

Refinance for NFS up to Rs.1.5 million is available to SCBs, SCARDBs,

RRBs and CBs on automatic basis, and under pre-sanction procedure up to SSI limit

to CBs and SCBs, enabling them to provide investment &edit to rural enterprises.

Short term refinance facilities under NFS include Credit limits to SCBs (on behalf of

DCCBs) for meeting the working capital j&quirements of primary/apex weavers co-

operative societies, industrial cooperative societies and rural artisan members of

Primary Agricultural Credit Societies (PACS) for pursuing various production,

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procurement and marketing activities. Short-term credit limits are also extended to

RRBs for financing non-agricultural activities. Refinance support is extended to CBs

for financing handioom weavers' co-operative societies in areas where the co-

operative credit structure is weak.

NABARD also extends refinance to banks for financing government

sponsored programmes like Swamjayanti Gram Swarozgar Yojana (SGSY), Prime

Minister's Rozgar Yojana (PMRY), action plans of SC/ST Development Corporations,

SEMFEX-II and for development of non-conventional energy sources.

Considering promotion of NFS as an important and necessary adjunct

to its crore refinancing function, NABARD provides grant/revolving fund assistance

to NGOs, voluntary agencies, Trusts and Promotional organizations. The objective

is to generate and enhance opportunities for employment and income generation

in rural areas in a sustainabie, demonstrative and cost-effective manner.

With a view to providing operational flexibility ro to 3ank in meeting

the changing requirements of the rural sector, comprehensive amendments to

NABARD Act, 1982 were effected from February 1, 2C01. Tlu amendments relate to

explicit reference to NABARD as a 'Development bank’, enhancement of capital

limit from Rs.5,000 million to Rs.50,000 miaic,i, allowing holding of private equity

up to 49% with a minimum of 51% by tie Government of India and RBI, flexibility in

resource mobilization and credit-delivery by the Bank, introduction of new products

and setting up of subsidiaries.

Besides, the major policy initiatives by NABARD during 2000-01 include

liberalisation of the existing scheme of financing the marketing ofj agricultural

produce covering even non-borrowing members of PACS rationalisation of

clean cash credit limits by SCBs/DCCBs to co-operative factories, permitting cash

credit limits to sugar factories for payment of bonus workers, permitting

SCBs/DCCBs to finance activities in service sec rationalization of interest rate on

refinance on investment credit, rationalizatioif of quantum of refinance for

investment credit bringing SCBs, RRBs commercial banks on par, po/cy changes

relating to refinance to non-farm sectq and making available' Kisan Credit Cards to

all the eligible farmers within next three years.

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The other important developments include setting up of a micro-

Finance Development Fund (MFDF) by NABARD with an amount of Rs. 1,000

million, in pursuance of the proposal contained in the Union-Budget 2000-01. The

fund has received an initial contribution of Rs.800 million equally contributed by

RBI and NABARD. Also, the Bank has set up a Watershed Development Fund with a

corpus of Rs.25000 million. Ten state governments have signed MoUs with NABARD

for participating in the programme

NABARD's operations under Rural Infrastructure Development Fund

(RIDF) are likely to gain further momentum, with an increased allocation of

Rs.50,000 million in the Union-Budget 2001-02. In addition, implementation of the

projects through ground level organizations, particularly fqr social infrastructure

development would be encouraged. Agro/food processing and post-harvest

management with upgraded technology would be the new areas of focus for the

Bank.

NABARD's refinance assistance to co-operative banks, commercial

banks and RRBs and loans to state governments, NGOs and other agencies during

2000-01 aggregated Rs. 1,64,610 million as compared to Rs. 1,47,780 million

during 1999-2000, registering a growth of 16.1%. Of the total refinance support,

investment credit disbursed by NABARD for financing farm and NFS amount to Rs.

61,581 million during 2000-01 as compared to Rs. 52,153 million during 1999-

2000, registering a growth of 18.1%.

2.4.2.10 State Industrial Development Corporations

The State Industrial Development Corporations (SIDCs) were

established under the companies Act, 1956 as wholly owned undertakings of the

State Governments with the specific objectives of promoting and developing

medium and large industries in their respective states/union territories. These

eorporations extend financial assistance in the form of rupee loans, underwriting &

direct subscriptions to shares/debentures, guarantees, inter-corporate deposits and

also opens letters of credit on behalf of its borrowers. SIDCs undertake a range of

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promotional activities including preparation of feasibility reports, Conducting

industrial potential surveys, entrepreneurship training & development programmes

and developing industrial areas/estates. Some SIDCs also offer package of

developmental services that include technical guidance, assistance in plant

location and co-ordination with other agencies. With a view to providing

infrastructural facilities for the establishment of industrial units, SIDCs are involved

in the setting up of industrial growth centers. To keep place with the changing

economic environment, SIDCs have initiated various measures to expand the scope

of their activities and have entered into various tee-based activities.

Of the 28 SIDCs in the country, those in Andaman & Nicobar, Vrunachal

Pradesh, Daman & Diu and Dadra & Nagar Haveli, Goa, Manipur, Vleghalaya,

Mizoram, Nagaland, Tripura, Pondicherry and Sikkim also act as SFCs to provide

assistance to small and medium enterprises and act as a promotional agencies for

this sector.

Operations

During 2000-01, financial assistance sanctioned and disbursed by

SIDCs increased by 29.9% and 3.1% to Rs. 20,801 million and Rs. 16,644 million,

respectively as against a decline in sanctions and disbursements of 29.8% and

25.8% in 1999-2000, respectively. Up to end March 2001, aggregate sanctions and

disbursements amounted to Rs. 2,23,309 million and Rs. 1,76,47; million

respectively.

During 2000-01, direct finance constituting 66.6% of overall sanctions,

increased by 4.1% to Rs. 13,849 million as against a decline of 41.6% in 1999-

2000. Of the direct finance, project finance forming 50.9% of total sanctions, grew

by 7.8% to Rs. 10,5 81 million. Of the project finance, rupee loans declined by 2.3%

over a decline of 49% in the previous year. Underwriting & direct subscriptions,

however, registered a growth of 315.4%. Non-project finance constituting 15.7% of

the total sanctions, declined by 6.4% during 2000-01. Of the non-project finance,

assistance under asset credit scheme/equipnu finance/corporate loans increased

by 48.3% while working capital/short-ter loans declined by 41.5%. Sanctions under

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bills finance, accounting for 31.8% the total sanctions, grew by 144.7% to Rs.

6,604 million during 2000-01.

During 2000-01, disbursements under direct finance were lower 4%,

constituting 59.6% of overall disbursements. Disbursements under proj< finance

grew by 1.3% to Rs.7,533 million, accounting for 45.3% of the tot disbursements.

Of the project finance, rupee loans declined by 12,7%, while underwriting & direct

subscriptions increased by 341.1%. Non-project finance, accounting for 14.4% of

total disbursements, declined by 17.4%. Disbursements under asset credit

scheme/equipment finance/corporate loans and working capital/short-term loans

were lower by 17.6% and 25.9% respectively, during 2000-01. Disbursements

under bills finance accounting for 38.4% of total disbursements, grew by 9.9%.

2.4.2.11 Export - Import Bank of India

Exim Bank of India, established in 1982, is a wholly government owned

financial institution set up for the purpose of financing, facilitating and promoting

India's foreign trade. Towards the end, the Bank plays a four^ronged role - that of

a co-coordinator, a financier, consultant and promoter. The Bank's financing

services include a range of fund and non-fund based programmes to enhance the

export competitiveness of Indian companies. Its major operations presently

comprise financing of projects, products and services exports, building export

competitiveness, promotional programmes and financing of research &

development activities of exporting companies. The information, advisory and

support services provided by the Bank enable exporters to evaluate international

risks, exploit export opportunities and improve competitiveness. The Bank also

helps Indian companies in identifying technology suppliers, partners and in

consumption of domestic and overseas joint ventures, through its network of

alliances and its overseas offices.

Upto end March 2001, the Exim Bank sanctioned and disbursed fund based

assistance aggregating Rs. 2,42,497 million and Rs. 1,93,171 million, respectively.

Loans outstanding as at end March 2001 were Rs. 56,443 million, registering an

increase of 11% over the previous year.

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Sanctions of fund based assistance to Overseas Entities by way of lines of

credit and buyers' credit increased sizably to Rs. 1,873 million to 2000-01 from

Rs.200 million in 1999-2000, while sanctions to Indian Exporters under various

programmes declined by 29.3% to Rs. 19,870 million from Rs. 28,118 million in the

previous year.

During 2000-01, the Bank sanctioned guarantees aggregating

Rs .2,118 million as against Rs. 4,404 million in 1999-2000. Guarantees issued

Minted to Rs. 1,741 million as against Rs. 3,017 million. These guarantees related

to overseas projects in sectors such as telecommunications, power generation,

transmission and distribution, oil exploration, cement and petrochemicals.

Outstanding guarantees as at end March 2001 were Rs. 10,740 million.

During 2000-01, 38 export contracts worth Rs. 18,330 million for export

to 23 countries were secured by 21 Indian exporters with the Exim Bank's support

as against 53 contracts worth Rs.34,440 million covering 19 countries secured by

27 Indian exporters during 1999-2000, The export contracts secured during 2000-

01 consisted of 19 turnkey contracts, 11 service contracts, 7 supply contracts and

1 construction contract.

During 2000-01, the Bank sanctioned term loan of Rs. 4,871 million to

33 export-oriented units (EOUs) and disbursed Rs.4,821 million as compared to the

sanctions and disbursements of Rs.8,459 million and Rs.4,747 million in the

previous year.

During 2000-01, the Bank sanctioned loans aggregating Rs. 1,570

million to 9 companies for setting up ventures abroad and for acquisition of

overseas companies. The salient feature was Bank's participation in a nonrecourse

leveraged buyout transaction of an international tea company representing the

largest overseas acquisition so far by an Indian company Disbursement during the

year amounted to Rs. 1,230 million.

During 2000-01, the Bank provides a wide range of fee based

information, advisory and support services to Indian companies and overseas

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entitles. The scope of services included market-related information, sector and

feasibility studies, technology supplier identification, partner search, investment

facilitation and development of joint venture both in India and abroad. The Bank's

operations also included information and support service to Indian companies to

improve their prospects for securing business in projects funded by World Bank,

Asian Development bank, African Development Bank and European Bank for

Reconstruction and Development.

During 2000-01, under the Product and Process Quality Certification

Programme, the Bank sanctioned financial support to the tune of Rs. 14.6 million to

19 companies covering a diverse range of certifications industry-specific, market-

specific and activity-oriented.

Under Technical Assistance programme with IFC, Washington and

Other International agencies, for sponsoring and part-funding Indian consultants,

the Bank sponsored 13 Indian consultants for various projects. These consultants

were selected for assignments in East Africa, Egypt, Ghana, Kosovo, Nigeria and

Vitenam in areas such as pharmaceuticals, cashew nut processing, general

management, investment banking, rural electrification, information technology,

stock exchange expertise and marketing and investment planning.

2.4.2.12 Sate Financial Corporations

State Financial Corporations (SFCs) are the stare level development

banks set up under the SFCs Act, 1951 for the development of small and medium

scale industries in their respective states. SFCs aim at bringing about balanced

regional development by wider dispersal of industries, catalyzing greater

investment and generating larger employment opportunities.

SFCs, numbering 18 at present, provide financial assistance to

industries by way of term loans, direct subscriptions to equity/debentures,

discounting of bills of exchange and guarantees. Most of this IDBI schemes for

assistances to small and medium sectors are operated through SFCs. These include

composite loan scheme, schemes foi women entrepreneurs, modernization

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scheme, equipment finance scheme, scheme for hospitals and nursing homes,

scheme for ex-servicemen, single window scheme and special capital and seed

capital schemes.

2.4.2.13 Technical Consultancy Organisations

A network of Technical Consultancy Organisations (TCOs) was set up in

seventies and eighties by IDBI, IFCI and ICICI in collaboration with state-level

financial/development institutions and commercial banks to provide inexpensive

consultancy services of small and new entrepreneurs in the country.

At present, there are 18 TCOs in the country, some of which cover

more than one state. The activities of TCOs include preparing project profiles and

feasibility studies, undertaking industrial potential surveys, conducting

entrepreneurship development programmes (EDPs) and rendering technical and

administrative assistance. Over the years, TCOs have diversified into newer areas

such as provision of consultancy services for modernization and rehabilitation of

industrial units, transfer of technology, design and engineeriitg services,

management and export consultancy, rural industrial development retailer

consultancy services, turn-key assignments and energy audit and conservation

services. TCOs also provide consultancy services to State Governments, state-level

development financing agencies and banks.

During 2000-01, TCOs completed 1774 assignments including 1092

feasibility studies/project profiles/reports, 121 project appraisals, 131 industrial

potential surveys/area development surveys, 82 valuation of assets, 85

modernisation / rehabilitation / diagnostic studies, 18 functional industrial

complexes/tum-key assignments and 245 other works. Besides TCOs conducted

158 EDPs for 38806 persons. 753 entrepreneurship awareness programmes, 66

skill upgradation programmes/EDPs under SEEUY and 76 other programmes.

List of Technical Consultancy Organisations

1. Andhra Pradesh Industrial & Technical Consultancy Organisation Ltd.

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2. Bihar Industrial & Technical Consultancy Organisation Ltd. (BTTCO)

3. Gujarat Industrial & Technical Consultancy Organisation Ltd. (GITCO)

4. Haryana-Delhi Industrial Consultancy Organisation Ltd. (HARDICON)

5. Himachal Consultancy Organisation Ltd. (HIMCON)

6. Industrial & Technical Consultancy Organisation of Tamil Nadu Ltd.

(ITCOT)

7. Jammu & Kashmir Industrial & Technical Consultancy Organisation Ltd.

(J&KITCO)

8. Kerala Industrial & Technical Consultancy Organisation Ltd. (KITCQ)

9. Madhya Pradesh Consultancy Organisation Ltd. (MPCON)

10. Maharashtra Industrial & Technical Consultancy Organisation Ltd.

(MTTCON)

11. North-Eastern Industrial Consultant Ltd. (NECON)

12. North-Eastern Industrial & Technical Consultancy Organisation Ltd.

(NEITCO)

13. North India Technical Consultancy Organisation Ltd. (NITCON)

14. Orissa Industrial & Technical Consultancy Organisation Ltd. (ORITCO)

15. Rajasthan Consultancy Organisation Ltd. (RAJCON)

16. Uttar Pradesh Industrial Consultants Ltd. (UPICO)

17. West Bengal Consultancy Organisation Ltd. (WEBCON)

18. Technical Consultancy Service Organisation of Kamataka (TECSOK)

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2.43 Lending Procedures of the Term Landing Financial

Institutions

The essential requirements insisted upon by the financial

nstitutions before taking up a request for financial assistance for consideration are:

i) the applicant concern should have obtained industrial license or shouia

have made some kind of commitment, where necessary

ii) the applicant should have obtained/applied for permission of the

Securities and Exchange Board of India to issue capital, wherever

necessary

iii) the applicant should have obtained the approval of the Government

regarding the terms of technical and/or financial collaboration agreement,

if any

iv) the applicant should have a clearance from the Capital Goods Committee

in respect of the machinery proposed to be imported

v) the applicant should have selected a site for the location of the factory

and have prepared a detailed 'project report'.

After the receipt of the filled up application in triplicate in the case of

non-corporate units and quadruplicate in the case of corporate bodies, the project

is appraised by ;i team of technical, financial and economic officers of the

Corporation from several angles - technical, financial, economic, managerial and

social.

2.4.3.1 Technical Appraisal

The technical appraisal of the project involves a critical analysis of the

following:

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i) Feasibility of the selected technical project and its suitability in Indian

conditions.

ii) Location of the project in relation to the sources and availability of inputs -

raw materials, water, power, fuel, transport, skilled and unskilled labour

and in relation to the market to be served by the product/service.

iii) Adequacy of the plant and machinery and their specifications

iv) Adequacy of the plant layout

v) Arrangements for securing technical know-how, if necessary

vi) Availability of skilled and unskilled labour and arrangements for training to

the labourers.

vii) Provision for the disposal of factory effluents and utilisation of byproducts

if any.

viii) Whether the process proposed for selection is technically sound and upto

date etc.

Another important feature of technical appraisal relates to the type of

technology to be adopted for the project. In case new technical processes are

adopted from abroad, attention is to be paid to the terms and conditions.

2.43.2 Economic Appraisal

The economic appraisal of a project involves:

i) Consideration of natural and industrial property of the project and

contribution to the national economy of the country in terms of

contribution to GDP, down stream and upstream projects.

ii) Savings in foreign exchange or prospects of exports.

iii) Employment potential, direct and indirect.

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iv) A critical study of the existing and future demand of the products

proposed to be manufactured, the licensed and installed capacity, the

level of competition etc.

v) Scrutiny of the project in relation to the import and export policies of the

Government and various other factors like regulatory controls, if any, in

regard to production, prices and raw materials.

2.4.3.3 Financial Appraisal

Financial appraisal of the existing concern deals with an analysis of its

working results, balance sheets and cash flow for the past years/projected future

years and an examination of the following aspects in all cases.

i) Estimated cost of the project.

ii) Financial plan with reference to capital structure, promoter's contribution,

debt-equity ratio and the availability of other resources.

iii) Crucial examination of the investments made outside the business and

justification therefor.

iv) Projections of cash flow, both during the construction and the operation

periods.

v) Projects break-even level of operation and time required to reach that

level operation.

vi) Estimation of future profitability in the light of competition and

product/service obsolescence.

vii) Internal rate of return, debt-service coverage and projected dividends on

share capital, pay-back period, abandonment value at the end of different

levels of milestones or years of operation.

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Managerial Appraisal

The confidence of the lending institution in repayment prospects of a

loan is largely conditioned by its opinion of the borrowing unit's management

Therefore, it has been remarked that appraisal of management is the touch sto*ie

of term credit analysis. Where the technical competence, administrative abi/fty,

integrity and resourcefulness of the management are well established, the loan

application gets the most favourable consideration. The expertise, experience and

earnestness of the management tells in the efficiency, effectiveness and

excellence of the project

2.4.3.4 Social Considerations

The social objectives of the project are considered keeping in view the

interest of the general public. The projects, which provide large employment

opportunities and canalize the income of the agricultural sector for productive use,

projects located in totally less developed areas and projects that stimulated small

scale industries are considered to serve the society well. The social benefits are

more. The social cost ofxpollution consumption of scarce resources, etc. are also to

be weighed.

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2.4.3.5 Conditions for Assistance from Financial Institutions

Different financial institutions stipulate different kinds of conditions

depending on the nature of the project, the borrower etc. The main conditions of a

term loan are as follows;

i) The borrower (applicant) has to obtain all relevant Government clearances

such as licensing, capital goods clearance for imported machines, import

license, clearance from pollution control board, etc.

ii) For consortium loan, the borrower has to satisfy all the institutions

participating in lending.

iii) Concurrence of the financial institution is necessary for repayment of any

existing loan or long-term liabilities.

iv) The term loan agreement may stipulate the debt-equity ratio to be

followed by the company.

v) As long as the loan is outstanding, the declaration of dividend is made

subject to the institution's approval.

vi) The term lending institution reserves the right to nominate one or more

directors in the management of the company.

vii) Once the loan agreement is signed, any major commercial agreements

such as orders for equipment, consultancy, collaboration agreement,

selling agency agreement etc. and further expansion need the

concurrence of the term lending institution.

viii) The borrower is not permitted to create any additional charge on the

assets without the knowledge of the financial institutions.

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ix) The financial institutions may appoint suitable personnel in the areas of

marketing, research and development, depending upon the nature of the

project.

x) The promoters cannot dispose their shareholders without the consent of

the lending institutions. This is stipulated for keeping the promoters

involved as long as the institutions involve in the business.

2.43.6 Schemes of Assistance of Financial Institutions

Financial institutions provide the bulk of finance required for industry.

For fulfilling the socio-economic objectives of our country, today the financial

institutions perform a variety of financing and promotional activities and have

designed special programmes specifically for the development of industries in

backward areas, encouraging competent new entrepreneurs, supporting

modernization schemes and development of small scale industries.

Fig. 2.1 gives the schemes of assistance.

Fig. 2.1 Schemes of Assistance.

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2.5 PUBLIC DEPOSITS

Deposits with companies have come into prominence in r cent years.

Of these the more important are the deposits accepted by trading and

manufacturing companies. The Indian Central Banking Enquiry Committee in 1931

recognised the importance of public deposits in the financing of cotton textile

industry in India in general and at Ahmedabad in particular. The growth of public

deposits has been considerable. From the company's point of view, public deposits

are a major source of finance to meet the working capital needs. Due to the credit

squeeze imposed by the Research Bank of India on bank loans to the corporate

sector during 1970s - 1980s and also due to the recommendations of the Tandon

Committee, restricting credit, many companies were not getting as much money in

the 1980s as they used to get, in the past, from the banks. So, public deposits

came handy as working capital fund for businesses. While to the depositor the rate

offered is higher than that offered by banks, the cost of deposits to the company is

less than the cost of borrowings from bank. Moreover, the availability and volume

of bank credit are restricted by consideration of margin, security offered, periodical

submission of statements etc. The credit available to companies through public

deposits is not affected by such consideration. There is no problem of margin or

security. Since the fixed deposits from the public are unsecured, the borrowing

company need not mortgage or hypothecate any of its assets to raise loans in this

form. These deposits are available for comparatively longer terms than bank credit

Merits of Public deposits

The merits of public deposits are as follows:

i) There is no need of creation of any charge against any of the assets of the

company for raising funds through public deposits.

ii) The company can get advantage of trading on equity since the rate of

interest and the period for which the public deposits have been accepted

are fixed.

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iii) Public deposit is a less costly method for raising short-term as well as

medium-term funds required by the companies, because of less restrictive

covenants governing this as against bank credits.

iv) No questions are asked about the uses ot public deposits.

v) Tax leverage is available as interest on public deposits is a charge on

revenue.

Demerits of public deposits

The main demerits of the public deposits are as follows:

i) This mode of financing, sorr.ci.:nes, puts the company into serious

financial difficulties. Even a siignt rumour about the inefficiency of the

company may result in a rush of the public to the company for getting

premature payments of the deposits made by them.

ii) Easy availability of fund encourages lavish spending.

iii) Public deposits are unsecured deposits and in the event of a failure of the

company, depositors have no assurance of getting their money back.

RBI Regulations for Public Deposit

The RBI regulation of public deposits has six main aspects:

i) There is a ceiling on the quantum of deposits in terms of paid-up capital

and reserves by the company because undue accumulation of short-term

liabilities in the form of deposits can lead a company into financial

difficulties. In the beginning the definition of deposits was quite narrow

and excluded unsecured loans accepted from the public and guaranteed

by the directors. Now the term deposit covers “any money received by a

non-banking company by way of deposit or loan or in any other form but

excludes money raised by way of share capital or contributed as capital

by proprietors”.

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ii) The second aspect of the Reserve Bank's regulation is the limit on the

period of such deposit. Formerly, in order to avoid direct competition with

short-term public deposits, companies were prohibited from accepting

deposits for a period of less than 12 months. But the 1973 amendment

reduced the period to less than 6 months. The short-term deposit is now

pegged down to 10 per cent of the ajjgreu.tX1 of the paid-up capital and

free reserves of the company while secured and unsecured deposits shall

not exceed 15 per cent and 25 per cent, respectively, of the paid-up

capital and free reserves.

iii) The Reserve Bank has made obligatory on the part of the companies

accepting deposits to regularly file returns, giving detailed information

about them, their repayment, etc. so that the Reserve Bank camverify

whether the companies adhere to the restrictions. However such

statements are not filed late and the Reserve Bank's action to prevent a

defaulting company from accepting any deposit fails to afford any

protection to existing depositors.

iv) The Reserve Bank has stipulated that while issuing newspaper

advertisements (or even the application forms) soliciting such deposits,

certain specified information regarding the financial position and the

working of the company must accompany. This clause is often mis-ued as

much advertisement often carried words like “as per Reserve Bank

directive”, thereby giving a wrong impression that these deposits are

actually governed by the Reserve Bank. Now such advertisements would

be illegal and attract penal provision prescribed in this behalf. Similarly,

the catalogues and handouts issued by brokers stating that the

companies mentioned therein had complied with Reserve Bank directives

would also attract the penal provision.

v) The Reserve Bank has entrusted the auditors of the companies with

additional responsibilities of reporting to it that the provision under the

Act has been strictly followed by the company.

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vi) The Reserve Bank has issued a broad "RBI Directives on Company Deposit

in order to clarify its role in protecting depositors. The bank has reiterated

that the deposits or loans are fully protected or are absolutely safe merely

because the companies claimed to have complied with the RBI directives

and that they should not presume that the Reserve Bank can come to

their rescue in the event of failure of a company to meet its obligations.

2.6 SUMMARY

The long term capital resources of a company are equity capital,

preference capital, debenture capital and borrowings from term lending institutions

(term loans).

Equity shareholders are owners of the company. They have the right of

control and pre-emptive right to purchase additional equity issued by the company.

Equity shareholders get residual claim over assets in the event of liquidation.

Equity share capital is a permanent capital to the company and it increases the

credit worthiness also. The issue cost of equity capital is high and sale of equity

shares to outsiders results in dilution of control.

Preference shareholders have two rights over equity share holders -

right to receive dividend and also right to receive back the capital in the event of

dissolution or liquidation, if there by any surplus. Preference share capital

enhances the cfeditworthiness of the company. There is no legal obligation to pay

preference dividend and the issue of preference shares does not create any charge

against assets of the company. Compared to debt capital, preference capital is a

very expensive source of financing and skipping dividend on preference shares

may adversely affect of the company and create control problems.

Debenture is an acknowledgement of the company's indebtedness to

it's debenture-holders. Debentures are instruments for raising long term debt

capital. Debenture-holders are the creditors of the company. Raising funds by issue

of debentures does not result in dilution of control. Interest paid to debenture-

holders is a charge on income of the company and is deductible from income for

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income tax purpose. In a period of rising prices, the burden of servicing debentures

in real terms is less. Debenture interest and capital repayment are obligatory

payments. Failure to meet these payments jeoparadiscs the solvency of the firm. If

the capital structure is heavily loaded with debentures, the major portion of the

company's earnings is absorbed in servicing the debt and little is left for

distribution by way of dividends. This may reduce the value of shares in the

market.

Institutional loans represent debt finance which is generally repayable

in more than one year but less than 10 to 15 years. The companies use

institutional loans for acr'risition of fixed assets and working capital margin. The

terr<i loans of (he financial institutions are secured borrowings. With the help of

term loans the companies perform their replacement, rehabilitation and renovation

programmes. Payment of interest on term loans is a contractual obligation. All the

projects are subject to technical appraisal, economic appraisal, financial appraisal

and managerial appraisal for sanctioning of term loans, and the financial

institutions stipulate different kinds of conditions depending on the nature of the

project, the borrower etc. The term tending institutions may be grouped into two

categories, i.e. All India Institutions and State Level Institutions. All India

Institutions are the Industrial Finance Corporation of India, the Industrial Credit and

Investment Corporation of India, I'.ie Industrial Development Bank of India,

Industrial Investment Corporation of India and other all-India Institutions. The

State-level institutions are the State Fin --ial Corporations and State Industrial

Development Corporation.

The assistance of the financial institutions, consists of providing 'ong

term loan, underwriting equity, preference and debenture issues and guaranteeing

of deferred payments of machinery imported from abroad or purchased in India.

Financial institutions provide concessional finance to the projects in backward

areas and soft loans for modernization of industries. They provide technical and

administrative assistance and undertake market ar-d investment research surveys

and also technical and economic studies related to development of industry.

Public deposits are a major source of finance to companies to meet the

working capital needs. For public deposits there is no need of creation of any

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charge against any of the assets of the company. It is less costly method to the

companies for getting short term and medium term funds.

2.6 SELF ASSESSEMENT QUESTIONS

1. Discuss the sources of long term finance of a company.

2. Critically evaluate equity shares a source of finance both the point of (i)

the company and (ii) investing public.

3. Discuss the features of preference shares and evaluate preference share

capital from the company's point of view.

4. What are right shares? Explain the significance of the same form the

company's and investors' view point.

5. Define ‘debenture’ and bring out its salient features as an instrument of

corporate financing.

6. Explain the different types of debentures that may be issued by a

company.

7. What are the advantages and disadvantages of debenture finance to a

company?

8. List out the SEBI guidelines for issuing bonus shares.

9. What are the major types of activities of financial institutions in India?

10. Discuss the importance of Industrial Development Bank of India as an apex

institution of Industrial finance.

11. Explain the lending procedures of the term lending financial institutions in

India.

12. Discuss briefly the working of

a) Industrial Finance Corporation of India

b) Industrial Credit and Investment Corporation of India

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c) Industrial Reconstruction Bank of India

d) Life Insurance Corporation of India

e) State Financial Corporation

f) State Industrial Development Corporations

13. What do you mean by Public Deposits? Explain their merits and demerits.

14. Explain the types of appraisal to be made in sanctioning project finance.

REFERENCES

1. Financial Management and Policy - Van Home

2. Financial Decision Making – Hampton

3. Management of Finance - Weston and Brigham

4. Financial Management - P.Chandra

5. Report on Development Banking in India, 2001, IDBl.

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UNIT-III

WORKING CAPITAL MANAGEMENT

In this unit you will learn, meaning and concepts of working capital,

kinds of working capital, working capital management functions, factors, affecting

working capital, estimation of working capital requirement, sources of working

capital, Tandem committee recommendations, Chore committee

recommendations, Marathe committee recommendations and Vaz committee

recommendations on working capital.

INTRODUCTION

The capital required for a business is of two types. These are fixed

capital and working capital. Fixed capital is meant for taking up capital

expenditures while working capital is for meeting revenue expenditures. Fixed

capital is the capital required for acquiring fixed assets such as land, building,

plant, machinery, fixtures, fittings, etc. forking capital refers to the capital (i.e.

funds) needed to meet day-to-day operations of the business, like payment for

purchase of raw materials, payment of wages and salaries, payment of recurring

overhead expenses and so on. Forecasting and managing working capital arc

somewhat more difficult than that of fixed capital. This is due to variability and

variety in respect of working capital needs of a business. Careful management of

working capital is needed, for poor working capital management would lead ti>

closure of business. It is said while faulty fixed capital management has lead u

closure of units in 10s, faulty working capital management has lead to closure o

100s of units. Hence the significance of working capital management.

3.1 MEANING AND CONCEPTS OF WORKING CAPITAL

Let us examine the meaning and concepts of working capital now

3.1.1 Meaning

James C. Van Home defines working capital management as the

administration of the firm's, current assets and the financing needed to support

current assets. As was already referred to working capital is the day-to-day

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requirement of funds. For day-to-day operations, a business needs to carry certain

amount of raw material of all sorts so that commencement of production is not

delated (for want of raw materials), certain amount of work-in-process so that

produc ion operations go smoothly, certain amount of finished goods so that supply

to ».ie market is not hampered by fluctuations in production, certain amount of

book debts so that sales take place continuously and certain amount of cash and

bank balance for meeting daily routine payments and for providing for any

unforeseen contingencies, jn other words, working capital refers to the investment

in the current assets of the business. Working capital is also referred to as

revolving capital as current assets and current liabilities are converted from one

form to other and again converted back to original form and reconverted into other

on and on. Hence it is called revolving capital or floating capital.

3.1.2 Concepts of Working Capital

There are several concepts of working capital- We just saw that

working capital means investment in the different current assets. Here two

interpretations are possible. These are: i) The value of all the current assets and ii)

The value of all current assets minus the value of all current liabilities, because to

the extent of current liabilities, the firm's investment in current assets stands

reduced. Accordingly we have two concepts of working capital, viz., Gross

concept and Net concept.

Gross working capital refers to investment in all current assets -raw

materials, work-in-progress, finished goods, book debts, bank balance and cash

balance. The gross concept of working capital is significant in the context of

measuring working capital needed, measuring the size of the business, continued

and smooth flow of operations of the business and the like.

Net working capital refers to the excess of current assets over

current liabilities. That is, value of current assets minus value of current liabilities

(current liabilities include trade creditors, bills payable, outstanding expenses such

as wages, salaries, dividend payable and tax payable, bank overdraft, etc.) The net

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concept of working capital is significant in the context of financing of working

capital, the short term liquidity aspects of the business, and the like.

3.2 KIND OF WORKING CAPITAL

There are two kinds of working capital. These are i) permanent working

capital, ii) temporary/varying working capital.

Permanent Working Capital refers to the minimum amount of all

current assets that is required at all times to ensure a minimum level of

uninterrupted business operations. Some minimum level of raw materials, working

process, bank balance, finished goods, etc. a business has to carry all the time

irrespective of the level of manufacturing/marketing operations. This level of

working capital is referred to as core working capital or core current assets. Van

Home defines permanent working capital as the “amount of current assets

required to meet a firm's long-term minimum needs”. You should note, that the

level of core current assets is not, however, a constant sum all the times. For a

growing business the permanent working capital will be rising, for a declining

business it will be decreasing and for a stable business it will be remaining more, or

less stay-put. So permanent working capital is perennially needed one though not

fixed in volume. This part of the working capital being a permanent investment,

needs to be financed through long-term funds.

Temporary or varying working capital varies with the volume of

operations. If fluctuates with scale of operations. This is additional working capital

required during up seasons over the above the fixed working capital. During

seasons more production/sales take(s) place resulting in larger working capital

needs. The reverse is true during off-seasons. As seasons alternate, temporary

working capital moves up and down like tides. Van Home defines temporary

working capital as the “amount of current assets that varies with seasonal

requirements”. Temporary working capital can be financed through short term

funds, ie, current liabilities. When the level of temporary working capital moved up,

the business might use short-term funds and when the level of temporary working

capital recedes, the business might retire its short term loans.

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Chart 3.1 gives the graphic versions of permanent and temporary

working capital for growth, normal and declining firms.

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3.3 WORKING CAPITAL MANAGEMENT FUNCTIONS

Thus for we dwelt only on the concepts and kinds of working capital. Now let

us see what is working capital management. Working capital management refers

to the planning, execution and control of investment in and financing of working

capital.

3.3.1 Investment in Working Capital

Investment in working capital involves determination of the total

quantum of current assets, the size of individual items of current assets and the

operating cycle. These may be planned, adopting any of the following approaches,

viz. industry norm approach, economic mode approach and strategic choice

approach.

Under the Industry norm approach the size and composition of

current assets are determined according to the convention or norms adopted by

die firms in the industry. For instance, 2 months' production requirements of raw

materials, 1 month's production needs of work-in-process, 3 months' sales t'o.

finished stock, 2 months' credit to customers, etc. may be norms. And yoi, follow

the norms. When this approach is adopted, automatically total volume arid

component size of currents assets become proportional with level of activity. But

this approach is not scientific. It is a rule of thumb. But we cannot say it is a wrong

course.

Under the economic model approach, for each item of current

assets the economic lot/order size is worked out. Economic lot size is that quantity

of inventory where the sum of both the costs of carrying and costs of ordering is

the least. When all the optimal quantities are added up you get the optimal size of

investment in current assets. This approach is good for it satisfies one criterion of

efficiency of working capital management. The level of working capital should be

neither too much nor too low. If it is too much, more capital is locked up and the

business loses interest, incurs loss on account of obsolescence, pilferage, pays

more towards storage and insurance. Perhaps more bad debts could also result. If

the size is too low, there is a hand-to-mouth living. There may result some lost

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sales, customer dissatisfaction and desertion, haste purchases, sub-optimal

production runs, etc. So; an optimal investment in current assets is needed. The

economic model approach helps in finding this optional size. But this approach is

based on a set of assumptions, which may render the results of the approach

subject to 'ifs' and 'buts'.

In the strategic choice approach which is more pragmatic, the

management decides the level of investment in each type of current asset case by

case taking into account the cost and benefits involved. No rule of thumb or pre-

designed plain models are used. Managerial consideration, competitors' strategies,

business exigencies and other relevant factors are used in deciding the size and

components of working capital.

3.3.2 Financing and approaches to financing working capital

Having dealt with the size of investment current assets, the methods of

financing of working capital needs our attention. Working capital is financed both

internally and externally through long-term and short-term funds, through debt and

ownership funds. In financing working capital, the maturity pattern of sources of

finance depended much coincide with credit period foi sales for better liquidity.

These are basically three approaches to financing working capital. These are: the

hedging approach, the conservative approach and the aggressive approach. These

three approaches are presented in the chart 3.2.

The management has to decide which approach it wants to adopt. The

essential difference between conservative and aggressive approach is ; The former

uses long term funds not only to finance permanent current assets, but also a part

of temporary current assets, while the later uses short term funds to finance a part

of permanent current assets. Risk preferences of management shall decide the

approach to be adopted. The risk neutral will adopt the hedging approach, the risk

averse the conservative approach and risk seekers will adopt the aggressive

approach.

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Figure 3.1 gives a summary of the relative costs and benefits of the

three different approaches:

Fig 3.1 : Impact of Financing Approaches

Factors Conservative Aggressive Hedging

Liquidity More Less Moderate

Profitability Less More Moderate

Cost More Less Moderate

Risk Less More Moderate

Asset utilization Less More Moderate

Working capital More Less Moderate

Thus management of working capital is concerned with determining

the investment needed and deciding the financing pattern. You would be now

knowing that deciding the financing pattern is essentially determining the size and

composition of current liabilities in relation to those of current assets. Cost of

different types of funds (the long-term and short-term funds), the return on

different type of current assets, ability to bear risk, desired liquidity levels, etc.

have to be considered to decide working capital management related issues.

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3.4 FACTORS AFFECTING WORKING CAPITAL

The level of working capital is influenced by a score effectors. In this

section let us examine the influencing factors.

Nature of Business is one of the factors. Usually in trading

businesses the working capital needs are higher as most of their investment is

found concentrated in stock. On the other hand, manufecturing/processing

business need a relatively lower (compared to that of trading business/level of

working capital. The terms of ‘higher’ and ‘lower’ used above are relative and not

absolute. That is, of the total capital employed in the businesses a higher or lower,

as the case may be, portion is employed in current assets.

Size of Business is also an influencing factor. As size increases, an

absolute increase in working capital is imminent and vice versa Chart 3.2 gives a

graphic version.

Chart 3.2 : Size of business and working capital

Size of business

Credit terms are important factors affecting the size and components

of workings capital. Consider these:

i) buy on credit and sell on cash, working capital is lower

ii) buy on credit and sell on credit, working capital is medium

iii) buy on cash and sell on cash, working capital is medium

iv) buy on cash and sell on credit, working capital is higher

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In situation (i) referred to above it is likely, the firm has more cash and

more trade creditors and in situation (iv) it might be having less cash and more

trade debtors. Hence the impact of credit terms on size and composition of working

capital.

Credit policy influences the working level. A liberal credit policy if

adopted more trade debtors would result and when the same is tightened size of

debtors gets slim.

Credit periods also inflv ince the size and composition of working

capital. When longer credit period is allowed to customers as against the one

extended to the firm by its suppliers, more working capital is needed and vice

versa In the former case, there will be a relatively higher trade debtors and in the

latter there will be a higher trade creditors.

Collection policy is another influencing factor. A stringent collection

policy might not only deter away some credit seeking customers, also force

existing customers to be prompt in settling dues resulting in lower level of working

capital. The opposite is true with a liberal collection policy.

Collection procedures do influence the level of working capital. A

decentralised collection of dues from customers and centralised payments to

suppliers, shall reduce the size of working capital. Centralised collections and

centralised payments or decentralised collections and decentralised payments

would lead to a moderate level of working capital. But with centralised collections

and decentralised payments, the working capital need will be the highest.

Seasonally of production is another influencing factor. Agriculture and food/fruit

processing and preservation industries have a seasonal production. During seasons

when production activities are in their peak working capital need is high.

Seasonally in supply of raw materials affects the size of working

capital. Industries that use raw materials which are available during seasons only,

like flour and rice-milling industries, have to buy and stock wheat, paddy, etc. They

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cannot afford jto buy these items in a phased way, since either supplies become

tardier or prices become higher. From the point of view of quality of raw materials

also, it pays to buy in bulk during the seasons. Hence the high level of working

capital needed.

Seasonality of demand for finished goods is yet another factor. In

the case of products like umbrella, rain-coats, text books and to some extent some

of the consumer durables like textile, jewellery, etc. the demand is seasonal,

climate and festival oriented. But the production has to be continuous throughout,

though the off-take is skewed. There happens a pile up of finished goods, resulting

in higher working capital.

Trade cycle is another influencing factor. Trade cycle refers to the

periodic turns in business opportunities from extremely peak levels, via a

slackening to extremely trough levels and from there, via a recovery phase to peak

levels, thus completing a cycle. There are four phases of a trade cycle. These and

their features are:

i) boom period: more business, more production, more working capital

ii) depression period: less business, less production, less working capital

iii) recession period: slackening business, stock pie-up, more working

capital

iv) recovery period: recouping business, stock moves fast, less working

capital.

Inflation has a bearing on level of working capital. Under inflationary

conditions generally working capital increases, since with rising prices demand

reduces resulting in stock pile-up and consequent increase in working capital.

Level of trading is another factor. There are two levels of trading, viz.

over trading and under trading. Over trading means the business wants to

maximize turnover with inadequate stock level, hastened production cycle and

swiftest collection from debtors. Eventually the working capital will be lower. It is

no good, however, for the business is starved of its legitimate working capital

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needs. Under trading is the opposite of over-trading. There is lethargy and overt

lags. There results a higher work-capital. This is no good either, since the working

capital is not effectively utilized. It is wastage of capital.

Length of the manufacturing process is an important factor

influencing the level of working capital. The time lapse between feeding of raw

material into the machine and obtaining of the finished goods from out of the

machine, is what is described as the length of the manufacturing process. It is

otherwise known as the conversion time. Longer this time period, higher is the

volume and value of work-in-process and hence higher is the working capital and

vice-versa.

System of production process is another factor that has a bearing.

If capital intensive, high technology automated system is adopted for production,

more investment in fixed assets and less investment is current asses are involved.

Also, the conversion time is likely to be lower, resulting in further drop in the level

of working capital. On the other hand, if labour intensive technology is adopted less

investment in fixed assets and more investment in current assets (especially work-

in-progress due to inclusion of an enhanced wage component and prolonged

processing) result.

Finally rapidity of turnover comes. There is a negative correlation

between rapidity of turnover and size of working capital. When sales are fast and

swift, lower is the investment in working capital. Actually stock of inventory is very

minimum. But, when sales are happening far and in-between, i.e. rather slow, as in

the case of jewellery, elaborate investment in working capital results. Thus faster

sales lead to lower working capital and vice-versa.

3.5 ESTIMATION OF WORKING CAPITAL REQUIREMENT

We nave already touched upon the aspect of planning of working

capital under the sub-heading management of working capital. It is concerned with

determining in advance the size and components of working capital. Two

approaches to determining the size of working capital are dealt with.

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3.5.1 Estimation through components approach

Here we take up one of the planning models of working capital to

estimate working capital.

The method adopted here attempts at estimation of working capital

and its components by taking into account, the period for which the various items

remain as stock or as outstanding, the cost structure of production and annual

production. It assumes even production and even sales, throughout and what is

produced is completely sold.

Let us take an example.

A company's cost sheet gives the following unit cost composition: Raw

material Rs.5; wages Rs. 4. production overhead Rs. 4; selling overhead Rs.2; profit

Rs.10 and therefore the selling price is = Rs.25 per unit. It expects to produce and

sell 36,000 units the coming year for which It needs a working capital budget. The

following turnover ratios are given:

Age of raw materials = Average stock of raw materials

Average daily consumption of

Raw material

Age of work-in-progress= Average work-in-progress inventory

Average cost of Production

Age of furnished goods = Average finished stock inventory

Average cost of sales per day

Age of debtors = Average book debts

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= 45 days

= 30 days

= 60 days

= 50 days

Average Credit sales per day

Age of Trade creditors = Average trade creditors

Average credit per day

Age of Expense creditors = Average expenses outstanding

Average expenses per day

With the above information one can find the working capital required

by the business. The same is attempted below. (Cash balance required Rs.20,000).

Step 1: Computation of daily requirements

Daily requirements of =

Raw materials

360 days

36000 x 5

360

Similarly,

Daily wage bill = 36000 x 4/360 = Rs.400

Daily production overhead bill = 36000 x 4 / 360 = Rs.400

Daily Selling overhead bill = 36000 x 2 / 360 – Rs. 200

Daily profit earnings = 36000 x 10 / 360 = Rs. 1000

Step 2: Computation of component values of working capital

a. Stock of raw material = Daily requirements x Age of raw materials

= 500 x 45 = Rs. 22,500

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= 30 days

= 15 days

Annual production x Cost of raw materials In units per unit of output

= Rs. 500

b. Stock of W-I-P = Daily requirement x Age of each component of

Working in progress (i.e. WIP)

i) Raw material component = Rs.500 x 30 = Rs. 15,000

ii) Wages component = Rs.400 x 30 = Rs. 12,000

iii) Production overhead component = Rs.400 x 30 = Rs. 12,000

Total Rs. 39,000

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c. Stock of finished goods = Daily requirement x Age of each component

i) Raw material component = Rs.500 x 60 = Rs. 60,000

ii) Wages component = Rs.400 x 60 = Rs. 24,000

iii) Production overhead = Rs.400 x 60 = Rs. 24,000

iv) Selling overhead = Rs.200 x 60 = Rs. 12,000

Total Rs.l 12,000

d. Value of outstanding debtors = Daily requirement x Age of each

component

i) Raw material component = Rs.500 x 50 = Rs. 25,000

ii) Wages component = Rs.400 x 50 = Rs. 20,000

iii) Production overhead component = Rs.400 x 50 = Rs. 20,000

iv) Selling overhead component = Rs.200 x 50 = Rs. 10,000

v) Profit = Rs. 1000 x 50 = Rs.

50,000

Total Rs. 125,000

e. Value of outstanding creditors - daily raw material requirements

x age of creditors

= Rs. 500 x 30 = Rs. 15,000

f. Outstanding wages = daily wages x outstanding period or age in days

= Rs.400 x 15 = Rs. 6,000

g. Outstanding production overhead = daily expenses x outstanding period

= Rs.400xl5 = Rs. 6,000

h. Outstanding selling overhead = daily expense x outstanding period

= Rs = 200 x l5 = Rs. 3,000

Step 3 : Computation of working capital

Add: Raw material stock Rs. 22,500

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WIP Stock Rs. 39,000

Finished goods stock Rs. 90,000

Debtors Rs. 1,25,000

Cash (given value is taken) Rs. 20,000

Sub total Rs.2,96,000

Less: Outstanding creditors Rs. 15,000

Outstanding wages Rs. 6,000

Outstanding production overhead Rs. 6,000

Outstanding selling overhead Rs. 3,000

Subtotal (-) Rs. 30,000

Working capital needed Rs. 2,66,500

To this figure an amount towards contingency may be added. Taking a

10% contingency need, the working capital required would be: Rs.2,66,500 + 10%

of Rs,2,66,500 = Rs.2,66,500 + Rs.26,650 = Rs.2,93,150

Note: Certain variations could be introduced in the above computations.

For example,

i) In respect of (i) WIP, the production overhead sub-component may be taken not

at the full value as in the above computation, but at say 70% or 80% of the same.

Some authors might even exclude the whole of production overheads regarding

stock of WIP. ii) In respect of finished goods stock, the selling overhead sub

component may be deleted or taken at say 50% or 60% of the level as the whole of

selling expenditure might not have been expended but only a part, like distribution

to regional depots, and the like has been spent, iii) In respect of debtors, the profit

sub-component may be deleted entirely for there is no out-of-pocket cost is

involved. But from he opportunity cost point of view, the inclusion of the same is

justified.

3.5.2 Estimation through operating cycle approach

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It was earlier referred to that working capital is also known as revolving

capital. That is, a circular path of conversion / re-conversion takes place. Consider

this example. You start your business operation with an initial investment. With

credit extended by expense creditors (labour, employees, utilities, etc.) you start

production process. Goods of varying levels of finish result. This is what we call as

work-in-process or work-in-progress. Once complete processing is done, you get

finished goods. Until these goods are sold, they remain in stock. Sales may be for

cash and/or on credit basis. You need to wait a little to realize cash from the credit

customers. The realized cash is used to pay creditors. You need to maintain a cash

balance for day-to-day transactions as well as for meeting sudden spurt in

payment obligations accompanied by sluggish cash collections from debtors. Thus

a revolution or cycle from cash to raw materials to WIP, to finished goods, to

debtors, and back to cash is taking place. This revolution or cycle is known as

operating cycle. You may look at the operating cycle in chart 3.3.

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Efficient woildng capital management is one which ensures continuous

flow without any interruptions/holdups at any of the stages referred to above and

involves as for as possible a rapid completion of the revolutions. In other words,

when raw materials remain in store pending issue for production for a less

duration, when raw materials get converted into WIP in short duration, when WIP is

converted into finished goods in short duration, when finished goods remain in

dept pending sales for a short while only, and when cash realizations out of sales

are made quickly and finally when payment to creditors is made slowly, the

operating cycle would be smaller and consequently the working capital will also be

reasonable.

There should be neither too little nor too much investment in working

capital. Efficient handling of the operating cycle would make pcssible the above.

Note, what is suggested is optimization, and not minimizat :on of current assets and

maximization of current liabilities. That will affect your liquidity and your

profitability. Too little means more illiquidiry, £ut more profitability, but not more

absolute profits. We want both high profitability and high profits. Too much current

liability means illiquidity but more profitability as it is assumed short-term funds

are less expensive for they can be redeemed the moment you don't need thus

saving interest. The reverse is true with too little current liability. Actually the

business has to trade-off between risk and return. If it wants less risk it has to carry

more current assets and less current liability. This will lead to lower profits. Low

risk means low profits. If the business takes more risk, ie., it carries less working

capital, it might make more profits. There is no guarantee however that higher

level of risk yields higher profits.

In terms of operating cycle concept, too long an operating cycle gives

more liquidity but only low returns and vice versa. The optimum operating cycle

has to be worked out taking into account the costs and benefits and levels of risk

and levels of return for varying lengths of operating cycle.

Computation of length of operating cycle

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You can compute the length of operating cycle this way. Consider die

example.

Period covered 1 Year or 365

days

Average credit period allowed by creditors 16 days

Average total of debtors outstanding Rs. 4,80,000

Total consumption of raw material per

annum

Rs. 41,00,000

Total production cost per annum Rs. 10,000,000

Total cost of sales Rs. 10,500,000

Sales during the year Rs. 16,000,000

Value of stock maintained : Rs. 3,20,000

Raw materials Rs. 3,50,000

Work in progress Rs. 2,60,000

Finished goods stock (FGS) Rs.

Calculate operating cycle (Here are used the formulae already given)

Add:

3,20,000Age of raw materials = ———————————— = 27 days

44,00,000/365

3,50,000Age of WIP = ———————————— = 13 days

1,00,00,000/365

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2,60,000Age of FGS = ———————————— = 9 days

10,500,000/365

4,80,000Age of Debtors = ———————————— = 11 days

16,000,000/365

Sub Total 60 days

Less: Age of creditors (given directly) 16 days

Length of Operating Cycle 44 days

Computation of working capital needed through operating cycle:

The length of operating cycle can be used to estimate total working

capital required. First, we have to calculate the number of operating cycles in the

period under study, normally a year.

No. of days in a year

So, No. of Operating Cycles = ———————————————————

Length of operating cycle in days

In the example we have taken, the no. of cycles per annum would be:

365/44 = 8.3 times

Cost of sales

Amount of working capital = ————————————————————

No. of operating cycle

In the case of ow( illustration, the amount of working capital thu» comes to Rs.

105,00,000 / 8:3 = Rs. 12,65,000. Hence the significance of operating cycle

concept in the efficient management of working capital. To this, cash balance

required may be added to get working capital figure inclusive of cash balance as

well.

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SOURCES OF WORKING CAPITAL

Sources of working capital are many. There are both external or

internal sources. The external sources are both short-term and long-term. Trade

credit, commercial banks, finance companies, indigenous bankers, public deposits,

advances from customers, accrual accounts, loans and advances from directors

and group companies etc. are external short-term sources. Companies can also

issue debentures and invite public deposits for working capital which are external

long term sources. Equity funds may also be used for working capital. A brief

discussion of each source is attempted below.

Trade credit is a short term credit facility extended by suppliers of

raw materials and other suppliers. It is a common source. It is an important source.

Either open account credit or acceptance credit may be adopted. In the former as

per business custom credit is extended to the buyer, the buyer is not signing any

debt instrument as such. The invoice is the basic document. In the acceptance

credit system a bill of exchange is drawn on the buyer who accepts and returns the

same. The bill of exchange evidences the debt. Trade credit is an informal and

readily available credit facility. It is unsecured. It is flexible too; that is advance

retirement or extension of credit period can be negotiated. Trade credit might be

costlier as the supplier may inflate the price to account for the loss of interest for

delayed payment.

Commercial banks are the next important source of working capital

finance commercial banking system in the country is broad based and fairly

developed. Straight loans, cash credits, hypothecation loans, pledge loans,

overdrafts and bill purchase and discounting are the principal forms of working

capital finance provided by commercial banks. Straight loans are given with or

without security. A one time lump-sum payment is made, while repayments may

be periodical or one time. Cash credit is an arrangement by which the customers

(business concerns) are given borrowing facility upto certain limit, the limit being

subjected to examination and revision year after year. Interest is charged on actual

borrowings, though a commitment charge for utilization may be charged.

Hypothecation advance is granted on the hypothecation of stock or other asset

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It is a secured loan. The borrower can deal with the goods. Pledge loans are

made against physical deposit of security in the bank's custody. Here the borrower

cannot deal with the goods until the loan is setded. Overdraft facility is given to

current account holding customers t^ overdraw the account upto certain limit. It is

a very common form of extending working capital assistance. Bill financing by

purchasing or discounting bills of exchange is another common form of financing.

Here, the seller of goods on credit draws a bill on the buyer and the latter accepts

the same. The bill is discounted per cash will the banker. This is a popular form.

Finance companies abound in the country. About 50000 companies

exist at present. They provide services almost similar to banks, though not they are

banks. They provide need based loans and sometimes arrange loans from others

for customers. Interest rate is higher. But timely assistance may be obtained.

Indigenous bankers also abound and provide financial assistance to

small business and trades. They change exorbitant rates of interest by very much

understanding.

Public deposits are unsecured deposits raised by businesses for periods

exceeding a year but not more than 3 years by manufacturing concerns and not

more than 5 years by non-banking finance companies. The RBI is regulating

deposit taking by these companies in order to protect the depositors. Quantity

restriction is placed at 25% of paid up capital + free services for deposits solicited

from public is prescribed for non-banking manufacturing concerns. The rate of

interest ceiling is also fixed. This form of workim capital financing is resorted to by

well established companies.

Advances from customers are normally demanded by producers of

costly goods at the time of accepting orders for supply of goods. Contractors might

also demand advance from customers. Where sellers* market prevail advances

from customers may be insisted. In certain cases to ensure performance of

contract in advance may be insisted.

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Accrual accounts are simply outstanding dues to workers, suppliers

of overhead service requirements and the like. Outstanding wages, taxes due,

dividend provision, etc. are accrual accounts providing working capital finance for

short period on a regular basis.

Loans from directors, loans from group companies etc. constitute

another source of working capital. Cash rich companies lend to liquidity crunch

companies of the group.

Commercial papers are usance promissory notes negotiable by

endorsement and delivery. Since 1990 CPs came to be introduced. There are

restrictive conditions as to issue of commercial papers. CPs are privately placed

after RBI's approval with any firm, incorporated or not, any bank or financial

institution. Big and sound companies generally float CPs.

Debentures and equity fund can be issued to finance working

capital so that the permanent working capital can be matchingly financed through

long term fiinds.

3.6 TANDON COMMITTEE RECOMMENDATIONS

Tandon committee was appointed by RBI in July 1974 under the

chairpersonship of Shri. P.L.Tandon who was the Chairman of PNB then. The terms

of references of the committee were:

i) To suggest guidelines for commercial banks to follow up and supervise

credit from the point of view of ensuring proper use of funds and

keeping a watch on the safety of advances.

ii) To suggest the type of operational data and other information that may

be obtained by banks periodically from the borrowers and by the

Reserve bank from the lending banks.

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iii) To make suggestions for prescribing inventory norms for different

industries both in the private and public sectors and indicate the broad

criteria for deviating from these norms.

iv) To suggest criteria regarding satisfactory capital structure and sound

financial basis in relation to borrowing.

v) To make recommendations regarding resources for financing the

minimum working capital requirements.

vi) To suggest whether the existing pattern of financing working capital

requirements by cash credit/overdraft requires to be modified, if so, to

suggest suitable modification.

Findings of the committee: The committee studied the existing system

of extending working capital finance to industry and identified the following as its

major weaknesses:

i) It is the borrower who decides how much he would borrow. The banker

cannot do any credit planning since he does not decide how much he

would lend.

ii) Bank credit, instead of being taken as a supplementary to other source of

finance, is treated as the first source of finance.

iii) Bank credit is extended on the account of secuntv available and not

according to the level of operations of the borrower.

iv) There is a wrong notion that security by itself ensures the safety of bank

funds. As a matter of fact safety essentially lies in efficient follow-up of the

industrial operations of the borrower.

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Commitment Recommendations: The report submitted by the Tandon

Committee introduced major changes in financing of working capital by commercial

banks in India. The report was submitted on 9th August 1975.

Fixation of norms. An important feature of the Tandon Committee's

recommendations relate of fixation of norms for bank lending to industry.

i) Working capita! gap

In order to reduce the dependence of businesses on banks to; working

capital, ceiling on bank credit to individual firms has been prescribed. Accordingly,

businesses have to compute the current assets requirement on the basis of

stipulations as to size. So, flabby inventory, speculative inventory cannot be carried

on with bank finance. Normal current liabilities, other than bank finance, are also

worked out considering industry and geographical features and factors. Working

capital gap is the excess of current assets as per stipulations over normal current

liabilities (other than bank assistance). Bank assistance for working capital shall be

based on the working capital gap, instead of the current assets need of a business.

This type of financing assistance by banks was introduced on the basis of

recommendations of Tandon Committee.

ii) Inventory and Receivables norms: The committee has suggested norms

for 15 major industries.

The norms proposed represent the maximum level for holding

inventories and receivables. They pertain to the following:

i) Raw materials including stores and other items used in the process of

manufacture.

ii) Stock in process

iii) Finished goods

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iv) Receivables and bills discounted and purchased.

Raw materials are expressed so many months' cost of production Stock

in process is expressed as so many months' cost of production. Finished goods and

receivables are expressed as so many months' cost of sales and sales respectively.

iii) Lending norms : The lending norms have been suggested in view of th

realization that the banker's role as a lender is only to supplement the borrower*

resources. The committee has suggested three alternative methods for wor out the

maximum permissible level of bank borrowings. Each successive me reduces the

involvement of short-term credit to finance the current assets, increases the use of

long term funds.

The first method provided for a maximum 75% of bank funding of the

working capital gap. That is, at least 25% of working capital gap must be financed

through long term funds. The second method provided for full bank financing of

working capital gap based on 75% of current assets only. That is, 25% of current

assets should be financed through long term fund. 25% of current assets is greater

than 25% of working capital gap. Hence 2nd method meant more non-bank finance

for working capital. The third method provided for long- term fimd financing of

whole permanent current asset and 25% of varying ci assets. That is bank

financing will be limited to working capital gap computed taking 75% of varying

current assets only.

The three methods are discussed below to show permitted funding of

working capital:

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Items Method 1 Method 2 Method 3

Core current assets 2,00,000 2,00,000 2,00,000

Varying current assets 7,00,000 7,00,000 7,00,000

Total 9,00,000 9,00,000 9,00,000

Less: Long-term Fund

To the extent of core

current asset

- - 2,00,000

9,00,000 9,00,000 7,00,000

Less: Long-term fund

To the extent of 25%

current assets or balance

of current asset (method

3)

- 2,25,000 1,75,000

9,00,000 6,75,000 5,25,000

Less:

Financed by short term

other than bank (Say

Rs. 4,00,000)

3,00,000 3,00,000 3,00,000

6,00,000 3,75,000 2,25,000

Less:

25% of WCG financed by I

torn foods (method 1)

1,25,000 - -

Maximum Bank Funding 4,75,000 3,75,000 2,25,000

Of the total current assets,

long-term fund financing

amounted to:

1,25,000 2,00,000 3,50,000

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Current Ratio: CA 8,00,000 8,00,000 8,00,000

CL 7,00,000 6,00,000 4,50,000

= 1.14 = 1.33 = 1.78

Today, Tandon committee recommendations are not relevant. Now'j

banks are flush with funds. But good borrowers aren't many. Tandon committee

recommendations were relevant when controlled economy prepared. Today, it is

open economy. Besides, these recommendations were relevant in these years j

when money market was tight and capital rationing was needed. Today, whole

environment has changed. Now banks want to provide long-term loans well.

Actually from April 15, 1997, all instructions relating to maximt permissible bank

finance (MPBF) were with drawn.

3.7 CHORE COMMITTEE RECOMMENDATIONS

Following the Tandon Committee the Chore Committee under the

Chairmanship of Shri. K.B.Chore, of RBI, was constituted in April 1979. terms of

reference were:

i) to review the working of cash credit system.

ii) to study the gap between sanctioned and utilized cash credit levels.

iii) to suggest measures to ensure better credit discipline.

iv) to suggest measures to enable banks to relate credit limits with oil levels.

The recommendations of the committee were:

i) To continue the present system of working capital financing, vizi/ credit,

bill finance and loan.

ii) If possible supplement cash credit system by bill and loan financing.

iii) To oeriodicallv review cash credit levels.

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iv) No need to bifurcate cash credit accounts into demand loan and cash

credit components.

v) To fix peak level and non-peak level limits of bank assistance wherever,

seasonal factors significantly affect level of business activity.

vi) Borrowers to indicate before commencement of each quarter the

requirement of bank credit within peak and non-peak level limits

sanctioned. A variation of 10% is to be tolerated.

vii) Excess or under utilization beyond 10% tolerance level is to be considered

as irregularity and corrective actions b? taken up.

viii) Quarterly statement of budget and performance be submitted by all

borrowers having Rs.50 lakh working capital limit from the whole of

banking system.

ix) To discourage borrowers depending on adhoc assistances over and above

sanctioned levels.

x) The second method of financing of working capital as suggested by the

Tandon committee be uniformly adopted by banks.

xi) To treat as working capital term loan the excess of bank funding when the

switch over to the second method bank financing is adopted and the

borrower is not able to repay the excess loan.

MARATHE COMMITTEE RECOMMENDATIONS

Later Marathe Committee was appointed to suggest meaningful dirctions to

the credit Management function of the RBI. The recommendations are:

i) the second method of financing Tandon committee should be followed

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ii) fast-track system of advance releasing upto 50% of additional credit

required by borrowers pending RBI's approval of such enhanced credit

authorization.

iii) the bank should ensure the reasonableness of projections as to sales,

current assets, current liability, net working capital by looking into past

performance and assumptions of the future trend.

iv) the current assets and liabilities to be classified in conformity with the I

guidelines issued by the RB1. For instance current liability should include

any liability that needs to be retired within 12 months from the] date of

previous balance sheet.

v) a minimum of 1.33 current ratio should be maintained. That is, 25% of

current assets should be financed from long term funds.

vi) a quarterly information system (Q1SO giving details as to project level of

current assets and current liabilities be evolved such that information is

given to the banker in the week preceding commencement of the quarter

to which the data are related, adopted.

vii) a quarterly performance reporting system giving data on performs within

6 weeks following the end of the quarter to which the ds related be

adopted.

viii) a half yearly operating and fund flow statement to be submitted 2 months

from the close of the half-year.

ix) the banker should review the borrower's accounts at least once

3.9 VAZ COMMITTEE RECOMMENDATIONS

As per VAZ committee recommendations working requirement is taken

as 25% of annual turnover, and the borrower has^ 5% of projected turnover from

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long-term sources as his contribution projected turnover will be provided by the

financing bank. Thus," for working capital is totally de-linked from current assets

level Hence the total departure from Tandon and Chore committee

recommendations. Since 15-4-1997, banks were instructed to evolve their own

method such of turnover method, the cash budget system or any other system

including erstwhile working capital gap system, for assessing the working capital

needs of businesses.

3.10 SUMMARV

Working capital is the life sustaining system of businesses. There are

different types and concepts of working capital. Permanent working capital,

temporary working capital, gross working capital and net working capital arc

different types. There are aggressive, matching and conservative approaches to

financing working capital. Trade credit, bank finance, internal accruals, debt ttd

equity finances are used to finance working capital.

3.11 SELF ASSESSMENT QUESTIONS

1. Define working capital and describe its components

2. Bring out the kinds and concepts of working capital and the nature and

significance each type of working capital

3. What do you mean by working capital management? What approaches

would you adopt to ensure effectiveness?

4. Discuss clearly the factors affecting the size and composition of

working capital.

5. Explain how would you plan the working capital requirements of a

manufacturing undertaking.

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6. What is operating cycle? Explain its significance in the context of

estimation of working capital and ensuring efficient management of

working capital.

7. Explain the different sources of working capital finance.

8. What is working capital gap? Explain the Tandon Committee views

about the same.

9. Discuss the terms of reference and recommendations of the Tandon

Committee. Give the impact on financing of working capital.

10. What are the recommendations of Chore Committee? Explain them.

11. The cost structure for a firm is: Raw materials Rs. 10 per unit; labour

Rs. per unit; overhead Rs.10 per unit; profit Rs.7 per unit. Credit

allowed creditors is 2 months and allowed to debtors is 3 months. Time

lag payment of expenses 1 month. Production and consumption are

equal even. For an equal production of 1,80,000 units prepare working

budget. Cash balance required is Rs. 50,000 and provision for continj is

required at 5%.

12. A business has projected its turnover as Rs.12 crs. As per Vaz coi find

its working capital need and extent of bank finance.

13. Now bank finance for working capital is de-linked from current Examine

implications of such a policy.

14. A firm's cost of goods sold is expected to be Rs.6 crs. Expected

operating cycle is 90 days. It wants to keep a cash balance of 1% of

cost of] sold. Find its expected working capital taking 360 days in the

year.

REFERENCES

1. Financial Management and Policy - Van Home.

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2. Financial Decision Making – Hampton

3. Management of Finance-Weston and Brigham

4. Financial Management - P.Chandra

5. Financial Management - Ravi M. Kishore

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UNIT-4

CAPITAL BUDGETING

In this unit you will learn capital projects, significance of capital

budgeting, appraisal techniques of capital projects, under conditions of certainty,

risk and uncertainty, etc.

INTRODUCflON

Capital budgeting is budgeting for capital projects. TTie exercise

involves ascertaining / estimating cash inflows and outflows, matching the cash

inflows with the outflows appropriately and evaluation of the desirability of the

project,

4.1 CAPITAL PROJECTS

Businesses invest in capital projects of different nature. These capital

projects involve investment in physical assets, as opposed to financial assets like

shares, bonds or funds. Capital projects necessarily involve processing/

manufacturing/service works. These require investments with a longer time

horizon. The initial investment is heavy in fixed assets and investment in

permanent working capital is also heavy. The benefits from the projects last for few

to many years.

Capital projects may be new ones, expansion of existing ones, [diversification

of existing ones, renovation or rehabilitation of infirm ones, R&D activities, or

captive service projects. An enterprise may put up a new subsidiary, stake in

existing subsidiary or acquire a running firm. All these are isidered capital projects.

Capital projects involve huge outlay and last for years. Hence are

riskier than investments in financial assets. Capital projects have iclogical

dimension and environmental dimension. So, careful analysis needed. Decisions

once taken cannot be reversed in respect of capital rts. So, "listen before leaping"

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and "think before jumping" are the caveats 1. Thorough evaluation of costs and

benefits is needed.

4.2 SIGNIFICANCE OF CAPITAL BUDGETING

Every business has to commit funds in fixed assets and permanent

working capital. The type of fixed assets that a firm owns influences i) the pattern

of its cost (i.e. high or low fixed cost per unit given a certain volume of production),

ii) the minimum price the firm has to charge per unit of product, iii) the break-even

position of the company, iv) the operating leverage of the business and so on.

These are all very vital issues shaping the profitability and risk complexion of the

business. Hence the significance of capital budgeting.

Capital budgeting is significant because it deals with right kind of i

evaluation of projects. A project must be scientifically evaluated, so that undue

favour or dis-favour is shown to a project A good project must not U; rejected and a

bad project must not be selected. Hence the significance of capitalf budgeting.

Capital investment proposals involve i) longer gestation period, ii) huge

capital outlay, iii) technological considerations needing technoloj forecasting, iv)

environmental issues too, which require the extension of scope of evaluation to go

beyond economic costs and benefits, v) irreversit decision once get committed, vi)

considerable peep into the future which > normally very difficult, vii) measuring of

and dealing with project risks whu a daunting task in deed and so on. All these

make capital budgeting a signifk task.

Capital budgeting involves capital rationing. That is the avail funds

must be allocated to competing projects in the order of project potentials. Usually,

the indivisibility of project poses the problem of capital ratk because required funds

and available funds may not be the same. A slightly 1 return projects involving

higher outlay may have to be skipped to choose with slightly lower return but

requiring less outlay. This type of trade-off has) be skillfully made.

The building blocks of capital budgeting exercise are estimates of price and

variable cost per unit output, quantity of output thai, be sold, the tax rate, the cost

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of capital, the useful life of the project, etc. period of years. A clear system of

forecasting is needed. Hence the signifk of capital budgeting.

What should be the discount rate? Should it be the pre-tax overall cost

of capital? Or the post-tax overall cost of capital? The choice is very crucial making

capital budgeting exercises significant ones.

Finally, which is the appropriate method of evaluation of projects There

is a dozen or more methods. The choice of method is important. And different

methods might rank projects differently leading to a confused picture of project

desirability ranks. A clear thinking is needed so that confusion is not descending on

the choice of projects. Hence the significance of capital budgeting. ,

4.3 APPRAISAL OF CAPITAL PROJECTS

Appraisal means examination and evaluation. Capital projects need to

be thoroughly appraised as to costs and benefits.

The costs of capital projects include the initial investment at the

inception of the project. Initial investment made in land, building, machinery, plant,

equipment, furniture, fixtures, etc. generally, gives the installed capacity.

Investment in these fixed assets is one time. Further a one-time investment in

working capital is needed in the beginning, which is fully salvaged at the end of the

life of the project

Against this fund committed returns in the form of net cash earnings

are expected. Net cash earnings - sales - variable cost - Fixed cost: (including

depreciation, Tax + Depreciation. These are computed as follows. T stand for price

per unit, ‘V for variable cost per unit, ‘Q’ for quantity & sold, ‘F’ stand to total fixed

expenses exclusive of Depreciation, stand to depreciation on fixed assets, T for

interest on borrowed capital T for tax rate).

Then cash earnings = [(P-V)Q-F-D-I](1 -T) + D

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These cash earnings have to be estimated through out the lie life of the

investment. That is, all the variables in the equation have to be forecast well over a

period of years.

Now that, we have the benefits from the investment estimated, the

same may be compared with costs of the capital project and 'netted' to find out

whether costs exceed benefits or benefits exceed costs. This process of estimation

of costs and benefits and comparison of the same is called appraisal. Payback

period, accounting rate of return, net present value, internal rate of return,

decision tree technique, sensitivity analysis, simulation analysis and capital asset

pricing model (CAPM) are certain methods of appraisal.

4.4 REQUISITES FOR APPRAISAL OF CAPITAL PROJECTS

The computation of profit after tax and cash flow are mucbj relevant in

evaluation of projects. Hence this is presented here as a prelude better

understanding the whole process.

Say in fixed assets at time zero, you are investing Rs.20 lakhs. You

have estimated the following for the next 4 years.

Year Expected

Sales

(Units)

Expected

selling price

Tax

rate

Expected

Variable

cost per

unit

Fixed

expenses

(excluding

depreciation

)

(Q) (P) (T) (V) (F)

Rs. Rs. Rs.

1 30000 200 30% 100 12,00,000

2 30000 250 30% 120 13,00,000

3 20000 300 40% 150 14,00,000

4 21000 300 40% 200 15,00,000

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With this information we can estimate profit after tax for business. For

that, apart the given variable expenses and fixed expenses depreciation of the

fixed assets has to be considered. The annual depreciation is given by the cost of

fixed assets divided by number of life. In our case the figure comes to Rs.

20,00,000/4 = Rs.5 lakhs.

The calculations are given in three stages, viz. computation of profit

before tax (PBT), profit after tax (PAT) and cash flow.

The profit before tax (PBT) for a period is given by: (selling price per

unit - variable cost per unit) * (No, of units sold) - Fixed expenses - Depreciation.

So, for the 1st year PBT = (200-100) (30000) - 12,00,000 - 5,00,000 = 30,00,000 - 1

7,00,000 = 13,00,000. Table 4.1 gives the working and results.

Table 4.1

Year (P-V) * (Q) - F - Dep. = PBT

Rs. Rs. Rs.

1 (200-100) * (30000

)

- 12,00,00

0

- 5,00,00

0

= 13,00,00

0

2 (250-120) * (30000

)

- 13,00,00

0

- 5,00,00

0

= 21,00,00

0

3 (300-150) * (20000

)

- 14,00,00

0

- 5,00,00

0

= 11,00,00

0

4 (300-200) * (21000

)

- 15,00,00

0

- 5,00,00

0

= 1,00,000

Profit after tax (PAT) for the different years is obtained by tax from the

PBT.

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Profit after tax - PAT « PBT (1-Tax Rate. So, for the first year T-

13,00,000 (1-30%) = 13,00,000 (0.7) = 9,10,000. Similarly for the other . the profit

figures can be obtained as in table 4.2.

Year

Table 4.2

Year

PBT

Rs.

Tax

rate

Tax = (PAT) x (Tax

Rate)

(PAT = PBT -Tax)

or PBT(l-TR)

1 13,00,000 30% 3,90,000 9,10,000

2 21,00,000 30% 6,30,000 14,70,000

3 11,00,000 40% 4,40,000 6,60,000

4 1,00,000 40% 40,000 60,000

Total 46,00,000 - 15,00,000 31,00,000

Cash-flow from business is equal to PAT plus depreciation. Ti 4.3 gives

cash flow from business.

Year PAT + Rs. + DEP Rs. = Cash Flow

Rs.

Cumultaive

Cash Flow Rs.

1 9,10,000 + 5,00,000 = 14,10,000 14,10,000

2 14,70,000 + 5,00,000 = 19,70,000 33,80,000

3 6,60,000 + 5,00,000 = 11,60,000 45,40,000

4 60,000 + 5,00,000 = 5,60,000 51,00,000

4.5 PAYBACK PERIOD (PBP) METHOD

Pay back period refers to the number of years one has to back the

capital invested in fixed assets in the beginning. For this we have’ cash flow from

business.

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We have invested Rs. 20,00,000 at time zero. After one year a sum of

Rs.14,10,000 is returned By next year a sum of Rs. 19,70,000 is returned. But we

have to get back only Rs. 5,90,000 (i.e 20,00,00 - 14,10,000). So, in the second we

have to wait only for part of the year to get backRs. 5,90,000. The part of the year -

5,90,000/19,70,000 - 0.30. That is, pay back period is 1.30 years or 1 year, 3

months and 19 days.

In general pay-back period is given by V in the equation

n

Σ CFt - I = 0.

t-1

where ‘t’ = 1 to n, I = initial investment, CFt = cash flow at time 't' and t = time red

in years.

Normally business as want projects that have lease pay back period,

because the invested money is got back very soon. As future is risky, earlier one

gets back the money invested the better for him. Some businesses fix a maximum

limit on pay back period. This is the cut-off pay back period, ig as the decision

criterion. Accordingly a pay back period ceiling of 3 years means, only projects with

payback period equal to or Jess than 3 years will be accepted.

Merits of payback period

i) It s cash flow based which is a definite concept

ii) Liquidity aspect is taken care of well

iii) Risky projects are avoided by going for low gestation period projects

iv) It is simple, common sense oriented,

Demrits of payback period

i) Time value of money is not considered as earnings of all years are

simply added together.

ii) Explicit consideration for risk is not involved

iii) Post-payback period profitability is ignored totally.

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4.6 ACCOUNTING RATE OF RETURN (ARR) METHOD

Here the accounting rate of return (ARR) is calculated. It is also called

as average rate of return. To compute ARR average annual profit is calculated first.

From the PBT for different years (as in table 4.1) average annual PBT can

calculated.

The average annual PBT = Total PBT / No. of years

AAPBT = 46,00,000/4

= 11,50,000

ARR = AAPBT / Investment

= 11,50,000 / 20,00,000 - 0.574 = 57.4%

The denominator can be average investment, i.e., (original value plus

terminal value)/2. Here it is 10 lakhs. Then the ARR will be

Rs.11,50,000/Rs.10,00,000 = 1.148 or 114.8%

ARR can also be computed on the basis of PAT. The formula is Average

Annual PAT / Original investment.

Average Annual PAT = Total PAT / No. of years

= 31,00,000/4 = 7,75,000

So, ARR = 7,75,000 / 20,00,00 = 0.3875 = 38.75%

The denominator can be the average investment, instead of original

investment, then ARR is - Rs.7,75,000 / Rs. 10,00,000 = 0.775 or 77.5%.

Merits of ARR

i) It is simple, common sense oriented

ii) Profits of all years taken into account

Demerits of ARR

i) Time value of-money is not considered

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ii) Risk involved in the project is not considered

iii) Annual average profits might be same for different projects but accrual of

profits might differ having significant implications on risk and liquidity

iv) The ARR has several variants and that it lacks uniform understanding.

A minimum ARR is fixed as the benchmark rate or cut-off rate. The

estimated ARR for an investment must be equal to or more than this {benchmark

or cut off rate so that the investment or project is chosen.

4.7 NET PRESENT VALUE (NPV) METHOD

Net present value is computed given the original investment, anual

cash flows (PAT + Depreciation) and required rate of return which is equal to the

cost of capital. Given these, NPV is calculated as follows

n

NPV = - I + Σ CFt / (l + k)t

t = 1

I = Original or initial investment

CFt = annual cash flows

K = cost of capital and

t = time measured in years.

For the problem we have done under the pay back period method we

can get the NPV, taking k = say 10% or 0.1. Then the

NPV = -I + CF1 / (1+k)1 + CF2 / (1+k)2 + CF3 /(I+k)3 + CF4/(l+k)4

= 20,00,000+14,10,000/1.1+19,70,000/1.12+11,60,000/1.13+

5,60,000/1.14

= - 20,00,000 + 14,10,000x0.909 + 19,70,000x0.826 +

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11,60,000x0.751 + 5,60,000x0.683

= - 20,00,000 + 12,81,818 +16,28,099 + 8,71,525 + 3,79,042

= - 20,00,000 + 41,60,484 = Rs. 21,60,484

If it is required that k = 10%, 11%, 12% and 13% respectively for year

4 through year 4, the formula is written as follows.

NPV = -I CFt/(l+kt)t

= -I + CF1 / (1+k1)1 + CF2 / (l-fk2)2 + CF3 /(l+k3)3 +

In the above example

NPV = -20,00,000+14,10,000/1.1+19,70,000/1.112+11,60,000/1.123+

5,60,000/1.134

=-20,00,000+14,10,OOOx0.909+19J70,OOOx0.817+ll,60,OOOx0.712+

5,60,000 x 0.635

= - 20,00,000 + 40,49,482 = Rs. 20,49,482

If the NPV – 0’ or greater than zero, the project can be case there are

several mutually exclusive projects with NPV >0, we will the one with highest NPV.

In the case of mutually inclusive projects you first take up the one with highest

NPV, next the project with next highest NPV, and so on as long as your fund for

investments lasts. The factor "k" need not be same for all projects. It can be high

for projects whose cash flows suffer greater fluctuations due to risk, and lower for

projects with lower fluctuation.

4.8 INTERNAL RATE OF RETURN (IRR) METHOD

Internal Rate of Return (IRR) is the value of "k" in the eqation, -I + Σ

CFt / (1+k)t - 0. In other words, IRR is that value of "k" for which aggregated

discounted value of cash flows from the project is equal to original investment in

the project When manually computed, "k" i.e., IRR is got through trial and error and

if need be, adopting a sort of interpolation. Suppose for a particular value of k, -I +

Σ CFt / (l+k)t > 0, we have to use a higher 'k' in our next trial and if the value is <

0, a lower 'k’ has to employed next time. Then you can interpolate k. The value of

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'k' thus got is the IRR. For the project in question (dealt under NPV), the IRR is

worked out as follows;

If we take, k = 50%, then, Σ CFt/(l+k)t comes to 22,69,877 i.e.,

[14,10,000/1.5 + 19,70,000/1.52+ 11,60,000/1.53 + 5,60,000/1.54]. This is higrier

fan the T by 2,69,877. So, V is enhanced to 60%. Then 14,10,000/1.6 +

19,70,000/1.62 + 11,60,000/1.63 + 5,60,000/1.64, i.e., Σ CFt / (l+k)t comes to !\

fti20,19,433. This is marginally higher than T. So, we have to still try at higher

.discount rate, say 61%. The PV comes to Rs.19,97,083. Now, we can take the

interpolated value as the IRR, which is between 60% and 61%.

IIRR = 60% + [(20,19,433 - 20,00,000)/(20,19,423 - 19,97,083)] X

(61%-60%)

= 60% + [19433/22350 ] X 1% = 60% + 0.869% = 60.869%

If the computed IRR is equal to or greater than cost of capital, the t will

be selected. Otherwise, it is rejected. For mutually exclusive projects, project with

highest IRR, subject to it being equal to or greater than cost of capital, will be

chosen. For mutually inclusive projects, you start taking up first the project with

highest IRR, next, the next highest IRR project and so on subject to (i) the IRR is

greater than or equal to cost of capital and (ii) you have investible fund.

4.9 DECISION TREE APPROACH

Decision tree approach is a versatile tools used for decision making

under conditions of risk. The features of this approach are: (1) it takes into account

the results of all expected outcomes, (ii) it is suitable where decisions are to be

made in sequential parts - that is, if this has happened already, what will happen

next and what decision has to follow, (iii) every possible outcome is weighed using

joint probability model and expected outcome worked out, (iv) a tree-form pictorial

presentation of all possible outcomes is presented here and hence the term

decision-tree is used. An example will make understanding easier.

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An entrepreneur is interested in a project, say introduction of a fashion

product for which a 2 year market span is foreseen, after which thej product turns

fade and that within the two years all money invested must be] realised back in

full. The project costs Rs. 4,00,000 at the time of inception.

During 1st year, three possible market outcomes are foreseen. Low

penetration, moderate penetration and high penetration are the three outcome

whose probability values, respectively, are 0.3, (i.e., 30% chance), 0.4 and and the

cash flows after tax under the three possible outcomes are respects estimated to

be Rs.1,60,000, Rs. 2,20,000 and Rs. 3,00,000.

The level of penetration during the 2nd year is influenced by le of

penetration in the first year. The probability values of different penetratw levels in

the 2nd year given the level of penetration in the lsl year and respecth cash flows

are estimated as follows:

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Level ofPenetratio

n inyear 2

If low penetrationin first year

If moderatepenetrationin first year

If highpenetrationin first year

Cash flow year 2 Cash flow year 2 Cash flow year 2

Amount Prob. Amount Prob. Amount Prob.

Low 80000 0.2 260000 0.3 320000 0.1

Moderate 200000 0.6 300000 0.4 400000 0.8

High 300000 0.2 320000 0.3 480000 0.1

How do you read the above table? It is very simple, penetration

resulted in 1st year, low presentation in 2nd year with probability of 0.2 and cash

flow of Rs.80,000, moderate penetration in 2nd year with probability of 0.6 and cash

flow of Rs.2,00,000 and high penetration in 2nd year with probability of 0.2 and cash

flow of Rs.3,00,000 are possible. Similarly you can follow for other cases.

Combining 1st and 2nd year penetration levels together, 9 outcomes are

possible. These are:

S.

No.

1st Year

penetra-

tion

2nd vear

penetra-

tion

1st year

cash

flow

1st year

probability

(P1)

2nd

year

cash

flow

2nd year

proba-

bility

(P2)

Joint pro-

bability

(P1xP2)

1 Low LOW 160000 .3 80000 -2 0.05

2 Low Moderate 160000 .3 200000 .6 0.18

3 Low High 160000 .3 300000 .3 0.06

4 Moderate Low 220000 .4 260000 .3 0.12

5 Moderate Moderate 220000 .4 300000 .4 0.16

6 Moderate High 220000 .4 320000 -3 0.12

7 High Low 300000 .3 320000 .1 0,03

8 High Moderate 300000 .3 400000 .8 0.24

9 High High 300000 .3 480000 .1 0.03

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At this stage, we may go for present value evaluation of these set of

outcomes. And this is done below. For this we require a discounting rate. Let take a

10% discount rate. Then the present value of Rs. 1 receivable at 1st year isRs.0.909

(i.e. 1/1.1) and at 2nd year end is Rs.0.826 (i.e., 1/1.12). Now the resent values of

the 9 cash flow streams can be worked out. These values, the ?V relevant to each

stream (i.e., the aggregate of the present value of the two flows of each stream

minus investment Rs.4,00,000), joint probability (i.e., luct of probabilities of the two

cash flows of each stream) and expected lue of NPV (i.e., joint probability times

NPV of each stream) are given below liable 4.5.

Table 4.5

S.No. PVofi*

year

flow

PVof 2nd

year

flow

PV of both

year flows

NPV of each

stream

Joint

Prob.

Expected

NPV.

(1) (2) (3) (4) =

(2)+(3)

(5)=(4)-

400000

(6) (7)=(5) (6)

1 145440 50080 195520 -204480 0.06 - 122691

2 145440 165200 310640 - 89360 0.18 - 16085

3 145440 247800 393240 - 6760 0.06 - 403

4 199980 214760 414740 14740 0.12 1709

5 199980 247800 447780 47780 0.16 7645

6 199980 264320 464300 64300 0.12 7716

7 272700 264320 537120 137130 0.03 4111

8 272700 330400 603100 203100 0.24 48744

9 272700 346920 619620 219620 0.03 6889

Total 1.00 47395

The expected NPV of the project is negative at Rs. 12269 if low

penetration prevailed both in the 1st and 2nd year and this has a probability of 6 out

of 100 or .06. The expected NPV is negative at Rs.16085, if low penetration in 1 st

year and moderate penetration in 2nd year prevailed and the probabilit this

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happening is 18%. S.No.8 tells that NPV of Rs.48744 with probability of 24% is

possible when high penetration in first year and moderate penetration in the 2 year

result. The expected NPV of the project is the aggregate of the expected NPVs of

the different streams == Rs.47395. Since, it is positive, the project may be taken

up.

4.10 CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM) is one of the premier methods of

evaluation of capital investment proposals. CAPM gives a mechanism by which the

required rate of return for a diversified portfolio of projects can be calculated given

the risk. According to CAPM the required rate of return comprised of two parts:

first, a rise-free rate of return and second a risk premium for the amount of

systematic risk of the portfolio. The formula is:

Required rate of return = Rf + (Rm- Rf) B when

Rf - risk free rate of return

Rm - return on market portfolio

Bi - Beta or risk coefficient of the evaluated portfolio given market portfolio beta= l.

CAPM, therefore, gives a risk-return relationship for portfolio of

projects.

4.10.1 CAM technique for evaluating capital projects

Just we have to calculate the required rate of return for the capital project

given its beta coefficient, risk free return and market return. Then get the

estimated return for the project. If the estimated return for the project is greater

than or equal to the required rate of return accept the project Otherwise reject

the project.

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The risk-free return is the rate of cejurp obtainable on risk free

investments, like investment in government bonds.

The market rate of return is the grand average rate of return

obtainable on market representative portfolio. A surrogate for this can be return of

representative market indices like NASDAG, DOW JONES INDUSTRIAL, 500, BSE

SENSEX (India), and the like.

Beta of the project -covariance between returns of the project and

chosen market portfolio divided by variance of the return on the market portfolio.

The returns referred to here can be historical or future expected or both. So, given

the returns (expected or actual) of the market portfolio over a period of time and

those of the capital project over the same time horizon as above, beta of the

project can be calculated. The formula is :

Beta = Σ (Rm-MRm) (Ri- MRi)/ Σ (Rm – MRm)2

When Rm = return on market portfolio over times

MRm = mean return on market portfolio

Ri = returns on the capital project over times

MRm = mean return of the capital project

Suppose the following are the R^ and Ri for 5 years given in rows (i)

and (ii) below. Beta is computed based on the above formula as given in the rest of

the rows below :

1 2 3 4 5 Total

i) Rm 14 16 10 22 -2 60

ii) Ri 15 18 15 28 -6 70

iii) Rm- MRm 4-2 +4 -2 +10 -14 0

iv) Ri-MRi 1 4 1 14 -20 0

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v) = (iii) (iv) 2 16 -2 140 280 1

vi) (Rm- MRm)2 4 16 4 100 196 320

MRm = 60/5 -12 and

MRm = 70/5 -14

β = Beta = Σ (Rm- MRm) (Ri-MRi)/ Σ (Rm- MRm)2

= 436/320=1.365

Let Rf = 8%

Required rate of return = Rf + (MRm - MRi) β

= 8% + (12% - 8%) 1.3625

= 8% + 5.45% =13.45%

The mean Ri = 14%. So, the actual or expected return is greater than

the required return. This project can be accepted.

CAPM assumes perfect capital market, free flow of information,

homogenous risk-return expectations of investors, that diversification thoroughly

reduces the unsystematic risk, existence of representative market portfolio and

soon.

4.11 SIMULATION ANALYSIS

When uncertainly haunts in the estimation of variables in a capital

budgeting exercise, simulation technique may be used with respect to a few of the

variables, taking the other variables at their best estimates.

We know that P, V, F, Q, T, K, I, D and N are the important variables. (P

- Price per unit of output, V - Variable cost per unit of output, F -rixed cost of

operation, Q - Quantity of output, T - Tax rate, K - Discount rate cost of capital, I -

Original investment, D - Annual depreciation and N -iber of years of the project's

life).

BSPATIL

Suppose in a project, P, V, F, Q, N and I are fairly predictable but ‘K’

and ‘T’ are playing truant. In such cases, the K and T will be dealt through nulation

while others take given values.

Suppose that P= Rs.300/unit, V - Rs. 150/unit, F =

Rs.15,00,000/p.a, Q - 20,000/p.a, N - 3 years and I = Rs. 18,00,000. Th0en lual

profit before tax - [(P-V)Q] - F - D = [(300-150)* 20000] - 15,00.000 -),6,00000 =

Rs. 9,00,000/p.a.

The profit after tax and hence cash flow cannot be computed as tax

rate, T is not predictable. Further as ‘k’ is not predictable, present value cannot be

computed as well. So, we use simulation here.

Simulation process gives a probability distribution to each of the truant

playing variables. Let the probability distribution for 'T' and 'K' be as follows:

T K

Probability Value Probability Value

0.20 30% 0.30 10%

0.50 35% 0.50 11%

0.30 40% 0.20 12%

Next, we construct cumulative probability and assign random number

ranges, as follows separately for T and K. Two digit random number ranges are

used. We start with 00 and end with 99, thus using 100 random numbers. For the

different values of the variable in question, as many number of* random number as

are equal by the probability values of respective values are used. Thus, for variable

T, 20% of random numbers aggregated for its first value. 30% and 50% of random

number for its next value 35% and 40%.

BSPATIL

Table 4.6 : Cumuiative Probability and Random Number range

Value Profitability Cumulative

profitability

Random

no. range

Value Profitability Cumulative

profitability

Random

no. range

30% 0.20 0.20 00-19 10% 0.30 0.30 00-29

35% 0.50 0.70 20-69 11% 0.50 0.80 30-79

40% 0.30 1.00 70.99 12% 0.20 1.00 80-99

For the first value of the unpredictable variable, we assign random

number 00 to 19. For the second value was assign random numbers 20 - 69 and for

the third value 70 - 99 are assigned. Similarly for the variable ‘K’ random numbers

are assigned. These are given in the above table 4.6.

Simulation process now involves reading from random number table,

random number pairs (one for ‘T’ and another for ‘K’). The values of ‘T’ and 'K'

corresponding to the random numbers read are taken from the above table.

Suppose the random numbers read are: 48 and 80. Then 'T' is 35% as the random

number 48 falls in the random number range 20-69 corresponding to 35% and 'K'

is 12% as the random number 80 falls in the random number range 80-99

corresponding to 12%. No w taking the T- 3 5% and K- 12%, the NPV of the project

can be worked out. We know that the project gives a PBT of Rs.9,00,000 p/a for 3

years. So, the PAT = 9,00,000 - Tax @ 35% = Rs.9,00,000 -3,15,000 = Rs.5,85,000

p.a. To this we have to add depreciation Rs.6,00,000 (i.e. Rs. 18,00,000 / 3 years)

to get the cash flow. So, the cash flow = 5,85,000 + 6,00,000-Rs. 11,85,000p.a

n

NPV = Σ CFt/(l+k)t - I

t = 1

= (11,85,000/1.12+ 11,85,000/1.122+ II,85,000/1.123)-

18,00,000

= 11,85,000 [1/1.12 + 1/1.122 + 1/1. 123]- 18,00,000 –

BSPATIL

= 11,85,000X2.4018-18,00,000

= 28,56,798 - 18,00,000 = Rs. 10,56,798

We have just taken one pair of random numbers trom the table and

calculated theNPVisRs.10,56,798.

This process must be repeated at least 20 times, reading 20 pairs of

random numbers and getting the NPV for values of T and K corresponding to each

pair of random numbers read. Suppose the next pair of random numbers is 28 and

49. Corresponding ‘T’ = 35% and 'K' - 1 1%. Then the PAT = PBT -T - 9,00,000 -

3,15,000 - 5,85,000. The cash flow = 5,85,000 + 6,00,000 -Rs. 11, 85,000.

n

NPV = Σ CFt/(l+k)t - I

t = 1

= (11,85,000/1.11 + 11,85,000/1.1 12 + 11,85,000/1.1 13) –

18,00,000

= (10,67,598 + 9,61,773 + 8,66,462)- 18,00,000

= 28,95,803 - 18,00,000 = Rs. 10,95,803

Similarly the NPV for other simulations be obtained. Thus computed

NPVs may be averaged and if the same is positive the project may selected.

4.12 SENSITIVITY ANALYSIS

Sensitivity analysis attempts to study the level of sensitivity of project

worth, say the NPV, for changes in a key influencing factor, keeping influence of all

other influencing factors at constant level.

Sensitivity analysis presumes uncertainty of the values of all or some

of the influencing factors. For such factors, the range of their values and most

likely values are given. Other factors take constant values.

BSPATIL

We know that NPV of a project is influenced by P, V, Q, F, I, N, D, T and

K. Let F, I, N, D and K are constant at Rs. 15,00,000, Rs. 18,00,000, 3 years,

Rs.6,00,000 and 15% P, V, Q and T are hence the uncertain variables. Let their

range of values and most likely values be as follows:

P : Rs.200-Rs.350; Most Likely value Rs.300

V: Rs.100-Rs.250; Most Likely value Rs.150

Q : 15000-22000; Most Likely value 20,000

T: 30%-40%; Most Likely value 35%

Suppose we want to study the sensitivity of NPV with respect to T. then

other uncertain variables, namely, P, V and Q will be assigned their most likely

values. Needless to say, the variables taking constant values will take their fixed

values. The variable 'T' will be taking different values within the range of its values

for each such values of T, the NPV will be worked out and sensitivity of the NPV to

that factor is analysed.

Accordingly, for our purpose: I = Rs. 18,00,000, N - 3 years, D =

Rs.6,00,000, F = Rs. 15,00,000, k = 15%. P, V and Q at their most likely values:

Rs.300, Rs.150 and 20,000 units. ‘T' shall take different values within its range, say

30%, 32.5%, 35%, 37.5% and 40%. For each of these 5 values of T, NPV will be

worked out and sensitivity of NPV analysed.

First let T be 30%. The annual cash flow is :

= [(P-V)Q - F - D] (I-T) + D

= [(300-150) 20000 - 15,00,000 - 6,00,000] (1-30%) + 6,00,000

= [30,00,000 - 21,00,000] (0.70) + 6,00,000

= 9,00,000 (0.70)+ 6,00,000

= Rs.12,30,000 p.a.

NPV =(12,30,000, 15 + 12,30,000/1.152 + 12,30,000/1.153)- 18,00,000

= 28,08,369 - 18,00,000 – Rs. 10,08,369

Let T be 32.5%, The annual cash flow is:

= [(P-V)Q - F - D] (I-T) + D

=[(30CM50) 20000 - 15,00,000 - 6,00,000] (1-32.5%) + 6,00,000

BSPATIL

= [30,00,000 - 21,00,000] (0.675) + 6,00,000

= 9,00,000 (0.675) + 6,00,000

= Rs. 12,07,500 p.a

NPV = (12,07,500/1.15 + 12,07,500/1.152+ 12,07,500/1.153)- 18,00,000

= 27,56,994 - 18,00,000 = Rs. 9,56,994

Let T be 35%. The annual cash flow is:

= [(300-150) 20000 - 15,00,000 - 6,00,000] (1 -35%) + 6,00,000 =

[30,00,000 - 21,00,000] (0.65) + 6,00,000

= 9,00,000 (0.65) + 6,00,000

= Rs. 11,85,000 p.a

NPV = (11,85,000/1.15 + 11,85,000/1.152 + 11,85,000/1.153)- 18,00,000

= 27,05,622- 18,00,000 = Rs. 9,05,622

Let T be 37.5%. The annual cash flow is:

= [(P-V)Q - F - D] (I-T) + D

= [(300-150) 20000 - 15,00,000 - 6,00,000] (1-37.5%) + 6,00,000

= [30,00,000 - 21,00,000] (0.625) + 6,00,000

= 9,00,000 (0,625) + 6,00,000

= Rs.l 1,62,500 p.a

NPV = (11,62,500/1.15 +11,62,500/1.152 +11,62,500/1.153)- 18,00,000

= 26,54,249 - 18,00,000 - Rs. 8,54,249

Let T be 40%, The annual cash flow is :

= [(P-V)Q - F - D] (I-T) + D

= [(300-150) 20000 - 15,00,000 - 6,00,000] (1-40%) + 6,00,000

= [30,00,000 - 21,00,000] (0.60) + 6,00,000

= 9,00,000 (0.60) + 6,00,000

= Rs. 11,40,000 p.a

NPV = (11,40,000/1.15 + 11,40,000/1.152 + 11,40,000/1.153) - 18,00,000

= 26,02,876 - 18,00,000 - Rs. 8,02,876

You might have noted that as T rises, NPV falls.

Rate of change in NPV for a given change in T.

When T rises to 32.5% (i.e. (0.325) ftom 30% (i.e. 0.3) NPV falls

toRs.9,56,994 fiom Rs.10,08,369.

BSPATIL

ANPV/NPVRate of change = ——————

AT/T.

-51375/10083.69 -0.0509= ————————— = ————— =-0.61

0.025/0.3 0.0833

When T rises to 35% (i.e. (0.35) from 32.5% (i.e. 0.325) NPV falls to

Rs.9,05,622 fix>m Rs.9,56,994.

ANPV/NPVRate of change = ——————

AT/T

= -51372/956994 -0.05368__________________ = ____________ = -0.698 .025/0.325 0.07692

When T rises to 37.5% from 35% NPV falls to Rs.8,54,249 from

Rs.9,05,622.

ANPV/NPVRate of change = ——————

AT/T

= -51373/905622 -0.0567__________________ = ____________ = -0.794 0.025/0.35 0.0714

When T rises to 40% from 37.5% NPV falls to Rs.o,02,816 frc

Rs,8,54,249.

ANPV/NPVRate of change = ——————

AT/T

= -51373/854249 -0.0601__________________ = ____________ = -0.9015 0.025/0.375 0.0667

BSPATIL

The rate of fall in NPV is rising with the rise :r. tax rets. Henc? NPV is

highly negatively sensitive with tax rate.

We can study the sensitivity of NPV to ‘T’ in the form of a graph, taking

NPV on the y-axi^m«d T on the x axis also.

We can do the sensitivity analysis of NPV with respect to another

uncertain variable, say 'P* keeping V, Q and T at their most likely values, other

variables at their fixed values and changing the value of P within its given range pf

values. Similarly, we can do the sensitivity analysis of NPV with respect to V,

keeping P, Q and T at their most likely values, other variables at their fixed values

and changing the value of V within its given range of values. So, also we can

replicate the sensitivity with respect to 'Q'.

Now of the 4 uncertain variables, namely, P, V, Q and T, with respect to

which the NPV is most sensitive can be seen. Knowledge of the same will help

monitoring the project with respect to those variables very ably. Hence the utility

of sensitivity analysis.

Illustration 4.1

A firm is currently using a machine purchased two years ago for

Rs.14,00,000. It has further 5 years of life. It is considering replacing of the

machine with a new one which will cost Rs.28,00,000 cost of installation

Rs.2,00,000. Increase in working capital is Rs.4,00,000. The profits before tax and

depreciation are as follows for the two machines:

BSPATIL

Year 1 2 3 4 5

Current

machine

(Rs)

6,00,000 6,00,000 6,00,000 6,00,000 6,00,000

New

machine Rs)

10,00,00

0

12,00,00

0

14,00,000 18,00,000 20,00,00

0

The firm adopts fixed installment method of depreciation. Tax rate

540% and capital gain tax is 10% on inflation un-adjusted capital gain.

Is it desirable to replace the current machine by the new one, along the

resale value of old machine at Rs. 16,00,000 at present and using, PBP, \RR, NPV

and IRR? (For NPV method take 10% as discount rate, for ARR Dethod cutoff rate is

15% and for PBP method cutoff period is 3.5 years).

Solution

First we have to calculate the size of investment needed. This includes,

purchase cost of new machine, cost of installation and working capital addition

needed, reduced by net sale proceeds (after capital gain tax) of old machine.

The old machine's original cost = Rs. 14,00,000

Depreciation for the past 2 years

@Rs.2,00,000 [14,00,000 + life 7

years]

Rs. 4,00,000

Rs. 10,00,000

It is sold for Rs. 16,00,000

Total Gain Rs. 6,00,000

This gain has two components, capital gain and revenue gain. Capital

gain = Rs. Sale value - original cost - Rs.16,00,000 - Rs.14,00,000 = Rs.2,00,000.

Revenue gain = Total gain-capital gain - Rs.6,00,000 -Rs.4,00,000 = Rs.2,00,000.

BSPATIL

Tax on revenue gain - Rs.4,00,000 x 40% = Rs. 1,60,000. Tax on capital gain

200000 x 10% = 20,000. Therefore, after-tax adjustment, net sales proceeds of old

machine = Rs.16,00,000 - Rs.20,000 -Rs. 1,60,000 - Rs. 14,20,000. Now we can

compute net investment at time zero, i.e. at beginning as follows:

Cost of new machine : Rs, 28,00,000

Add installation cost : Rs. 2,00,000

Cost of machine : Rs. 30,00,000

Add. Addl. Working capital : Rs. 4,00,000

Rs. 34,00,000

Less net sale proceeds of old machine : Rs. 14,20,000

Net investment : Rs. 19,80,000

Now we have to calculate change or increment in cash flow because of

the firm going for replacement of old machine by new one. For this purpose, what

is the cash flow from new machine and what would be the cash flow from old

machine had the firm continued with that must be computed. The difference of

former over the latter is the change in cash flow.

First let us take cash flow from new machine

BSPATIL

Details Year 1 Year 2 Year 3 Year 4 Year 5

PBT&D 1,00,00

0

12,00,00

0

14,00,00

0

18,00,00

0

20,00,00

0

Less

depreciation

6,00,00

0

6,00,000 6,00,000 6,00,000 6,00,000

(30,00,000 » 5)

PBT 4,00,00

0

6,00,000 8,00,000 12,00,00

0

14,00,00

0

Less Tax @ 40% 1,60,00

0

2,40,000 3,20,000 4,80,000 5,60,000

PAT 2,40,00

0

3,60,000 4,80,000 7,20,000 8,40,000

Add depreciation

working capital

recovery

6,00,00

0

6,00,000 6,00,000 6,00,000 6,00,000

4,00,000

(1) Cash flow 8,40,00

0

9,60,000 10,80,00

0

13,20,00

0

18,40,00

0

Second, let us take cash flow from old machine

Details Year l Year 2 Year 3 Year 4 Year 5

PBT & D 6,00,00

0

6,00,000 6,00,000 6,00,000 6,00,000

Less

depreciation

2,00,00

0

2,00,000 2,00,000 2,00,000 2,00,000

(14,00,000 » 5)

PBT 4,00,00

0

4,00,000 4,00,000 4,00,000 4,00,000

Less Tax @ 40% 1,60,00

0

1,60,000 1,60,000 1,60,000 1,60,000

PAT 2,40,00

0

2,40,000 2,40,000 2,40,000 2,40,000

Add depreciation 2,00,00

0

2,00,000 2,00,000 2,00,000 2,00,000

BSPATIL

(2) Cash flow 4,40,00

0

4,40,000 4,40,000 4,40,000 4,40,000

Increment cash

flow = (l)-(2) 4,00,00

0

5,20,000 6,40,000 8,80,000 14,00,00

0

Cumulative

A cash flow 4,00,00

0

9,20,000 15,60,00

0

24,40,00

0

38,40,00

0

Payback period (PBP) method evaluation

Fresh additional investment needs is Rs. 19,80,000. Upto 3 years from

now, Rs. 15,60,000 cumulative cash flow is got. So, PBP is 3 years plus that fraction

of 4th year to recover balance Rs.4,20,000 (i.e. Rs. 19,80,000 -Rs. 15,60,000). The

fraction of year - 4,20,000 / 8,80,OU « 0.4772 a year. So, pay back period - 3.4772

years or 3 years and 5.8 months. The project's PBP of 3.4772 years is less than the

cut off period of 3.5 years. So, replacement is advisable.

ARR method of evaluation

For ARR method, we have get incremental PBT. This is computed as

follows.

Year 1 Year 2 Year 3 Year 4 Year 5

PBT: New Machine 4,00,00

0

6,00,000 8,00,000 12,00,00

0

14,00,00

0

PBT: Old machine 4,00,00

0

4,00,000 4,00,000 4,00,000 4,00,000

APBT 0 2,00,000 4,00,000 8,00,000 10,00,00

0

Annual average APBT = Σ PBT/5 = 24,00,000 / 5 = Rs.4,80,000 Average

investment = (Investment + Working capital) / 2

BSPATIL

= (19,80,000 + 4,00,000) / 2 =1 1 ,90,000

ARR = (4,80,000 / 1 1,90,000) X 100 = 40.34%

Note: Working capital Rs.4,00,000 introduced at the beginning is recoverable at the

end of the last year and this is treated as salvage value.

NPV method of evaluation (Discount rate 10%)

NPV = nΣ CFt/(l+k) t I

t=1

=(4,00,000/1.1+5,20,000/1.12+6,40,000/1.13+8,80,000/l.14+14,00,000/1.15)-

19,80,000

= (3,63,636 + 4,29,752 + 4,80,841 +6,01,051+8,69,296)- 19,80,000

= 27,44,576 - 19,80,000 = Rs. 7,64,576

As NPP > 0, replacement is advised.

IRR method of evaluation

NPV at 10% discount rate is +ve. This itself shows that the IRR > 10%.

So, the replacement is advised. Any how, we can calculate IRR too. Let us take the

assumed IRR as 20%. At 24%, the NPV is: 20,51,826 - 19,80,000 = 71,826. So, IRR

is still higher. Let using at 22% as assumed IRR. The NPV = 19,44,920 - 19,80,000 -

- 35,080. Since the NPV at 22 is negative and at 20% it is positive, ERR is > 20%

but < 22%. We can interpolate as follows:

IRR = 20% + (71 826/(71826+35080))x2% = 20% + 1.34 = 21.34%.

As the IRR at 21.34% is > cut-off IRR of 10%, replacement is advised.

Illustration 4.2

A company brought a machine 2 years earlier at a cost of Rs.60,000

and estimated useful life of 12 years in all. Its current market price is Rs.25,000.

BSPATIL

The management considers replacing this machine with a new one, life 10 years,

price Rs. 1,00,000. The new machine can produce 15 units more per hour. The

annual operating hours are 1000 both for new and old machines. Selling price per

unit is Rs.3. The new machine will involve addl. Material cost by Rs.6,000 and

labour by RS.6,000 p.a. But savings in cost of consumable stores of Rs. 1000 and

repairs of Rs.lOOOp.a. will result. The corporate tax rate is 40%. Advice on the

replacement assuming additional working capital of Rs. 10000 introduced now, can

be redeemed at 10 years later, cost of capital as 10% and SLM of depreciation,

using NPV method.

BSPATIL

Solution

i) Computation cash outflow at present

Cash of new machine : Rs. 1,00,000

Add: Addl Working capital : Rs. 10,000 1,10,000

Less: Sales value of old machine : Rs. 25,000

Tax shield on loss of old

Machine (book value

-Market value) x tax rate

[(50000-25000)x40%] Rs. 10,000 35,000

75,000

ii) Computation of Addl. Gross income

Addl. Production per annum = Hours of operation x Addl. Output

= 1000x15=15,000

Addl. Gross income per annum = Addl. Production p.a x unit price

= 15,000 x Rs.3 = Rs.45,000

From 1 year to 10th year, Rs.45,000 addl. Income is thus predicted.

iii) Cash flow computation

Details Year 1 to

9

Year 10

Addl. Gross income 45,000 45,000

Add. Savings in consumable stores & repairs 2,000 2,000

47,000 47,000

Less: Addl. Material & labour cost 12,000 12,000

PBD&T 35,000 35,000

Addl. Depreciation (10000 - 5000) 5,000 5,000

PBT 30,000 30,000

BSPATIL

Less Tax @40% 12,000 12,000

PAT 18,000 18,000

Addl. Depreciation 5,000 5,000

Add : Working capital recovery - 10,000

Cashflow 23,000 33,000

NPV = ∑ CFt/(l+k)t + CF10/(l+k)10- I

t = 1

Since uniform cash flow is found throughout 1st to 9th years, the NPV formulates can

be slightly modified as:

NPV = [ACF ∑ 1/(1+k)t + CF10 X 1 (1+k)10] - I

= 23000[1/1. 1 + 1/1. 12 +……… 1/1.99]33000 x1/1. 110-75000

= (23000 x 5.759) + (33000 x 0.386) - 75000

= 145195 - 75000 = Rs. 70195

The replacement is advised.

Illustration 4.3

A company has 3 investment proposals. The expected PV of cash flows

and the amount of investment needed are as below:

Projects Investment required PV of cash flows

1 Rs. 2.00 lakhs Rs. 2.90 lakhs

2 Rs. 1.15 lakhs Rs. 1.85 lakhs

3 Rs. 2.70 lakhs Rs. 4.00 lakhs

BSPATIL

If projects 1 and 2 are jointly taken, there will be no economics or

diseconomies. If projects 1 and 3 are undertaken, economics result in investment

and combined investment will be Rs.4.4 lakhs. If 2 and 3 are combined, the

combined PV of cash flow will be Rs.6.2 lakhs. If all the 3 projects are combined, all

the above economics will result but diseconomy in the form of additional

investment of Rs.1.25 lakhs will be needed. Find which project projects be taken.

Solution

Projects Invt. Needed PV of cash flows NPV

1 2,00,000 2,90,000 90,000

2 1,15,000 1,85,000 70,010

3 2.70,000 4,00,000 1,30,000

1&2 3,15,000 4,75,000 1,60,000

1&3 4,40,000 6.90,000 2,50,000

2&3 3,85,000 6,20,000 2,35,000

1,2&3 6,80,000 9,10,000 2,30,000

Projects 1 & 3 will be chosen as NPV is higher.

4.13 RISK ANALYSIS IN THE CASE OF SINGLE PROJECT

Project risk refers to fluctuation in its payback period, ARR, IRR, NPV or

so. Higher the fluctuation, higher is the risk and vice versa. Let us take NPV based

risk.

If NPV from year to year fluctuate, there is risk. This can be measured

through standard deviation of the NPV figures. Suppose the expected NPV of a

project is Rs. 18 lakhs, and std. deviation of Rs.6 lakhs. The coefficient of variation

C V is given by std. deviation divided by NPV.

BSPATIL

C. V = Rs.6,00,000 / Rs. 18,00,000 - 0.33.

4.14 RISK RETURN ANALYSIS FOR MULTI PROJECTS

When multiple projects are considered together, what is the overall risk

of all projects put together? Is it the aggregate average of std. deviation of NPV of

all projects? No, it is not Then what? Now another variable has to be brought to the

scene. That is the correlation coefficient between NPVs of pairs of projects. When

two projects are considered together, the variation in the combined NPV is

influenced by the extent of correlation between NPVs of the projects in question. A

high correlation results in high risk and vice versa. So, the risk of all projects put

together in the form of combined std. deviation is given by the formula:

σp = [∑pij σi σj]1/2

where,

σp - combined portfolio std. deviation

pij - correlation between NPVs of pairs of projects

σi σj - std. deviation of iin and jth projects, i.e., any pair of projects taken at a time.

Three projects have their std. deviations as follows: Rs.4000, Rs.6000

and Rs.10000. The correlation coefficients are 1&2 : 0.6, 1&3 : O.V and 2&3 : -0.5.

What is the overall std. deviation of the portfolio of projects?

σp = [∑pij σi σj]1/2 = [σ12 +σ2

2 +σ3

2 +2p12 σ1 σ2+ 2p23+σ2 σ3 +2p13+ σ1 σ3] 1/2

=[40002+60002+100002 + 2x0.6x4000x6000 +2x0.78x6000x10000+

2x (-0.5)x 10000 x 4000]1/2

= 6000000+36000000+100000000+28800000+93600000-4000000]1/2

= [234400000]1/2 = Rs. 15,310

What is the return from these multiple projects? This is simple. It is the

aggregate NPVs. Suppose the three projects have NPVs of Rs. 16,000, Rs.20,000

and Rs.44,000. The combined NPV = 16000 + 20000 + 44000 = Rs.80000.

BSPATIL

The combined coefficient of variation = combined std. deviation

combined NPV - Rs.15340/Rs.80000 = 0.19 - 19%. If we take the correlatiol factor

unadjusted figures of combined std. deviation and combined NPVs, thi coefficient

of variation would have been: 20000/80000 = 0.25 = 25%. Thi factor has resulted

in reducing overall portfolio risk from 25% to 19%. This results essentially when

there is low degree of correlation among the projects. More so if there is higher

negative correlation among the projects.

Illustration 4.4

Three projects involve an outlay of Rs.2,00,000, Rs.3,00,000 and

Rs,5,00,000 respectively. The estimated return from the projects are 14%, 16%

and 20%. The std deviation of returns are 5%, 10% and 10%. The correlation

coefficients are 1&2 : 0.4,2&3 : 0.6 and 1&3 : 0.2. Find the portfolio return and risk.

Solution

The portfolio or combined return is simply the weighted return of

projects. This is given by: ∑wi Ri where wi - is the weight (0.2, 0.3 and 0.5 fee three

projects respectively) and Ri - is the respective project return.

Portfolio return = (wiRi

= 0.2x14% + 0.3x16% + 0.5x20%

= 2.8% + 4.8% + 10% = 17.6%

Portfolio risk = [(wi wj pij (i (j]]1/2

= [w1w1(1(l + w2w2 (2(2 + w3w3(3(3 +

2w1w2(12 (1(2 + 2w2w3(23 (2(3 +

2w1w3(13(1(3]l/2

[Putting the given values, we get that,

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σp = [0.2 + 0.9 + 2.5 + 2.4 + 18 + 2]1/2

= [25]1/2 = 5.099%

4.15 SUMMARY

Capital budgeting essentially involves evaluation of the worth of capital

investment proposals based on estimates of cash inflows and outflows. It is

scientific exercise and uses several techniques. PBP, ARR, NPV and IRR are

certainty techniques. CAPM, sensitivity analysis, simulation analysis, decision tree

technique etc. are techniques of evaluation used under conditions of risk and

uncertainty. CAPM technique can be used for single as well as a portfolio of

projects. For a portfolio of projects, overall return (in NPV or IRR mode) and overall

risk (in the form of std. deviation Af NPV or IRR) can be computed to judge the

efficiency of the portfolio.

4.16 SELF ASSESSMENT QUESTIONS

1. Bring out the meaning and significance of capital projects

2. Explain various tools of evaluation of capital investment projects.

3. Calculate pay-back period, ARR, NPV (at k=10%) and IRR given

Years 1 2 3 4

PBT (Lakhs Rs 40 45 50 55

Tax Rate 45% 40% 5% 35%

4. Using decision tree approach find the expected NPV of the project given the

following cash flows:

Time zero Time 1 Time 2

10 lakhs 6 lakhs P. (.6) 4 lakhs P. (.6)

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5 lakhs P. (.4)

10 lakhs P. (.4) 6 lakhs P. (.4)

2 lakhs P. (.6)

The cost of capital is 10%

P = Probability

5. For two mutually exclusive projects the projected cash flows are:

Period Project A Project B

Time zero (outflow) Rs.2,20,000 Rs.2,70,000

1 to 7 years (inflow each

year)

Rs. 60,000 Rs. 70,000

using IRR method, find the better of the two (an annuity of the I fa 7 years

has a present value of Rs.3.92, Rs.3.81, R13.91 and Rs.3.60 at 17%, 18%,

19% and 20%).

6. Machine A costs Rs. 10,00,000 payablej immediately, while Machine B

costing Rs. 12,00,000 can be paid Rs.6,00,000 down and balance 1 year

hence. The cash flow from the machines are:

Year 1 2 3 4 5

A (Rs. in lakhs) 2 6 4 3 2

B (Rs. in lakhs) Nil 6 6 8 Nil

At 7% discount rate which is better by NPV?

7. Texas filaments ltd has the following figures for its expansion plan, involving

a capital outlay of Rs.5 crs.

Year 1 2 3 4

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Unit selling price (Rs.) 7.0 10.0 12.0 15.0

Addl. Sales quantity

(Crs)

0.9 0.95 1 1.05

Unit variable cost (Rs) 4.0 5.0 6.5 8.0

Tax rate 30% 30% 35% 35%

Find the PBP and ARR of the expansion project.

8. A project has an equity beta of 1.2 and debt beta zero and is a have a debt -

equity ratio of 3:7. Given risk free rate of return of 10% and market return of

18%, Find the required return for the project per CAPM.

9. The P, V, Q,F, I, T and K of a project are as follows:

P = Rs. 300; Investment I = Rs. 20,00,000; N - 4 years, K - 10%, T = 30%

fixed cost (excluding depreciation) = Rs. 15,00,000. The quantity of sales (a)

is a sensitive factor with the range 12,000 to 20,000 with most likely value

17000. Similarly, variable cost, V, is a sensitive factor with range Rs.130 to

Rs.180, with most likely value of Rs.160 per unit perform sensitivity analysis

w.r.t. quantity and variable cost

10. A project's cash flow, life and discount rate have the following probability

distribution.

Cashflow Prob. Life Prob. Dis. Rate Prob.

Rs.5 crs .20 2 .25 9% .22

Rs.8 crs .72 3 .45 10% .66

Rs.10 crs 08 4 .30 12% .12

Perform simulation of PV of cash flow for five runs taking the following

random number sets: i) 12, 18, 82; ii) 70, 38, 48; iii) 78, 02, 49; iv) 22, 18,79;

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v) 65, 92, 36. If the project outlay is Rs.18 crs, find the expected NPV of the

project.

REFERENCES

1. Financial Management and Policy - Van Home

2. Financial Decision Making - Hampton

3. Management of Finance - Weston and Brigham

4. Financial Management - P.Chandra

* * * * * *

UNIT-V

COST OF CAPITAL AND CAPITAL STRUCTURE

In this unit you will learn concepts of cost of capital, methods of

computing cost of capital for a specific and combination of sources of capital,

concept of capital structure, theories of capital structure, optimum capital structure

and related issues.

INTRODUCTION

Cost of capital and capital structure are important aspects as far as the

financing of a business. Cost of capital influences the choice of capital structure as

well. Cost of capital even influences the choice of investments or projects of a

business. Capital structure has a bearing on value of the business. Hence the

significance of the cost of capital and capital structure.

5.1 COST OF CAPITAL

Capital, like all resources, involves a cost. Business organizations when

mobilizing capital incur cost and later when serving the capital incur servicing cost.

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The former known as floatation cost is one-time and includes underwriting and

brokerage commission, cost of printing and vetting of prospectus, financial

advertisement costs, etc. Floatation cost accounts for 3% to J% of issue size, it is

said. Higher the issue size less is the floatation cost varies. In boom sentiments the

cost is lower and vice versa. The servicing cost is recurring and includes dividend,

interest etc. paid periodically. While interest rates are fixed and payment of

interest is compulsory, dividend rates are varying and dividend payment is not a

legal binding on the management. Yet, companies pay dividend lest share price

shall fall. Cost of capital is computed considering the above factors. The

components of cost of capital consist of risk-free rate premium for financial risk,

premium for business risk and the like.

5.1.1 Concepts of cost of capital

There are several concepts of cost of capital Cost of capital is the

minimum return expected by investors in financial investments. The minimum

return expected by debenture holders is the cost of debt, by the shareholders is

the cost of equity and so on. The fiim must provide this minimum return in order to

enthuse the public to subscribe to the debentures or shares, as the case may be.

Cost of capital is the minimum return that should be earned by a business (so as to

be in a position to satisfy the providers of capital). If 16% return is expected by

investors in bonds of a company, the company must earn at least 16%on the funds

mobilized through issue of bonds. Hence minimum return expected by investors

and minimum return to be earned by a company both mean one and the same.

Cost of capital may refer to specific cost or combined cost of

capital. Specific cost of capital refers to cost of each component of capital, like

share capital, debt, etc. combined cost of capital is the overall cost of all funds

employed by a business.

Actual and imputed cose concepts need to be looked into. Actual

cost of capital refers to the out of pocket cost of capital. In the case of debentures

payment of interest is an actual expenditure. So cost of debenture is generally

actual as to shares in the initial years dividend payment may not be there. But a,

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capital appreciation might be there in the stock market due to potentials of the

scrip. So, equity capital in this context has an inputted

Cost of capital may be of the opportunity cost type. The retained earnings

belong to shareholders but are not capitalized. Yet, they involve a cost, an

opportunity cost which means what the shareholders could have earned had these

been distributed as dividend or capitalized by means of bonus share issue.

Cost of capital may be marginal cost and average cost. Marginal

cost is the cost of additional capital that may be raised, whereas average cost is

the combined cost of total capital employed.

Cost of capital can be pre-tax or post-tax cost. Debenture interest is

deducted while computing income for tax purposes. So, debentures’ post-tax cost

is lower than pre-tax cost. Accordingly, overall cost of capital also can be classified

into pre-tax and post-tax overall cost of capital.

Cost of capital may be explicit or implicit cost. Explicit cost o capital

is similar to out-of-pocket cost It is an accounting cost. Implicit cost hidden and it

may not involve actual payment and hence may not be directly accounted for.

Cost of capital may be classified into past and future costs. Post cost is

irrelevant for decision making, while future cost is relevant. For funds raised

already the floatation cost is a past cost, whereas future interest/ iividend

commitments are future cost. /

5.1.2 Computation of cost of capital

Now computation specific and overall cost of capital is attempted.

5.1.2.1 Cost of debt (K, or Kb)

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Debt capital is a predominant method of corporate financing. Debt may be

short-term or long-term debt. Short term debt takes over several forms like bank

loan, bank cash credit and bank overdraft, trade credit, bill discounting, etc. The

rate of interest applicable to bank loan, cash credit, overdraft and bill discounting

is the pre-tax cost of those credit forms. The post tax cost of these forms of

financing is obtained by multiplying pre-itax cost of capital by (1-Tax rate)

5.1.2.1.1 Cost of trade credit

Regarding trade credit, the supplier may prescribe a payment term

such as, 5/30, net 60 days which means, a cash discount of 5% if payment is made

within 30 days, else full payment by the 60th day. It means on a transaction of Rs.

100, Rs. 95 payment is enough if payment is made by 30ih day, otherwise Rs. 100

be paid by the 60th day. That is, failing to pay Rs. 95 by 30th day, entails payment

of Rs. 100 by 60th day, or Rs. 5 interest for 30 days, on a capital of Rs. 95. So,

interest rate comes to : 100 x 5 x 360 /95 x 30 = 63%. Failing to take advantage of

cash discount results in heavy interest cost. This is an opportunity cost.

5.1.2.1.2 Cost of Debenture

Debentures are debt instruments. These are issued by companies with

interest rate coupon depending on the market rate of interest and the credit rating

of the issuing company.

Suppose irredeemable debentures of Rs, 100 with a coupon of 14% are

issued by a company at a net issue price of Rs.98, The company pays 40% tax. The

pre tax and post tax cost of debentures can be computed.

Coupon Interest

Kd (Pre-tax) = ———————————— x 100 x 100 =14.3%

Net Price

Kd (Post-tax) = Kd (Pre-tax) x (1-Taxrate)

= 14.3% (1 – 4)

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= 8.58%

For redeemable debentures the cost of debt is computed differently.

Let the net issue price be Rs. 98 and redemption price after 8 years be Rs. 102.

The coupon rate is 17% p.a, then the cost of debt will be:

Actually, the above formula is an approximation of the formula:

Annual Coupon Interest + Redemption Premium/

No. of years to redemption)Kd(Pre-tax) = ________________________________________________ x 100

(IssuePrice + Redemption Price)/2

Rs. 17 + (102-98)/8 Rs.17.5= _______________________ x 100 = _________ x 100 =17.5%

(98+100)/2 100

Actually, the above is an approximation of:

Rs.17 Rs.17 Rs.17 Rs.100

Rs.98 = (1+r) + (1+r) +……+ (1+r)8 (l+r)8

Where ‘r’ is the pre-tax cost of debt This is the present value model.

The general form is:

I1 I2 I3 In AP = + + +….+ +

(l-r) (1+r)2 (1+r)3 (1+r)n (1+r)n

Kd (Post-tax) = Kd (Pre-tax) (I -Tax rate)

= 17.5% (1-40%) - 17.5% (0.6)

= 10.5%

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Where interest payments are made semiannuaJly or quarterly, the effective

cost will be slightly higher. Assuming a semi-annual interest payment and using

the present value model, the pre-tax cost of debt is the value of ‘r’ in the formula.

Rs.8.5 Rs.8.5 Rs.8.5 Rs.8.5

Rs.98 = + +……..+ + (l-r/2)

(1+r/2)2 (1+r/2)16 (1+r/2)16

The general form here, is :

I I2 I3 In AP = + + +….+ +

(l-r/2) (1+r/2)2 (1+r/2)3 (1+r/2)n (1+r/2)2n

Cost of debt that we have seen is the explicit or out of pocket cost.

There may be an implicit cost due to restrictive covenants imposed, bankruptcy

cost in the event of forced winding up and so on. Explicit cost varies with credit

standing and market factors. With higher credit rating, larger issue size and

booming market sentiment, explicit cost decreases and vice versa.

5.1.2.1.3 Cost of Term Loans

The pre-tax cost of term loans is the combinational interest rate/ [The

post-tax cost is pre-tax rate multiplied by (1-tax rate).

Cost of Preference Shares (Kps)

In the case of irredeemable preference shares, the cost of capital is

given by

Coupoon dividedKps = ______________________________

Issue Net Price

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Say Rs. 200 face value preference shares carry a dividen4 rate of 1 5%

p.a. Issue expenses amounted to 3%. Then the Kps is :

Rs.30 30 ——————— X 100 = _________

(Rs.200-3%) 194

No tax benefit is available to the company on preference dividend paid.

Hence 1 5 .4% is the effective cost. Sometime back dividend tax was levied. This

enhanced the cost of preference share capital.

If the preference shares are redeemable preference shares,

adopting the present valuation model, cost of preference share can be computed

by solving for ‘r’ in the usual equation:

D1 D2 Dn AP = ————— + ———— +..... + ————— + ————— (l+r/2) (l+r/2)2 (l+r/2)n (l+r/2)n

Where, P = net issue price, Dl, D2, ... Dn are dividends for 1st through

nth years, A = redemption price, n = number of years to maturity and r discount

rate (ie., the cost of capital). An approximation for the above model is

Redemption Premium

D+ —————————————

No. of years to maturity

Kps = ———————————————— x 100

(Issue price + Redemption price)/2

Let us take an example. Issue Price (P) = Rs. 96. Coupon dividend is

17% Redemption at a premium of 2% after 6 years. Then

Rs.l7 + (102-96)/6 18 x 100

Kps = ————————————— x 100 = —————— = 18.2%

(Rs.96+102)/2 99

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5.1.2.2 Cost of Equity (Ke)

There are several cost models relating to equity capital. These are

dividend approach, dividend plus growth approach and earnings approach. These

are explained below.

5.1.2.1 D/P Approach

Dividend Approach (D/P), assumes a constant dividend per share (DPS)

continually for an infinite period. Then Ke = D/P, where ‘D’ is the fixed [DPS and ‘P’

is current price. A company’s equity share gives Rs. 5 dividend p.a. an infinite time

to come and its price is Rs. 50 at present. Then Ke (D/P) x 100 = (5/50) x 100 -

10%. Constant dividend model is not realistic. Hence the above method lacks

practical significance.

1.2.2.2 D/P + g Approach

Dividend plus growth (D/P + g) approach assumes a constantly ig

dividend, at ‘g’ rate p.a. Here, K = (D1/P) + g, where D1 is the dividend ted one

year from now, P is the current price and 'g1 is the annual growth lividend expected

to contanue infinitely.

Let’s take a case. A company has declared Rs. 1.00, Rs. l.10 and Rs.

1.21 for the past three years. The current market price is Rs. 12. The cost of equity

is Ke = (D1/P) + g.

A look at the annual dividends of the past indicates a 10% in dividend.

So, ‘g’ = 10% D1 = Dividend one year hence = Rs. 1.21 + 10% Rs. 1.21 +.121 =

Rs. 1.331. So,

Rs.1.331Ke = _______________ x 100 + 10% = 11.1% + 10% = 21.1%

12

5.1.2.3 Cost of Convertible Debentures (K«i)

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Cost of convertible debentures is to be calculated adopting present

value model. Present value of interest payable upto conversion and present value

of shares that may be allotted on conversion should be equated to issue price of

the convertible debenture. The discount rate that equates the two is the cost of

convertible debenture.

A company has issued convertible debentures carrying a coupon rate

of 12% p.a, at a net issue price of Rs. 90 (ie., at 10% discount). After three years

each convertible debenture is to be converted into an equity share. The equity

dividends for the last three years were Rs. 5, Rs, 5.50 and Rs. 6.05 and the; current

market price is Rs. 80.

To find the cost of convertible debenture we must know the of shares

that will be given at the end of the 3rd year in lieu of the debent. That is equal to:

Expected dividend 4 years hence. And this is equal to D4 g.K-(DI/P) + g.

Dl = dividend per share one year hence = Last year dividend growth

for 1 year. Growth, g - 10% p.a (you can easily know this by a glance over the past

DPS, viz., Rs. 5, Rs. 5.5 and Rs. 6.05. So, Dl = Rs. 6.05 + 10% Rs. 6.66. Ke = Rs.

(6.66/Rs. 80) x 100 + 10% = 8.3% + 10% = 18.3%. Expected dividend 4 years

hence = Rs. 6.05 (1 + g) 4 = Rs. 6.05 x (1.1)4 = Rs. 8.87. Value of the share at the

time of conversion = 8.87 / (18.3% -10% = Rs. 8.37 / 8.3% = Rs. 107.

Now we can use the present value model to get the convertible

debentures. As per the model, current net issue price is the value of future cash

earnings in the form of interest for 3 years and value share receivable at the end of

3rd year from now. That is:

I I2 I3 107Rs. 90 = _________ + _________+ _________ + _________ or,

(1+r) (1+r)2 (1+r)3 (1+r)3

Rs.12 Rs.12 12 107Rs. 90 = _________ + _________+ _________ + _________

(1+r) (1+r)2 (1+r)3 (1+r)3

where ‘r’ = cost of convertible debenture. We can get the value of Y by trial and

error method. It may be arrived at through the approximation formula as well.

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I + (Premium / No. of Years) 12 + (107-90)73KCD = ___________________________________________x 100 = ————————— x100 (90+107)/2

Average of issue and redemption price

12 + 5.67 17.67 17.67= ________________ X 100 = ________ x 100 =18%

98.5 98.5

5.1.2.4 Cost of Retained Earnings (Kr)

Retained earnings are accumulated profits and free reserves belonging

to equity shareholders. Though it has no explicit cost, opportunity cost is involved.

It is not cost free, though it may appear to be so. The business musi earn at least

what the shareholders can earn on this sum if it is distributed as dividend. Say a

company has Rs. 10,00,000 retained earnings. Assume it declares the whole sum

as dividend. The shareholders receive dividends Rs. 10,00,000. But they are

assessed to tax on the dividends. Let us assume the marginal rate of taxation of

the shareholders is 30%. So, 30% of Rs. 10,00,000 is paid as tax. So only a sum of

Rs. 7,00,000 is left with the shareholders. Let us assume they invest in various

financial assets earning an overall return of 18% p.a. Cost of investment amounted

to 3%. That is, of the Rs. 7,00,000, 3% is spent on incidentals to investment and

that only, Rs. 6,79,000 are invested earning 18%. The return would be Rs.

1,22,220. That is, shareholders make an earning of Rs. 1,22,220 on the dividend of

Rs. 10,00,000 received. If the company does not pay dividend, it must at least earn

Rs. 1,22,220 on the Rs. 10,00,000 retained earnings, equal to what the

shareholders can earn. This is the breakeven of parity return. The rate comes to

12.222%. So, Kr = 12.222%.

It can be calculated adopting the formula; Kr = Ke (1-TR) (l-FC), where,

Ke= cost of equity, or minimum return expected by equity investors, TR = marginal

tax rate of shareholders and FC = floatation cost. Kr - 18% (1- 30%) (1-3%) = 18%

(.7) (.97) = 12.222%.

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5.1.2.5 Weighted Average Cost (KJ

When different sources of capital are employed, overall or weighted

average cost of capital can be calculated. This gives an idea about the average

return that the firm must earn on its investment.

To compute the weighted average cost of capital two factors are cost

of individual sources of capital. The latter has been dealt at so far. The former is a

simple concept. But there are several alternatives of weights. Book weights,

market weights and marginal weights are the alternative forms of weights.

Book weights method uses book weight of individual sources of capital.

Book weight = book value of source divided by total book value of all; sources

capital employed. Book weights are definite and historical but devoid of realism as

current market values are not reflected. Hence K0 computed on this basis may lead

to deflated K0 and investment decisions based on such K0 may prove to be fatally

wrong.

Market weights method uses market value based weights individual

sources of capital. Market weight - market value of a source; capital employed

divided by total market value of all sources of employed. Market weights are

realistic, but subject to fluctuation. So, weight based K0 is also fluctuating.

Sometimes market values may not. known. Hence the difficulty.

Formula: K0 = ∑ Wt Kt, where Wt and Kt are respectively the weight and cost of the tth

source of capital

An example may be taken up now to further discuss KO

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Source of capital Cost Book

Value

Market

Value

Rs. Rs

Equity share capital 18% 8,00,000 28,50,000

Retained earnings 15% 10,00,000 —

Pref. Share capital

Debentures

14%

12% 4,00,000 4,50,000

27,00,000

(Tax rate 50%) 28,00,000

50,00,000 60,00,000

The book weight and market weight based KO values are computed

below:

Source Ko.-Book Weight Ko.-Market Weight

(K)(Wt) (K)(Wt)

Eq.share capital 18%x8/50=2.88% 18x285/600=8.55%

Retained earnings 15%x10/50=3.00

%

—

Pref.share capital 14%x4/50=1.12% 14%45/600=1.05%

Debentures 6%x28/50=3.36% 6x270/600=2.70%

K0 10.36% K0 12.30%

(Post-tax Kd = 6% at 50% tax

rate)

Marginal weight method becomes relevant when additional capital is

raised from more than one source, If only one source is used to raise additional

capital, specific cost of that source is the overall cost of marginal capital raised. In

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other situations using marginal weights, the marginal overall cost of capital is

calculated. Acceptance or rejection of new investment proposals is done by

comparing marginal rate of return of the new investment with the marginal cost of

additional capital funding the investment. The marginal ROI should at least be

equal to marginal K0.

A concern is considering an investment proposal requiring an

investment of Rs. 50,00,000 and promising an ROI of 14% Debt capital to the tune

of Rs. 30,00,000 is available at 18% (The tax rate is 45%). Balance of capital is to

be financed through retained earnings. Ke - 25%. Marginal tax rate of share holders

is 20%. Floatation cost is 2%. Can the project be taken up?

Marginal cost of capital = Marginal Wt. + Marginal Wt. Cost

cost debt of retained profit

Marginal cost of debt = 18% (1-45%)= 9.9%

Marginal cost of Kr, = Ke (1-20%) (1-2%)

= 25% (0.8) (0.98) =19.6%

Overall marginal cost = ∑ marginal cost x marginal weight

= 9.9%x0.6 + 19.6%xO.4

= 5.94% + 7.84% = 13.78%

The project's ROI at 14% is greater than the marginal cost of capital at

13.72%. Hence the project may be accepted. As long as marginal ROI > MCC, that

project can be taken up.

5.1.3 Uses of Cost of Capital:

To know whether capital has been mobilised cost effectively, cost of

capital data are useful Cost of capital of firms of like nature can be compared and

efficiency or inefficiency in capital mobilisation can be spotted. Cost of capital is

used as the acceptance - rejection criterion of investment proposals. If the return

on investment is higher than the cost of capital, the proposal is to be accepted and

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vice versa. Cost of capital is the minimum target retum that a firm must earn to

remain in business. Cost of capital should be closely monitored and moderated, if

need be by altering the capital structure, if possible.

5.2 CAPITAL STRUCTURE

Capital structure refers to the portfolio of different sources of capital

employed by a business. It is the mix of capital. It is the portfolio of liabilities of

business. It is the structure of long term liabilities of a business. Short term

liabilities being fluctuating type, for structure analysis, which is some what long

term in nature, are not considered for capital structure analysis. There is another

concept viz., financial structure which studies the structure of whole of the

liabilities of business including both short term and long term capital. In final

analysis, capital structure analysis is considered with the equity and debt

composition of capital of a business.

5.2.1 Capital Structure Planning

The capital structure for a business should be planned. The debt-equity

proposition, mix of equity sources, mix of debt sources and the like need to be

planned. To plan capital structure, therefore, means determining the debt-equity

proportion and mix of individual components of equity (paid equity and earned

equity, that is ratio of paid up equity capital to retained earnings) and mix of debt

capital types (bank loan, debentures, public deposits, etc.,) so that the firm is

optimally capitalized. Optimum capital structure is one that maximizes value of

business, minimizes overall cost of capital, that is flexible, simple and futuristic,

that ensures adequate control on affairs of the business by the owners and so on.

To reap the above benefits without accompanying costs, planning of capital

structure is needed.

5.2.2 Determinants of Capital Structure

There are several factors, which influence the capital structure. These

are: cost of capital of different sources of capital, the tax advantage of different

debt sources of capital, the restrictive conditions as to debt capital^debt capacity

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of ajbusiness, the financial leverage, securitibility of assets, preference for trading

of equity, stability of earnings, gestation period of projects, financial risk

perception, variety of debt instruments available, experience in using debt capital,

investor preferences, tax rates on capital gain and interest income, capital market

conditions, management philosophy and so on. A short description of these

determinants is taken up now.

Cost of capital of different sources of capital influences capital

structure. A company would be interested in less overall cost of capital and that a

source that is less expensive will be used more than the one that is costlier.

Generally debt capital is said to be less expensive, hence the tendency to use more

debt capitaUBut, of late, equity capital has become cheaper due to free pricing of

capitaj^ssues. Hence, now, more equity capital is used by companies. Among debt

capital, bank loans are viewed more expensive than market borrowings and that

more debt capital is raised through the capital market than from bank loans.

Tax advantage of debt capital is a factor in favour of using more; debt

capital. The interest paid on debt capital is deducted while computing taxable

income. So, tax saving to the extent of interest paid times tax rate is enjoyed by

the company, reducing the effective cost of debt. This advantage lures companies

to use more debt capital)

A Restrictive covenants such as restriction on business expansion,

on raising additional capital, on declaration of dividend, nominee directors on the

board, convertibility clause, etc. go with^ debt financing, especially; borrowings

from term lending financial institutions. These restrictive condition^; are the

implicit cost of debt capital normally not considered, but should considered in

deciding the mix of capital.

Debt capacity of a business needs consideration. How much del

capital a business can bear, that is, comfortably service is a factor to reckoned.

Debt service coverage ratio is calculated using the formula

Annual Cash flow

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DSCR= ——————————————————————————————

Interest + (Annual Principal Installments)/(l-TR)

Where TR - Tax rate on corporate profit.

DSCR should be at least 3 for comfortable 4e^t servicing. Businesses

that do not generate sufficient cash flow should think of alternative sources.

Interest coverage ratio is another measure of debt capacity of a

firm. The formula for ICR is ICR = EBIT /1, Where EBIT - is earning before interest

tax and I - is interest on debt capital. The ICR should be in the range of 4 or more

for better debt servicing capacity.

Debt equity norm in the industry / region is another factor. Normally

a 2:1 debt equity ratio is in vogue with dilution in favour of more debt |for small

scale business, capital intensive projects, projects undertaken by weaker sections,

etc.

Leverage effect has to be looked into. Financial leverage refers to

rate of change in Earnings per Share (EPS) for a given change in Earnings re

Interest and Tax (EBIT). A more than proportionate positive change in for a given

change in EBIT might tempt management to use further debt initially to enhance

EPS and later go for additional equity capital at a num.

Securitibility of assets is a determining factor for using debt Firms

which have assets that are readily accepted as security can raise capital. Land at

prime locations, modem buildings, machinery in good tion, etc. are accepted as

security, undertakings owning these assets can go more debt financing.

Trading on equity is a technique by which low cost debt is used avely

to enhance earnings for equity share holders. If the management is in this it would

use more debt capital. ROI must be greater than cost of reap benefit of trading on

equity. Suppose a firm's investment is Rs.100 ite overall ROI is 18% and it pays

10% on debt capital. Suppose a debt-equity of 1.1. Then available earnings for

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equity capital will be Rs.l8crs – Rs.5crs = Rs.13 crs. The rate of earning on equity is

26%. If a debt-equity ratio of 3:1 is adopted the earnings available for effect will be

Rs. 18crs - Rs.7.5crs = Rs.10crs. The rate of earnings on equity will be 42%, i.e.;

Rs.10.5 crs / Rs.26 crs = 0.42 or 42%. Thus by rising debt component, return on

equity is enhanced.

This is called trading on equity. If the management has high preference for this it

will go for more debt and vice versa.

Gestation period refers the period between commencement of

project construction and first conimercial operation of the project. Longer the

gestation period, more equity financing is advised as there will not be need for

servicing of capital in the initial times. Reliance Petroleum Limited used triple

convertible debentures equivalent to equity, to fund its integrated petroleum

project in Jamnagar, Gujarat, in the 1990s.

Financial risk perception is an influencing factor of capital structure.

Financial risk refers to the chances of bankruptcy proceedings against the firm for

non-repayment of debt or failure to service debt for a period. If the risk is higher,

less debt capital is good.

Variety of debt instruments available is another factor. While

ordinary bonds may be unsuitable for long gestation period project, zero coupoi

bonds are a good substitute. Convertible bonds are again superior to ordinan

bonds in terms of saleability. Now variety is available as against the recent past.

And this influences the choice in favour of more debt.

Experience in using debt capital is another factor. Debt needs to be

handled expediently. Periodic servicing, roll over, swap early retirement and the

like need to be adopted when needed. Not all are good at dealing with debt. Hence

experience in using debt capital is important.

Investor preferences for securities for investment need to be kept in

mind. At times people want debt securities, while at other times equity is

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preferred. The risk averse prefer debt instruments, while the risk seekers go for

equity investments.

Capital market conditions are another factor. When capital market

is booming, firms can take the market route to raise capital. In the depressed

situation, firms depend on bank finance, and other debt finance.

Cost of floating can also influence capital structure. Cost of floating is

high in India; the same is less in International market. Some Indian firms raised

capital by floating GDRs (Global Depository Receipts), an equity capital form,

involving lower, 3-5%, floating cost as against the domestic ituation of, as high as,

over 8% floating cost.

Rate of tax on capital gain and current income may influence form )f

capital. People in the higher tax bracket prefer capital gain as against current

ncome. Hence preference for equity instruments is evinced by them. So, firms nay

opt for equity capital.

Management philosophy comes next Some management are not

interested in debt financing at all. Colgate-Palmolive Ltd. is an all-equity firm by

choice. Some companies depend extensively on debt capital. Management

orientation is one of the deciding factors.

Legal stipulation as to debt ceiling is another factor influencing

capital structure. Earlier a debt equity norm of 2:1 was generally insisted on by the

controller of capital issues. Though no longer this legal stipulation exists with the

repealing of the Capital Issue Control Act, it has become a rule of thumb. Banks

and financiers look at the debt equity ratio before committing further debt

investment in a firm.

Free-pricing of public capital issues, now in vogue in the country

made companies using more equity financing than debt financing.

5.2.3 Optimal Capital Structure

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As already referred to companies want to be optimally structured i to

capital. Neither over dependence on equity nor on debt capital is advised. Again

extent of dependence on any type of capital is influenced by both firm lific and

market-wide factors. Optimal capital structure as earlier referred to is one that:

maximizes value of the firm, minimizes overall cost of capital, rigidity of capital

structure, enhances control over affairs of the less, increases simplicity of capital

structure, ensures enjoyment of tax , helps reaping financial leverage benefits to

the maximum and so on.

Optimum capital structure is a classical concept. Debt capital and

capital are in fine balance here producing optimal results on value, cost, ige, and

the like. As a firm uses debt upto a level its value increase. Beyond level debt

capital proves costlier and value starts dropping downwards.

The debt equity, point at which value is maximized, is called the optimal capital

structure. Optimal capital structure varies with firms and with market factors. As

market and firm specific factors keep changing, optimal capital structure also

varies.

Businesses try to reach optimal capital structure. Do they reach is

question mark. Mostly, they are about, but not at optimal capital structure.

5.2.4 Theories of Capital Structure

The theories of capital structure analyses whether or not value of the

firm is influenced by capital structure. There are several theories of capital

structure. Net income, net operating income and Modigliani-Miller theories are

some capital structure theories. The theories are based on the following general

assumptions:

i) Only two sources of capital, debt and equity, are used

ii) Debt capital is cheaper than equity capital

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iii) Debt capital cost is fixed

iv) There is no corporate taxation

v) There is perfect competition in capital market

vi) There is 100% dividend payout.

vii) The total assets do not change, there is no expansion

viii) The operating profit, ie., EBIT remains constant

ix) Business risk is constant over time and is independent of capital struct

and financial risk.

x) There is perpetual life of the firm.

5.2.5 Net Income Theory

The Net Income Theory (NIT) was propounded by D.Durand. The theory

considers that capital structure influences value of the business. As more and more

of debt capital is employed, value of the firm increases, as per the theory. Chart

5.1 gives a graphical explanation of the theory. Vertical axis measures cost and

horizontal axis measures leverage, ie., debt / Equity.

Chart 5.1 Net Income Theory

Leverage (D/S)

The theory assumes that both Ke and Kd are constant. As more and

debt is used, the Ko decreases and at extreme position Ko - Kd when no rity is

used. As, Ko decreases, value, ‘V’ rises.

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Let EBIT = Rs. 1,00,000. Let the debt carry 10% coupon. The Ke = L5%.

Then for varying levels of debt capital being employed, the value of the - changes

as deduced below:

Details:

Case l Case 2 Case 3

Debt Rs.2,00:000 Rs.4,00,000 Rs.6,00,000

EBIT Rs. 1,00,000 Rs. 1,00,000 Rs.1,00,000

(Less) interest on debt

@10% (I) Rs. 20,000 Rs. 40,000 Rs. 60,000

Net income on equity (NI) Rs. 80,000 Rs. 60,000 Rs. 40,000

Ke% 12.5 12.5 12.5

Value of equity(S):NI/Ke Rs.6,40,000 Rs.4,80,000 Rs.3,20,000

Value of debt (D): I/Kd Rs.2,00,000 Rs.4,00,000 Rs.6,00,000

IK/Kd

Value of debt (V):(S+D) Rs.8,40,000 Rs.8,80,000 Rs.9,20,000

Ko=EBIT 11.9% 11.4% 10.9%

It is seen above that value increases and overall cost of capita! decreases as more

and more of debt is used. The optimum capital structure is undefined here. As we

use more of debt we may approach the optimum capital structure. 100% debt firm

is perhaps optimally capital structured as per this! theory. But that is the most

unreal. Such situation has no capital structure at alt] as only one type of capital is

used.

5.2.6 Net Operating Income Theory (NOIT)

Net operating income theory is also suggested by D.Durand this is a

negation of the NIT. As per the NOIT all capital structures are equally good or bad.

So any capital structure can be taken as optimum. It can be also told that there is

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no optimal capital structure. That is value of firm and overall cost of capital are

unaffected by capital structure. The theory assumes that both Kd and Ko are

constant and it is the equity capitalisation rate (Ke) that is changing. Ke changes

with leverage, Ke = Ko + (Ko-KdXD/S), Where D - value of debt, S - value of equity

and S = V-D, where 'V is the value of the firm = EBIT/Ko. Ko

depends on risk complexion of the business and not on capital structure. In Chart

5.2 NOIT is represented.

Let EBIT - Rs. 1,20,000; Kd = 10%; Ko = 12%. We can prove that V

remains constant as shown below.

Case 1 Case 2 Case 3

Debt Rs. 2,00,000 Rs. 4,00,000 Rs. 6,00,000

EBIT Rs. 1,20,000 Rs. 1,20,000 Rs. 1,20,000

V=EBIT/Ko Rs. 10,00,000 Rs. 10,00,000 Rs. 10,00,000

Dept interst 10% Rs. 20,000 Rs. 40,000 Rs. 60,000

Earnings after interest Rs. 1,00,000 Rs. 80,000 Rs. 60,000

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Market value D (I/Kd) Rs. 2,00,000 Rs. 4,00,000 Rs. 6,00,000

S=V-D Rs. 8,00,000 Rs. 6,00,000 Rs. 4,00,000

Ke=NI/S 12.5% 13.3% 15.0%

It is seen that Ke is raising with rising leverage, that is more and use of

debt Ke is increasing in a linear ratio with leverage (D/S). For instance, when

D=2,00,000 and S=8,00,000, Ke = Ko+(Ko-Kd)B/S = 12 + (12-12,00,000/8,00,000

- 12 + 2(0.25) = 12.5%. When D - 6,00,000 and S = 4,00,000, Ke = 12 (12-10) 1.5

=15%. As leverage rises, equity shareholders expect higher return in order to

compensate the increasing financial risk they are exposed to.

5.2.7 Modigfiani - Miller (MM) Theory: (Without corporate taxation)

Franco Modigliani and Merton H.Miller proposed a theory of capital

structure which appeared like the NOIT in effect, but different in process. Like

NOIT, MM theory holds that Ko and V are independent of capital structure Ko and V

are constant for all leverage. Ke is rising with leverage and is equal to the sum of

Ke of an equity capitalisation rate of a pure-equity firm and a financial risk

premium which is equal to the difference between the equity capitalisation rate of

pure equity firm and cost of debt times the leverage ratio, i.e., debt to equity.

MM adopt the arbitrage process to prove their theory. Suppose two

firms, one using debt capital (L-Levered firm) and another not using any debt

capital (U-Unlevered firm) are identical in all other aspects. EBIT = Rs.2,00,000;

Debt used Rs. 10,00,000 with a coupon of 10%. Let the equity capitalisation of L be

16% and of U be 12.5%. Then the value and Ke of the firms shall be as shown

below:

L U

EBIT 2,00,000 2,00,000

Less Debt interest 1,00,000

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EAI 1,00,000 2,00,000

Ke 16% 12.5%

Value of shares S = EAI/Ke 6,25,000 16,00,000

Value of Debt = D 10,00,000

Valueoffirm = V = S+D 16,25,000 16,00,000

Ko-EBIT/V 12.3% 12.5%

The levered firm is purported to have less cost and higher value man

the unlevered firm. But this situation will not lost long and the difference will be

ironed out over a period by a process of arbitrage. The arbitrage process is dealt

below.

Here L's shares are commanding a higher market price. So, investors

will begin to sell the shares. Say 'A' is holding 1% of shares of L. His present

income is 1% of Rs. 1,00,000 or Rs.iOOO. By selling his holding he realizes

Rs.6250, ie., 1% of Rs.6,25,000, the value of shares of I/. He in turn buys 1% of

shares in “U”.

To buy 1% of shares in U, whose shares are under-priced, ‘A’ ; needs

Rs. 16,000 an additional sum of Rs,9750 is needed, which he borrows at 10%. It is

assumed that 'A' can borrow at the rate companies do borrow and ‘A’ is not to feel

uncomfortable of such personal borrowing. And with the Rs. 16,000, now he has A

buys 1% of shares in U. His gross income will be 1% Rs.2,00,000 or Rs.2000. Out of

this Rs.2000, he has to pay 'interest Rs,.975 on borrowed sum. His net income is

Rs.2000-Rs.975 - Rs.1025, which is iter than the income which he used to get on

his share holding in L. The additional income of this arbitrate process drives more

investors to sell their holding in ‘L’ and buy shares of 'U'. Due to selling pressure

price of shares of ‘L’ falls and due to buying pressure price of shares of ‘U’ rises

and that the ial position of price of shares of 'L' being higher than that of ‘U’ is no

longer existing. Thus, in the long run, whether a firm is levered or unlevered, ie.,

whether one uses debt or not, value and overall cost of capital cannot be

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influenced by this factor, other things remaining constant. Thus this is similar to

NOI theory.

5.2.8 M-M Approach (With corporate taxation)

If corporate taxes are there, value of the levered firm will be higher and

overall cost of capital of the firm will be less than those of an unlevered firm. That,

VL Vu + DT, Where VL= value of levered firm, Vu - value of unleavred firm and DT is

the value of debt times corporate tax rate. So, to the against of debt multiplied by

tax rate, the levered firm is going high in value as against the unlevered firm.

Chart 5.3 gives a pictorial presentation of value of leveraged and unlevered firms.

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Chart 5.3 MM Theory value otlevereri and unlevered firm (with tax)

5.2.9 Limitations of Capital Structure Theories

First the assumption that Kd remains constant for all levels of leverage

is not right. As debt rises Kd is likely to rise. Second, under MM theory, the

individual has to go for personal debt to effect the arbitrage process. Such practice

may not be liked by all investors. Asking a person to go for a leveraged portfolio

may not be comfortably received. Third, for personal loan, rate of interest is

generally higher than on corporate borrowings. Hence the incentive for arbitrage is

wiped out. Fourth, the assumption of perfect competition is no good. Fifth some

corporate investors cannot got for leverage portfolio and that arbitrage process

cannot take place. Most assumptions of the theories are bordering around

unreality.

5.2.10 Traditional theory

As per traditional theory of capital structure, upto certain level of

leverage, Ko declines, afterwards it increases. In other words, there is a defined

optimum capital structure. At the optimum capital structure, marginal real cost of

debt is equal to the marginal real cost of equity. For a debt equity ratio before the

optimum level, marginal real cost of debt is lower than that of equity and beyond

optimum level of debt equity, marginal real cost of debt is more than that of

equity. Marginal rea! cost of debt = out of pocket cost + implicit cost of debt like

bankruptcy cost. Initially implicit cost is negligible and that overall cost falls. Both

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the out of pocket and implicit costs rise, as leverage rises. As a result overall cost

rises. In the process, Ko passes through a minimum point. That is called the

optimum capital structure.

Chart 5.4 gives a pictorial presentation of the traditional theory. Ke is

rising with leverage, while Kd is constant and Ko initially slopes down. Once Kd

starts rising after certain leverage level, Ko starts rising. The lowest point of Ko is

the optimum capital structure.

Chart 5.4 Traditional Theory

5.2.11 Significance of Capital Structure Analysis

In a world of corporate taxation, capital structure is analysis is relevant.

It helps firms to have optimum capital structure. More the tax rate, more debt will

help maximizing value of the business. Yet, there is a limit, beyond which debt

capital induced leverage benefit may be eaten away by enhanced financial and

business risk requiring the firm to pay more interest on debt as well as more

reward to equity investors.

53 SUMMARY

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Cost of capital, one of the influencing factors of choice of capital

structure, varies with type of capital and the tax factor. There are different

approaches to compute specific cost of capital. Overall cost of capital can be

computed taking book weights, market weights or marginal proportions used. Cost

of capital is a significant factor as this influences even/the choice of projects a firm

can take up.

Capital structure refers to the proportion of different types of long-term

funds used by a business. Capital structure is supposed to influence the overall

cost of capital and the value of the business. There are different theories of capital

structure. Net income and net operating income theories were proposed by

Durand. The former tells extensive use of debt enhances value, while latter tells

that value is independent of capital structure. MM theory with out taxation is

similar to NOI theory in the final disposition. But MM theory with corporate taxation

is similar to NI theory in the effect on value. MM theory however uses a different

line of argument. Traditional theory of capital structure recognizes the concept of

optimal capital structure.

5.4 SELF ASSESSMENT QUESTIONS

1) Explain the different concepts of cost of capital.

2) Present the opportunity cost of capital for retained earnings and for trade

credit with cash discount option.

3) A firm has issued, 5 year Rs.500 debentures at a net price of Rs.460. The

debentures carry a coupon of 12% p.a and redeemable at 5% premium. Ta

rate is 40%. Find the pre-tax and post-tax cost of debentures.

4) A firm has floated preference shares redeemable at par after 7 years, face

value Rs. 1000, coupon dividend 10% and issue expenses 3%. Findthei of

the shares.

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5) XYZ Ltd. has a paid up capital of Rs.6 crs of equity shares of Rs.10 each. Its

shares due currently quoting at Rs.45. The company has declared dividend

as follows for past 5 years.

Year 1 2 3 4 5

Dividend

(Rs. crs)

9 10.5 15 18 21

Find the cost of equity as per D + g approach.

6) Given Ke = 18%, Floatation cost 3% and tax bracket of shareholders of a

firm at 25%. Find the cost of retained earnings.

7) A firm employs the following capital funds of costs mentioned against each.

Find the weighted cost as per book and market weights.

(Rs.crs)

Capital Cost Book Market

(%) value value Equity share

18 8 12

Preference share 15 3 2

Debentures 14 4 4

8) ABC Ltd. is setting up a project with a capital outlay of Rs ;60 lakhs and it

has the following alternatives in financing the project:

Alternative I = 100% Equity finance

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Alternative II = Debt = Equity 2:1

The Kd is 18% p.a and corporate tax rate is 40%. Calculate the EBIT at which both

the alternatives provide the same EPS.

9) ABC Ltd is a 100% equity firm with a Ke of 21%, XYZ Ltd, similar to ABC,

except in capital mix, has a debt - equity ratio of 2:1 and its Kd is 14%. Find

the Ke of XYZ Ltd. as per MM Hypothesis and find the overall average cost

of capital.

[Hint: KeL. = Keu + (Keu – Kd) D/E]

The Ke and Kd at different levels of D/E ratio are as follows:

D/E Ke(0%) Kd(0%)

0.0 21 0

0.4 21 12

1.8 22 12

1.2 22 14

1.6 24 14

2.0 24 16

2.4 28 20

Find the optimum capital structure.

REFERENCES

1. Financial Management and Policy - Van Home

2. Financial Decision Making - Hampton

3. Management of Finance - Weston and Brigham

4. Financial Management - P.Chandra

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5. Financial Management - Ravi M. Kishore

* * *

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MANAGEMENT OF CURRENT ASSETS

In this unit you will learn forecasting of current assets, objectives and

techniques of cash and liquidity management, objectives and techniques of

receivables management, evaluation of alternative credit policies and significance,

objectives and methods of inventory management.

INTRODUCTION

Current assets constitute an important investment of any business.

Current assets include inventory (raw materials, working progress, finished goods,

sundry materials, tools and jigs, etc.) receivables (bills receivable and sundry

debtors), deposits with suppliers, cash on hand, balance with banks, prepaid

expenses, etc. The management of current assets is concerned with the size and

composition of the current assets of the business. The size must be optimum so

that there is neither over nor under investment. The composition should reflect the

quality of current assets.

6.1 FORECASTING OF CURRENT ASSETS

Level of current assets required by a business is influenced by several

factors. We have studied the same in our lesson on working capital. Seasonal

factors, operating cycle, credit policy, etc. influence current assets. To forecast

current assets budgetary techniques, accounting techniques, and Statistical

techniques can be used.

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6.1.1 Budgetary Technique

The budgetary technique involves budgeting for various components of

current assets, based on average life of each items of current assets, average

value of each item of current assets in terms of selling price per unit and total sales

volume projected for the budget period.

Illustration 6.1

Budgeted sales for the next year for a firm is 104000 units. The cost

structure per unit of output is as follows:

Raw material (Rs) 4

Labour 5

Production overhead 2

Administrative overhead 1

Selling overhead 3

Profit 6

Total 21

4 weeks raw material stock, 2 weeks’ work in process stocks and 6

weeks finished goods stock are needed. Two months' credit need to be given for

customers. A contingency of 10% to the computed currents assets figure is

needed. Find the current assets required for the business. Production and salt are

even throughout the year.

Solution

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We have to work out the value of each item of current assets namely,

raw material, work in progress, finished stock, debtors and contingency

component. The same is attempted below:

Annual sales and production : 104000 UNITS

Annual weekly production : 104000 / 52 - 2000 units

The following formula is adopted for any component,

Value of the component = Weekly production x unit cost of that

component x period of stock of that component.

Raw material stock = 2000 x Rs.4 x 4 - Rs.32000

Work-in progress stock = 2000 x Rs. 11 x 2 - Rs. 44000

(Note: WIP unit cost = Raw material + Labour + Production overhead each per unit

Rs. 5+4+2 = Rs.11)

Finished goods stock - 2000 x Rs. 1 2 x 6 - Rs. 1 ,44,000

(Note: Finished stock unit cost = WIP cost per unit + Admn. Overhead= Rs. 11+1 =

Rs. 12)

Debtors stock - 2000 x Rs.21 x 8 = Rs.3,36,000

(Note: Weekly units x selling price per unit x weeks of credit; 2 months = 8

weekly).

Total of all the four components - Rs.32000 + 44000 + 144000 + 336000 =

Rs.556000.

To this 10% contingency be added.

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Total current assets = Rs. 5,56,000 +10%

= Rs. 5,56,000 + 55,600

= Rs. 6,11,600

6.1.2 Accounting Technique

Accountants estimate current assets need of a business by studying

the relationship between current assets and sales. A percentage of estimated sales

are taken as the value of current assets needed.

Illustration 6.2

For the year just ended a firm's current assets were: stock Rs.10 lakhs,

receivables Rs. 11 lakhs and cash Rs. 1 lakh. The sales amounted to Rs.50 lakhs.

For the ensuring year sales are estimated at Rs.90 lakhs. Find the current assets

requirement of the business,

Solution

First let us find the percent of current assets to sales for the last year.

Rs. 10 lakhs

Stock as % of sales = ——————— x 100 = 20%

Rs.50 lakhs

Rs. 11 lakhs

Receivables % of sales = —————— x 100 = 22%

Rs.50 lakhs

Rs. 1 lakh

Cash as % of sales = ——————— x 100 - 2%

Rs.50 lakhs

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So, the current year current assets needed on basis of last year's

percent basis are as under:

Stock: 20% of sales = 20% of Rs.90 lakhs = Rs. 18.00 lakhs

Receivables: 22% of sales = 22%of Rs.90 lakhs= Rs. 19.80 lakhs Cash : 2%

of sales - 2% of Rs. 90 lakhs = Rs. 1.80 lakhs

Total = Rs. 38.6 lakhs

6.1.3 Statistical Techniques

Statistical techniques analyse the relationship between ci assets and

components of current assets and one or more other variables sales, cost of

production, etc. Through regression (simple or multiple) analysis the relationship

equation is established And then the value of current assets is computed. Time

series model can also be used to estimate current s«ets needed.

Illustration 6.3

The sales and current assets of a business over a period of years are

studied and a definite relationship is established. During the last five years the,

sales and current assets are:

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Sales value (Rs.crs): 160 220260 285 345

Current assets (Rs. crs): 110 135157.

5

217.5 225

Estimate the current assets needed for the current year with projected

sales of Rs.435 crs, using simple linear regression.

Solution

The linear regression model has TO be used here.

Sales Current Assets

X Y XY X2

160 110.00 17600.0 25600

220 135.00 29700.0 48400

260 157.5 40950.0 67600

285 217.5 61987.5 81225

345 225.0 77625.0 119025

1270 845.0 227862.5 341850

So, ∑X = 1270, ∑Y = 845, ∑XY = 227862.5, ∑X2 = 341850

For linear regression: Y = a + bx, we have to solve two equations to get the value

land b.

Na + ∑Xb = ∑Y ; a∑X + b∑X2 = ∑XY

The equations are: 5a+1270b = 845 --- (1)

1270a + 341850b = 227862.5 --- (2)

(1) x254; 1270a + 322580b = 214630 --- (3)

(2) - (3): 19270b = 13232.5 b = 0.6867

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5a = 27 ; a=5.4

Y = -5.4 + 0.6867X. Suppose X = 400; then Y = -5.4 + 0.06867x400 = 269.28

6.2 CASH AND LIQUIDITY MANAGEMENT

Management of cash and liquidity is concerned with providing sufficient

cash for meeting cash needs of a business as and when needed. It involves

synchronizing outflows and inflows of cash. Outflows of cash are of several types.

Redemption of debt, retirement of debentures, repayment of bank loans, payment

of taxes, interest, dividend etc. are capital account outflows of cash. Payment of

wages, for purchases, for overhead expenses, etc. are operating cash flows.

Similarly, inflows are of several types. Issue of shares and debentures, raising of

debt and public deposit, receipt of dividend/interest on inter corporate investment,

etc. are capital type of cash inflows; cash sales, realisation from debtors, etc.

constitute operating cash inflows. A matching of cash inflows with cash outflows is

essential. But this is not possible to the complete extent. So, occasionally outflows

might exceed inflows resulting in cash deficiency and occasionally cash inflows

may exceed cash outflows-resulting in surplus. ^Managing cash deficiency by

holding reserve cash managing cash surplus by going for investment of excess

cash are essent functions of cash management. Van Home defines cash

management “efficient collection, disbursement and temporary investment of

cash”.

6.2.1 Objectives of Cash Management

Cash is a barren asset. Holding too much of cash involves cost. There is

loss of interest. But more liquidity is there. Holding too little of cash also involves a

cost as day-to-day operations may be hindered reducing liquidity. Profitability may

be high as there is no idle cash. Businesses need both profitability as well as

liquidity. Hence optimum cash level need to be maintained. Determining and

maintaining such optimum balance of cash is the prime objective of cash

management.

The objectives of cash management may be elaborated as;

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i) to provide cash to meet day-to-day needs of the business.

ii) to provide'cash to meet business contingencies T.

iii) to provide cash to profit from speculative trades iv) to match inflows of

cash with outflows of cash v) to tide over cash deficiency ably.

iv) to profitably employ excess cash, if any, vii) to ensure that there is neither

paucity of cash nor excess cash balance.

v) to maintain good relations with bankers so that they do not hesitate to

come to the help of the firm, if need be.

vi) to ensure prompt collection of dues to the firm from varied parties.

vii) I to ensure that payments are effected timely taking advantage of cash

discounts, etc if that is profitable to do so.

62.2 Motives for Holding Cash

Individuals and institutions have a preference to hold cash. This is as

liquidity preference, to use the language of J.M.Keynes. What are the motives

behind this liquidity preference? These are given as: transaction motive,

precautionary motive and speculative motive.

Transaction motive of cash holding refers to cash holding for

meeting transaction needs of the business. To pay for purchases, for labour, for

overheads and others, a firm needs to carry cash. Depending on the size of

operation, the cash-credit composition of transactions and the like, the holding of

cash for meeting transactions shall vary.

In a general sense, the main motive for holding cash is to promptly pay

off creditors as and when dues to them mature for payment. This is the transaction

motive. Advance retirement of debts to take advantage of cash discount, if any,

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allowed is another transaction motive. To make cash deposit with suppliers, to

ensure uninterrupted supply cash may be needed. This is again transaction motive.

Precautionary Motive of cash holding refers to holding of cash for

meeting unforeseen business contingencies. Due to a sudden pick up a demand or

fall in debt collections or cash sales, or urgent expenses cash need my rise. A

business must provide for such contingencies. Businesses that ar inctioning in a

volatile market, that are subject to seasonal pulls and pressures, lat face fast rate

of fashion changes, that face stiff competition and the like hold ,iore cash for

meeting unforeseen contingencies.

Speculative Motive of cash holding refers to cash holding to profit

from price fluctuation. If prices of inputs are expected to rise in the future, a firm

with strong cash base may buy now for sale later and profit thereby. Similarly, if j

prices are expected to fall, a firm may short sell (selling without holding) nowj and

buy later at lower price and may profit thereby. This profiteering by the by the

price movement is known as speculation. Some management, especially the and

cash rich do speculate and gain. It is a risky affair. So, only the able shrewd do the

speculation.

Apart these liquidity motives, a firm may be required to hold as

compensation balance with banks. A minimum credit balance need to maintained

in bank accounts. This is known as compensation balance, quantum of

compensation balance varies with banks. Foreign and the newly formed private

sector banks in India demand a high minimum credit balance in

account

6.23 Cash Budgeting

Budgeting is determining in advance the level of activity income and

expenses) for a definite period of time and the policy to be paid to be pursued to

achieve the planned level of activity. Cash budgeting is determining in advance die

cash inflows and cash outflows for a definite future period. It is a tool for foreseeing

the period or periods when cash surplus and extent of surplus and cash deficiency

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and the amount of deficiency are expected and devising .measures to manage

both the situations. Cash budget is usually prepared for a sbort period, ranging

between few weeks and a maximum of 6 months. Long-run forecast is resorted to

in a limited way. Usually the duration of cash budget Id cover one cash cycle

period. There are three methods of preparing cash; budget.

Batancesheet Method, cash flow statement method and

receipts and payments method are the 3 methods.

In the balancesheet method a forecast balancesheet is prepared to the

cash balance on the date of the balance sheet. This method has no tional use

except indicating the net cash position on the particular date.

The cash flow statement method prepares cash inflows and outflows

during an accounting period based on forecast incomes and expenses it and

forecast balancesheet. This is slightly better than the balance sheet lod for one can

find cash inflow and outflow on various heads. But only jgates for an entire period

are given. As break up figures are not available is eroded. An exercise on this

method of preparing cash budget follows.

Illustration 6.1

Forecast Balance Sheets of X Ltd. on 1-1-2003 and 31-12-2003 are as

follows :

Balance Sheet (Figures in Rs.)

Liabilities 1-1-2003 31-12-

2003

Assets 1-1-

2003

31-12-

2003

Creditors 40,000 44,000 Cash 10,000 7,000

Mrs. X’s

loan

25,000 - Debtors 30,000 50,000

Loan from

bank

40,000 50,000 Stock 35,000 25,000

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Capital 1,25,000 1,53,000 Machinery 80,000 55,000

Land 40,000 50,000

Building 35,000 60,000

2,30,000 2,47,000 2,30,000 2,47,000

During the year 2003, a machine costing Rs.10,000 (accumulated

depreciation Rs. 3,000) is to be sold for Rs. 5,000. The provision for depreciation

against machinery as on 1-1-2003 is Rs. 25,000, and on 31-12-2003 it is Rs.

40,000. Net profit for the year 2003 is estimated to be Rs. 45,000. You are required

to prepare cash flow statement.

Solution

Forecast Cash Flow Statement

Cash balance as on 1-1-2003 Rs. 10,000

Add: Cash in flow:

Cash from operation 59,000

Loan from bank 10,000

Sale of machinery 5,000

74,000

Less: Cash out flows: 84,000

Purchase of lands 10,000

Purchase of building 25,000

Mr. X's Loan repaid 25,000

Drawings 17,000 77,000

Cash balance as on 31-12-2003 7,000

Working notes 45,000

Cash from operations 18,000

Profit made during the year 2,000

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Add: Depreciation on

machinery

10,000

Loss on sale of machinery 4,000 34,000

Decrease in staff 79,000

Increase in creditors 20,000

Less: increase in debtors 59,000

Cash from operations

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Machinery Account

To balance b/d 1,05,000 By Bank 5,000

Loss on sale of machinery 2,000

Provision for depreciation 3,000

Balance c/d 95,000

1,05,000 1,05,000

Provision for depreciation

To Machinery a/c 3,000 To Balance b/d 25,000

To Balance c/d 40,000 By P&L A/c

(depreciation charged

balancing figure) 18,000

43,000 43,000

The receipts and payments' is the third method. Under this method

monthly/weekly/fortnightly receipts and payments can be known. And that a hetter

monitoring of cash position is possible here. Let us consider the methodology of

preparing a cash budget here, on a monthly basis.

Start with opening cash balance for the 1st month of the cash budget

period. Record various receipts month-wise and item-wise. Cash sales are first

item. Collections from debtors is the second item. Depending on the terms of

credit, collections from debtors are effected. Other occasional receipts are then

recorded whenever expected. Dividend received, share capital raised, debt capital

raised, etc. come here. For the first month now total resources (opening

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balance & receipts) can be found. Payments are now recorded. First cash

purchases and other cash operating expenses are recorded. Payments to creditors,

as per terms of credit allowed, are recorded. Occasional payment like purchase of

plant, machinery, redemption of debt, payment of tax, dividend and interest, etc.

are recorded. Total payments can be found month-wise now. From total resources

of 1st month, total payments of 1st month are deducted to get closing balance of

1st month. This becomes opening balance for the second month. Then for the

second month total resources and total payments can be found and then for that

month closing balance is found- Negative closing balance reflects deficiency and

the next period opening balance is therefore a negative balance reducing that

month's total resource. An illustration is given below.

Illustration 6.2

The projected sales of ABC Limited for the months of July to

November are

Rs.

July 6,20,000

August 6,40,000

September 5,80,000

October 5,60,000

November 6,00,000

The anticipated purchases are

Rs.

July 3,80,000

August 3,33,000

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September 3,50,000

October 3,90,000

November 3,40,000

The wages are expected to be Rs. 1,00,000 per month. The management is

expected to pay two months wages as bonus during October. The company is

expected to pay an advance tax Rs. 90,000 before 15th September. The company

has ordered in June for a machine costing Rs.16,00,000. IDBI has agreed to finance

the purchase of machine which is expected to be delivered in January next. The

company has advanced 5% in June with order, and they agreed to pay another

10% advance after 3 months. The company extends 2 month's credit for the

customers and the company enjoys one month credit from the suppliers. The

general expenses for the company is Rs. 60,000 per month payable at the end of

each month. The company anticipates to receive interim dividend of 10% for the

investment of 90,000 shares of Rs. 10 each during October. The company

anticipates to have an overdraft of Rs. 40,000 on 1st September (limit sanctioned

is Rs. 55,000). Draw a cash budget for September-November for approaching your

bankers for a short-term further credit.

Solution

Working notes are: (1) In Sep, collection for July sales, in Oct collection

for Aug sales and in November collection for Sep sales are obtained (2) Interim

dividend is received m Oct. (3) As there is no opening cash, total resource for Sep,

is Rs. 6,20,000. (4) Payment for Aug purchases is made in Sep, for Sep purchases

in Oct and for Oct purchases is Nov. (5) Wages paid monthly, (6) Bonus paid in Oct.

(7) Advance tax and Advance for purchase of machine are paid in Sep. (8) Gen.

Expenses paid monthly, (9) Total payment for Sep. is Rs. 7,43,000. (1) Deficit in

Sep. is Rs. 1,23,000 for which bank loan is obtained. (11) So there is no closing

cash balance in Sep and hence no opening balance for Oct. (12) For other months

figures are worked similarly.

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ABC Limited

Cash Budget for September - November

September

Rs.

October

Rs.

November

Rs.

Receipts :

1 . Cash Balance in the beginning 0 0 0

2. Collection from debtors 6,20,000 6,40,000 5,80,000

3. Interim dividends — 90,000

Total cash available (A) 6,20.000 7,00,000 5.80.000

Payments:

1, Payments to creditors for

purchases

3,33,000 3,50,000 3,90,000

2 Wages 1,00,000 1,00,000 1,00,000

3 Bonus of workers - 2,00,000 -

4. Advance tax for income tax 90,000 - -

5. Advance for the purchase of

machine

1,60,000

6. General expenses 60,000 60,000 60,000

Total payments (B) 7,43,000 7,10,000 5,50,000

"Surplus (Deficit) (A-B) (1,23,000) 20,000 30,000

Finance requires:

Borrowings 1,23,000 - -

Repayments - 20,000 30,000

Total effect of financing (C) 1,23,000 20,000 30,000

Closing Cash Balance (A+C-B) 0 0 0

6.2.4 Planning optimum level of cash:

Determining the optimum level of cash that should be held is a crucial

point in cash management. It was seen already that firms hold cash for transaction,

precaution and speculation purposes. How much? It should not be too much, as

holding cost will rise (loss of interest that could be earned). It would not be too

little either as opportunities may be missed and frequent short term cash resource

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raising activities may have to be entertained resulting in added transaction cost.

Hence an optimum cash balance be held. Inventory model may be adopted here to

find the optimum cash balance.

EOQ Model

To find the optimum cash balance the net cash outflow during a period,

the interest rate per rupee per period and the transaction cost per transaction are

needed. The optimum cash balance (EOQ Model) is obtained by taking the square

root of 2AT/I, Where 'A' is the annual net cash needs (which is the excess of

outflows over inflows), T is the transaction cost per transaction; and T is the

interest per rupee per annum.

The chart 6.1 given at the end gives a pictorial explanation optimum

cash balance. Cash balance is taken on the horizontal axis and cost i taken on the

vertical axis. As cash balance rises, the carrying cost (interest increases and vice

versa. The transaction cost moves in the opposite directk cash balance. At

optimum level of cash balance, both the transaction cost carrying cost are equal to

each other and total cost is the least.

Illustration 6.3

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During, a year a firm forecasts that is cash outfiows will exceed cash

inflows by Rs. 8,00,000. The transaction cost per transaction is Rs. 150 and interest

rate is 15% p.a.

Solution

The optimum cash balance is square root of 2 x 8,00,000 x 150 / 0.15

= Square root of: 2 x 8,00,00 x 1000 = Rs. 40,000. Total number of transactions

will be: 8,00,000/40,000 or 20. The total transaction cost: 20 x Rs. 150 = Rs. 3,000.

The carrying cost is: average cash times interest rate. Average cash balance is Rs.

40,000/2 = Rs. 20,000. Carrying cost is = Rs. 20,000 x 0.15 = Rs. 3,000. The total

cost is Rs. 6,000.

Instead of Rs. 40,000 optimum cash balance, suppose Rs. 80,000 is

considered as cash balance. Then the total carrying cost will be Rs. 6000 and total

transaction cost Rs. 1500 and total cost Rs. 7500. Thus, cost is minimum at the

optimal cash balance of Rs. 40000. 20 times over the year, or every 18th day, Rs.

40000 cash will be arranged to manage excess outflows.

The method assumes uniform rate of cash inflows and outflows.

Transaction cost, carrying cost etc. are known to be constant. This certainty

assumption, however, is not sustainable in a world of risk and uncertainty. The

daily cash balance under this model shall be as in chart 2. 'Q' is the EOQ level of

cash, steady payments reduces balances to zero. Immediately cash balance is

restored to 'Q' and payment made,

Miller - Orr Stochastic Model

A Stochastic model is suggested by Miller and Orr. The certainty

assumption of inventory model is not tenable in real world. So, a model based on

business realism is needed. Miller-Orr model assumes away certainty and is based

on uncertainty. The model is based on a two-asset theory. That is, the firm has

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cash and marketable securities to complement each other. When excess cash is

there, the same is invested in marketable securities and when deficiency of cash

balance is felt, marketable securities are realised into cash. The model establishes

two cash levels - the minimum and maximum. In between an optimum level (Z) is

fixed which is: 3√S2 b / 4i, where s2 is the variance of daily net cash balance, b is

the transaction cost (cost of investing in marketable securities or cost of liquidating

investment) per transaction, ‘i’ is the interest per day per rupee investment in

marketable securities.

In Chart 6.2, the Miller-Orr model is exp* ned. Once the optimal level,

‘Z’ is determined an upper bound is fixed such that the upper level ‘H’ is 3 times

the optimum level. The lower bound, ‘U’ is fixed, below the optimum level,

independently of the model. When actual cash balance touches the upper bound,

‘ZH’ level of cash is invested in securities, bringing cash level to the optimum level

‘Z’. When cash balance touches the lower bound, ‘L’, ‘LZ’ amount of cash is

generated by selling marketable securities. The model is complex and difficult to

operate. Short-term borrowing as an alternative to selling of marketable securities

is not considered by the model. Its complexity makes it less practicable.

Chart 6.2 : Miller Orr Model

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Illustration 6.4

The daily net cash balances in a business for a 15 days period are:

Rs.1500,1400,1300,1200,1100,1000,900, 800, 900, 1000, 1100, 1200,1300, 1400

and Rs. 1500, The interest rate per day per rupee is 0.001 or 36.5% per annum.

Transaction cost is Rs. 40 per transaction fix Z & H. Then the s is 186667. Then Z =

cube root of 3 x 186667 x 40 / .001 x 4 - cube root of 3 x 186667 x 10000 = Rs.

1750. ‘H’ will be 3 times of Z or Rs. 5250. Let the low point be Rs. 750. As long as

cash balance moves within Rs. 5250 and Rs. 750 range no intervention will be

taken. If however, when the cash balance reaches the Rs. 5250 mark, Rs. 3500 will

be invested in marketable securities reducing cash balance to the optimum level of

Rs. 1750. If cash balance falls to Rs. 750, marketable securities will be sold to the

extent of Rs. 1000 to take the cash balance to Rs. 1750. Can instantaneously and

in exact quantities such investment/ disinvestment be made are debatable

questions.

7. Collection Practices

Cash management is intimately connected with realization from

debtors. Prompt collection from debtors is preferred for that involves less money

being locked-up in accounts receivables, less bad debts, etc. How can collections

be prompted? We can give cash discount to prompt collections. Besides a system

of decentralised collection is suggested for prompt collections.

Concentration Banking is a technique of decentralised or prompt collection.

Concentration banking system works this way: (i) there is decentralised billing of

customers, so that immediate dispatch of goods, invoices are made and

dispatched, (ii) customers are directed to send the remittances to corresponding

regional offices, (iii) regional offices on receipt of remittances send them to banks

for collection, (iv) After collection is effected, after retaining a minimum sum, the

regional office sends the balance on account to the head-office bank account. As all

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such cash balance remittances get concentrated in the head-office bank account,

the method is known 'concentration banking'. This system involves quick dispatch

of invoices, quick receipt of remittances, quick posting of entries, quick forwarding

of remittances to banks for collection, quick collection by banks and lump-sum

transfer to the concentration bank of collections from debtors. As a result,

collection float, that is, total time between mailing of a cheque by a consumer and

the availability of cash to the receiving firm, is reduced.

Lock-box System is another method of prompt collection. Here (i) the

regional branch offices send invoices to credit elastomers in respective branch

areas and direct them to send remittances to specified post-boxes hired from post-

office under an arrangement (ii) the bankers of the company clear the post boxes

several times a day and process for collection and also inform the firm's branch

office of the remittance (iii) after keeping a minimum balance, thef rest of funds is

remitted onward to the firm's main bank account.

Lock box system is an improvement over the concentration system.

In lock-box system the bankers clear the remittances from post-boxes instead of

remittances being sent to branch offices and branch offices sending the cheques

and bills to the bankers for collection. Thus one more interim step is skipped to

speedup the collection.

Preauthorised debit is another method of prompt collection. He the

transfer of funds from payer's bank to payee's bank is pre-authorised triggered, by

the payee with payer's advance authorization.

Now-a-days cash transfer is also done electronically - E-cash is used to

instantly transfer funds from payer's bank to the payee's bank. Electronic fund

transfer through SWIFT i.e., Society for Worldwide Inter-bank Financial

Telecommunication, and CHIPS, ie.. Cleaning House Inter-bank Payment System; is

now in vogue to instantaneously transfer funds.

8. Payment Practices

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While collections are prompted through decentralisation, payments

may be centralised, so that the same are delayed to the net advantage of the firm.

Suppliers are directed to send bill for payment to the Head-office. A transmission

delay is quite possible to the advantage of the firm. This is also known as mailing

float. A processing delay, due to centralised processing, is also imminent. Cheques

are issued and posted to suppliers. Another transmission delay results. The

supplier might cause a processing delay at his end before die cheque is sent for

collection to its banker. The banker sends the instrument for collection, again

involving a delay. Knowing that these delays are systematic, the firm may issue

cheques without sufficient cash balance on the day of issue of the cheque. This

practice is known as "playing the float'. The different floats involved here arc: First

transmission float Processing float Second transmission float Processing float

Collection float.

Payable through Drafts only, Zero Balance Account, remote

disbursement, controlled disbursement, etc are other alternatives of delayed

payment tactics.

9. Are Prompt Collection and delayed payment possible?

If one firm wants to speed up collection, others may also do so. So,

prompt collection and prompt payment are likely to go together in practice. One

firm may ask its customers to send remittances to regional branch offices.

Similarly, the firm's suppliers may also go for decentralised collection. The firm

must adjust to the collection practices of its suppliers. Lest, suppliers might stop

supplying. Of course, everything depends on the firm's equation with customers

and with suppliers. If the firm's market for its output is of the sellers' market type,

prompt collection may be resorted to and if it is of the buyers' market type this

system of collection may not be possibly. Similarly, if the firm's input market is of

the sellers' market type delayed payment cannot be adopted and if it is of the

buyers' market type delayed payment can be adopted. Collection efforts and

payment practices are generally governed by general trade practices. But in any

case, every customer and every supplier are individual cases and that the

treatment meted out to them should help establishing long-run relationship.

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10. MANAGEMENT OF RECEIVABLE

Receivables are an important current assets. Businesses have

receivables, i.e., dues from credit customers. To increase sales, to earn more, to

meet the competitors, to achieve break even volumes, to gain a foot hold in the

market, to help the customers on whom the business fortune is intimately in nexus

and to develop a strong brand, receivable, ie., credit sales, is vital. Maintaining

accounts receivable involves cost. Administrative cost, capital cost, collection cost,

bad-debt cost, etc., are diverse costs involved. As in any financial decision

matching costs with benefits is needed here too. And what is the optimum level of

accounts receivable is to be decided. Too little of accounts receivable, that is very

limited credit sales reduces sales, loss of customer to the competitor's camp,

reduced profit and so on. Of course no bad debt, less capital locked up in accounts

receivables resulting lower capital cost etc., are benefits. But, a little more risk can

be taken and profits can be inflated. Too much of accounts receivables lead to

scale advantage and hence y-ore profit, but costs of added bad-debt, capital cost,

etc., are involved. Perhaps by reducing accounts receivables costs can be steeply

reduced, when benefits are not similarly decreasing. Therefore optimum

investment in accounts receivable has to be planned and achieved.

63.1 Credit Policy

Policy is a guide line to action. Policy establishes guideposts or limits

for actions. Credit policy, therefore, refers to guidelines regarding credit sales, size

of accounts receivables, etc. Credit policy has a few variables. Credit standard,

credit period, credit terms and collection policies are the policy variables.

Credit standard refers to classification of customers on the basis of

their credit standing and stipulation of credit eligibility of different classes of

customers. The high rated customers may be extended unlimited credit, the

moderate credit standing class may be extended a limited credit facility and the

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rest may not be given any credit facility at all. Credit period refers to how long

credit, is allowed. Longer credit period might help drawing more customers and

vice versa Credit terms refer to discount incentive for prompt payment. Even

though a longer credit period may be allows, prompt payment by offering, cash

discount can be ensured. 2/30, net 45 means, 2% cash discount for payment within

30 days, failing which full payment by the 45th day of transaction. Collection Policy

refers the seriousness or otherwise with which collection is dealt with, especially

the delinquent customers. It may be harsh or warm.

Credit policy can be liberal or stringent Liberal credit policy adopts a

lenient credit standard (i.e., almost all are extended credit), longer credit period,

higher cash discount for a longer entitlement period and informal and

accommodative collection procedure. Stringent credit policy does not opposite.

Both policies have advantages and accompanying costs. Hence, choice must be

exercised by individual firms after assessing the net effect of liberalizing or

tightening up the credit policy.

6.3.2 Lenient Vs. Stringent Credit Policy

An analysis of effects of lenient and stringent credit policies is depicted

below in a table form.

Factors Lenient policy Stringent policy

Sales More Less

Capital locked up More Less

Customer base More Less

Competitive edge More Less

Profit More Less

Customer goodwill More Less

Capital cost More Less

Bad debt loss More Less

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Administrative cost More Less

Collection cost More Less

Discount allowed More Less

Lenient credit policy enhances benefits as well as costs. Stringeni

reduces both benefits and costs. Hence the problem of choice. Hence the need for

detailed evaluation for decision making. Evaluation needs to be done in respect

each and every credit policy variable. The same is done in the rest of this lesson.

6.3.3 Credit Standard

Illustration 6.4

A firm classified its customers into 4 classes-the nil risk, the less risk (1

to 2% bad debt), moderate risk (2 to 5%) and the high risk (bad-debt exceeding

5%). It extended unlimited credit for the less risk and insisted cash dealings with

the rest. Its current sales (So) amdunt to Rs. 50 lakh p.a. Average collection period

(ACP) is 60 days. SeHing: price and variable cost of sales (V) are Rs. 10 and Rs. 7.

Cost of capital (K) is 12% p.a. The firm is considering extending credit facility to the

moderate risk class, as a result of which sales will rise to Rs. 60 lakh (Sn) p.a. Bad

debts which are currently 0.5% of sales will rise to 1% of sales. In the credit

standard relaxation welcome?

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Solution

The impact of the credit standard deviation can be studied in terms of

benetfts and costs. Here, the benefit is contribution on additional sales.

C = Additional Sales x Contribution Ratio

Sales - Variable cost

(Rs.60 lakh - Rs.50 lakh) x ——————————————

Sale

10-7

= Rs.l01akh x ————— =Rs.3 lakhs 10

The additional costs are ii) cost of capital additionally locked ip and ii)

additional bad debt.

Additional Cost of Capital = Addl. Capital x cost of capital

= (Add. Sales X ACP XV) X K

360

= Rs. 10,00,000 x 60

360

= Rs. 14,000

Additional Bad Debt = Bad debt on proposed - Bad debt on Present

policy

= (Rs. 60,00,000 X 1/100) = (Rs. 50,00,000 X 1/200)

= Rs. 60,000 -Rs. 25,000

= Rs. 35,000

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The net benefit = Addl. Contribution - Addl. Capital Cost - Addl. Bad Debt

= Rs. 3,00,000 - Rs. 14,000 - Rs. 35,000

= Rs. 2,5 1,000

The credit relaxation is good for the business.

A formula approach can be adopted here.

AP = (AS X CR) - (AC X k) - ABD, where AP is change in profit, AS -

change: in sales, CR - Contribution ratio, AC - Change in capital, k - cost of capital,

ABD - Change in bad debts.

If AP is positive, change is advised.

1.4 Credit Period

Credit period relaxation or tightening may be effected. The effect such

change in policy can be evaluated and decision taken.

Illustration 6.5

A firm is giving 2 months credit to its credit customers. It proposes to

reduce the credit period to 45 days. Present sales are Rs, 60,00,000, CR is 10%,

present bad debt is 1% of the sales and cost of capital is 15%. The effect of credit

period contraction is expected to be a 15% fall in sales and bad debt to sales

getting reduced to 0.75% of 1 %. Assess the policy.

Solution

Here the benefits are reduced capital cost and reduced bad debt; The

cost is reduced contribution.

Reduced Capital Cost = (Old Capital in Receivable - New Capital inj Receivable) X K

= (S0 X ACPo/360) - ( Sn X ACPn/360 X 45/360) X K

= (60,00,000 X 60/360) - (51,00,000 X 45/360) X 15/100

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= Rs, 54,375.

(Sn = New Sales, S0 = Old Sales, ACPn = New Collection Period, ACP0 - Old

Collection Period)

Contribution Loss = Reduction in sales X CR

= Rs. 9,00,000X10/100

= Rs. 90,000.

Reduction in Bad debt - (S0 X Old Bad debt ratio) - (Sn X New Bad debt ratio)

= (60,00,000 X 1/100) - (51,00,000 X 75/10,000)

60,000 - 38,250 = Rs. 21,750.

The net effect is = Benefit - Cost

= (54,375 + 21,750) - 90,000

= 76,125 - 90,000 = - Rs. 13,875.

There is reduced profit So the policy change is not good.

Illustration 6.6

Take another example. Here credit period is increased to 60 days from

45 days resulting in sales rising to Rs. 60,00,000 from Rs. 51,00,000. Assuming K =

15%, CR = 20%, and bad-debts to sales ratio of 1% and 1.5 in the I pre and post

relaxation period we can evaluate the relaxed credit policy.

Solution

Addl. Profit = Addl.S x CR -AddLCapital x K - Addl.Bad debt. Addl Sales =

60,00,000 -51,00,000 - Rs. 9,00,000.

Addl. Sales X CR = Rs. 9,00,000 X 20% = Rs. 1,80,000.

Capital has two components. Additional capital on old accounts and

additional capital on new accounts.

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Addl. Capital on old accounts = S0 x (ACPn. ACP0)/360

= Rs. 51,00,000 X (60 –45)/360

= Rs. 2,12,500.

Addl. Capital on new accounts = Addl. Sales X V X ACPn /360

= 9,00,000X0.8 X 45/360

= 90,000.

Therefore Addl. Capital = Rs. 2,12,500 + Rs. 90,000 = Rs. 3,02,5000; Capital Cost

= Rs. 3,02,5000 X. 15 = Rs. 45,375.

Addl. Bad debt = Sn x Bad debt ratio - S0- x Bad debt ratio

= 60,00,000X1.5/100-51,00,000X1/100

= Rs, 39,000.

Therefore Net effect = Addl.Contribution - Addl. Capital Cost – Addl. Bad effect

= Rs. 1,80,000 - Rs. 45,375 - Rs. 39,000

= Rs. 95,625.

The change is good and hence good to implement.

Sometimes, capital locked up, (C) is calculating using average cost

figure instead of basing the same on variable cost. Suppose the average cost per

unit is Rs. 8 in this problem. Then AC is computed as follows. AC has two

components. Increase in capital on existing accounts and fresh capital on new

accounts. The former is calculated on the average cost basis and the later on the

variable cost basis.

Illustration 6,6

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Let the current ACP be 45 days, with sales of 30000 units. Variable cost

per unit is Rs. 6, average cost per unit is Rs. 8 and selling price per unit Rs. 10.

Cost of capital is 15%. Increased credit period resulting in an ACP of 75 days, is

likely to rise sales by 4500 units. Bad debts are likely to go up to 2% of sale? from

1% of sales. What is the impact of credit period relaxation on profit?

Solution

P = AS x CR – AC x K - ABD

S x CR = 4,500 (Rs. 10 - Rs. 6) - Rs. 18,000.

So x AC x (ACPD - ACP0) + AS x VC x ACPn

C =360 360

30,000 x Rs.S x (75-45) + 4500 \ Rs.6 x 75=

360 360

= 20,000 + 5625 = Rs.25,625

C x K = Rs.25,625 x 0.15 = 3844

BD = New Bad debt-Old bad debt

= 34500 x 10 x 0.02 - 30000 x 10 x 0.01

= 6900-3000-Rs.3900 AP

P = Rs. 18000 -Rs.3844 - Rs.3900

= RS. 10256.

63.5 Credit Terms

Credit terms refer to cash discount rates, eligibility period for availing

cash discount, the maximum credit period allowed and so on. Credit policy is made

liberal by increasing the cash discount rate and/or lengthening the eligibility period

and the same is made stringent by decreasing both the cash discount rate and

time to avail the same. There are both costs and benefits in each move. Hence

evaluation is to be done for each proposed move and decision taken.

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Illustration 6.7

A firm is currently allowing: 2/20, net 45 days. Its current sales are Rs.

60 lakhs, 50% of accounts are cleared by 20th day, the balance on 45th day. There

is no bad debt. It is considered that, a 2/30, net 45 days will boost sales to 72 lakhs

and 90% sales getting collected by 30th day. A 1% bad debt on additional sales is

expected. The contribution to sales ratio is 20%. The cost of capital is 20%.

Ascertain the utility of the above move.

Solution

(i) Additional Contribution = Addl. S x CR - 12,00,000 x 20/100

= Rs. 2,40,000

(ii) Old ACP = 50% of 20 days + 50% of 45 days = 32.5 days,

(iii) New ACP - 90% of 30 days + 10% of 45 days = 31.5 days.

(iv) Decrease in capital locked up with old customers =

(32.5-31.5) = 60,00,000 x _________

360 = Rs. 16,667

31.5 80(v) Capital locked in Addl. S = 12,00,000 x ——— x ——

360 100

= Rs.84,000

(vi) Net addl. Capital locked up = Rs. 84,000 - Rs. 16,667 = Rs. 67,333

(vii) Cost of capital locked up = Rs, 67,333 x .2 = Rs. 13,467.

(viii) Discount availed earlier

= 60,00,000 x 50% x 2% = Rs. 60,000

(ix) Discount availed after policy change

= 72,00,000 x 90% x 2% = Rs. 60,000

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(x) Addl. Discount now allowed

= Rs. 1,29,600-Rs. 60,000

(xi) Bad debt likely to occur

= Addl S x 1% = 12,00,000 x 1% = Rs. 12,000

(xii) Change in profit = Addl. Contribution - Addl. C x K - Addl. Discount - Bad

debt

Rs. 2,40,000 - Rs. 13,467 - Rs. 69,000 - Rs. 12,000

= Rs. 1,44,933

The policy change gives a net benefit of Rs. 1,44,933 additional profit.

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6.3.6 Collection Efforts

Collection efforts refer to the extent of seriousness of measures taken

to collect dues from customers. Firms may be liberal with customers or very

stringent. In the later situation each account is closely monitored, normal

remainders are sent initially and if still payments do not forthcome conditional

remainders are made. This would involve additional cost. There may be reduced

sales too. But capital lock up will be slim and bad debts small. If a liberal attitude is

adopted bad debts and capital cost shall be higher, sales higher with reduced

administrative cost Collection efforts should not be stringent nor too general.

Individual cases must be considered on merits and relaxation or lightening up may

be undertaken.

Illustration 6.8

A firm is thinking of tightening its collection policy. The details are:

Current sales 3,60,000 units on credit. Price Rs.32 per unit. The variable and

average cost per unit are Rs. 25 and Rs. 29 respectively. The ACP is 58 days with a

bad debts of 3%. Collection expenses Rs. 1,00,000. A tightening of collection

efforts is considered which will result in a sale contraction to 3,55,000 units,

additional collection amount Rs. 2,00,000, bad debts 1% and ACP 40 days. Cost of

capital 20%. Ascertain whether the tightening up is in the overall interest of the

firm?

Solution

(i) Loss of contribution = Reduction in units x contribution per unit

= 5,000 x (32 - 25) = Rs, 35,000

(ii) Addl. Collection Cost = Rs. 2,00,000.

(iii) Total Cost of the Decision = (I) + (ii) = Rs. 2,35,000

(iv) Capital locked up as per Existing plan

3,60,000

Existing plan = ——————— x 58 x Average cost per unit

360

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= Rs. 16,82,000.

(v) Capital locked up as per New project

3,60,000 x 40 x 29 5,000 x 40 x 25New Project =

360 360

= Rs.l 1,60,000 - Rs. 13,900 - Rs. 11,46,100

(vi) Reduction in Capital Locked up = Rs, 16,82,000 - Rs. 11,46.100

= Rs. 5,35,900

(vii) Capital cost of Savings = Rs. 5,35,900 x .2 = Rs. 1,07,180

(viii) Reduction in bad debt

= 3% of 3,60,000 x 32 - 1% of 3,55,000 x 32

= 3,45,600- l,13,600 = Rs. 2,32,000

(ix) Total benefits of the decision = (vii) + (viii) = 3,39,180

(x) Net benefit - (ix) - (iii) - Rs. 1,04,180

The tightening of the credit collection is ;hoix'ibre advantageous to the

firm.

6.3.7 Control on Accounts Receivables

As was earlier referred to the investment in accounts receivable should

be within accepted level. To achieve this, control measures are needed so that

when actuals fall outside the prescribed range, corrective actions can be taken. In

controlling accounts receivables certain techniques are adopted* Three such

techniques are described below. These are: (i) Debtors turnover ratio (ii) Debtors

velocity and (iii) Age of debtors.

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Debtors Turnover Ratio (DTK) refers to ratio of sales to accounts

receivable (Sundry debtors plus bills receivables). The accounts receivable may be

closing figure, or average of year beginning and year-end figures or average of

monthly opening and closing figures. An acceptable range for the ratio be fixed.

Say a DTR of 5 to 6 times is fixed as ideal. When the actual ratio is within this

band, it is all right. If the actual DTR is less than 5, it means more money’s locked

up in accounts receivables. Either sales have slumped relative to size of debtors, or

debtors have risen relative to sales. If the ratio exceeds the upper band, it means

customers promptly pay willingly or by out offeree. However, if more sales can be

booked through relaxation should be considered.

Debtor’s velocity refers to how many days’ sales are outstanding with

the customers. This is given by: Accounts receivables/Per day credit sales. In fact,

debtors' velocity indicates the average collection period (ACP). If the ACP is

hovering around the credit period allowed, every thing is fine. If it exceeds the

credit period allowed, it signals snag in our collection, or unattractiveness of cash

discount allowed, which should be corrected. If ACP is less than credit period

allowed, it can be considered as good, but behind it a very stringent collection

policy or very liberal cash discount facility might be there. The exact cause and the

desirability of its continuation needs to be examined. Debtors' velocity can be

computed, this way also, that is: Number of working days in the year/DTR.

Age of debtors refers how long debts are outstanding. Say 10% of

accounts receivable is 6 months old, 15% is 5 months old, 25% is 4 months old,

25% is 3 months old, 15% is 2 months old and 10% is 1 month old. The average

age of debtors comes to: ΣW; Ai, Where Wi is proportion and Ai is age in months.

= .6 + .75 + 1.00 + .75 + .3 + .1 = 3.5 months. An ideal breakup of accounts

receivables can be established and actual position is monitored accordingly. The

ideal average age and actual average age on accounts receivables can be

compared and control is exercised and accounts receivables.

6.4 INVENTORY MANAGEMENT

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Inventory is an important current asset, the management of which is

dealt now. What is inventory? What are its varieties? Inventory is the buffer

between two related sequential activities. Between purchase and production,

between the beginning and completion of production, and between production and

marketing buffers are needed. Buffer means a cushion to fall back on. Production

should not suffer due to some difficulty in purchase of raw materials. Marketing

should not suffer due tg some difficulty in production. If the business has some

stock of raw materials, a temporary difficulty in purchase will not effect production

since the stock of raw materials can be used. If there is a stock of finished goods

marketing will not be effected duetto any temporary hurdle in production. The

stocks ofrraw materials and finished goods, therefore serve as buffers absorbing

the difficulties in purchase and production respectively. So, inventory takes

different forms. Stocks of raw materials, work-in-process and finished goods are

prime inventory. Stocks of consumable stores (like cotton waste, lubricants,)

maintenance materials (tools, jigs, etc), and packing materials are some secondary

inventory. A business has to carry certain amount of inventory. Carrying too much

or too little of inventory is bad. Inventoiy management is concerned with deciding

of right quantity. You will sea how this right quantity is determined in the course of

this lesson.

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Inventory management refers to the planning and control of the size of

individual items of materials that is carried on by a business. Take any business

firm-trading or manufacturing. Many and diverse materials are dealt with/used by

the firm. Quite a lot of money is locked up in these materials carried as stock.

Several factors account for this. The nature of the business, the size of the

business, the seasonality of production/consumption of the production, the

seasonality of raw material availability, the terms of purchase/sale, the length of

the production cycle, the dependability of transport facilities, the inventory policy

of the business, the costs of emergency action courses, the lead time and the lead

time consumption needs and the probabilities associated therewith etc, influence

the size of inventory. To elaborate a little, trading and most manufacturing

businesses, large businesses, seasonal businesses (like those in the manufacture

of umbrellas, rain-coats, etc), businesses using raw materials which are available

only during certain seasons (like flour mills, edible oil mills, etc), businesses which

buy on cash and sell or credit terms, businesses with longer production cycle

(where the time gap between beginning of production process and its completion is

more), businesses with uncertain transport infrastructure, businesses pursuing

cautious inventory policy (which cany more stock relative to their level of

operation), businesses where emergency purchases cost heavily, and businesses

with large/ fluctuating lead time and lead time requirements carry a lot more

inventory than other businesses.

Well, coming back to determination of the optimum size of inventory,

due regard given to all the above said factors, different questions arise. There are

i) How much to order every time? ii) When to order or what is the re-order level?

What should be the safety stock? What stock-out probabilities and levels are

acceptable? Inventory management has to find optimal/satisfying answers to these

and the size of inventory is thus determined.

The quantum of inventory carried depends on the motives of the

organisation. There are principally three motives, namely, transaction motive,

precautionary motive, and speculative motive. Inventory carried in order to

facilitate smooth running of day-to-day operations (production and sales) comes

under the first category. Inventory held to avoid slock-outs due to unforeseen

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contingencies (like spurt in demand, increase in rate of usage, delay in arrival of

ordered inventory, etc) comes in the second category. When excessive inventory is

held taking advantage of favourable price trends in the market, such excessive

inventory is called inventory held for speculative motives

Inventory requirements for meeting the transactional and

precautionary needs can be planned with fair degree of accuracy given the rate of

usage, lead time, the level of insurance against stock-out that is considered

prudent and other relevant information. With the help of these information the

maximum, minimum and reorder level of stock and the optimum quantity of stock

to be ordered each time can be ascertained, the stock level and optimum order

quantity plans help achieving the objective of inventory management.

6.4.1 Importance of inventory Management

Inventory forms a significant segment of current assets. For

manufacturing businesses a chunk of their current asset is in inventory. For

durable goods manufacturers work-in-process constitutes a good portion of their

current assets. For trading businesses finished goods account for a good portion of

current assets. In manufacturing businesses roughly 30% to 70% of current assets

is in inventory of one form or the other. In trading businesses the maximum range

can even approach 100% and the maximum may never fall below 50% or so. So

large funds are kept invested in inventory. As these funds are not free of costs and

investible funds are limited, every business has to see that it carries only just

enough inventory which must ensure that:

i) the increasing demand of the customers is met,

ii) there is no lost sales (i.e., sales that could have been made

but for stock availability) and there is no loss of consumer goodwill,

ii) the production operations go smoothly,

iii) there is no pile-up of stock of any item and consequent loss

due to obsolescence, theft, etc, and

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iv) there is no lock-up of more than adequate capital

inventory.

These objectives are conflicting. The first three objectives call for more

investment in inventory, while the rest pull in the opposite. Herein the

management has to play its role and balance these divergent objectives and set

the optimal level of investment in inventory. Hence the significance of inventory

management.

6.4.2 Inventory Costs

There are three types of costs. These are: Ordering costs (costs

associated with placing orders), cost of materials and carrying costs. Ordering

costs include cost of stationery, postage, telegram, etc in placing an order, and

cost of administration of the purchase organisation. Ordering costs are generally

assumed to be fixed per order and directly proportional with the number of orders.

Cost of materials is the purchase price, plus transport and insurance during transit.

Carrying costs include space cost, storage costs, insurance, taxes, obsolescence,

theft and pilferage, wastage and loss, the interest on capital locked-up, etc. If you

carry more inventory all the above costs will be increasing, though not

proportionally and vice versa. Besides, if you carry less inventory there are also

costs like high unit price for the inherent smaller order siz^s, contribution on sales

lost, cost of lost consumer patronage, and so on. Fof any given level of inventory,

these three components of carrying costs are present in some proportional-mix.

Inventory management aims at reducing both the ordering cost and

carrying cost. As these move in opposite directions, minimizing the total of both

these costs is the crux of the whole of inventory management exercises. Economic

order quantity technique of inventory management is based on this minimization

effect.

6,4.3 Inventory Levels

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Better inventory management is possible by setting inventory levels,

like maximum level, reorder level and minimum level.

Maximum stock level represents the quantity of inventory beyond which the stock

should never move up. Reorder level refers to the level of stock at which an order

for replenishing the inventory has to be placed. Minimum level or safety level is the

stock level below which the size of inventory should not normally fall. Lead time,

lead time consumption and the economic order quantity (EOQ) determine these

inventory levels. Lead time refers to the time lapse between order placement and

receipt of goods. Lead time consumption refers to the requirement/demand during

the lead time. Lead time is not a constant factor, neither lead time consumption is.

So, minimum, average and maximum lead times and minimum, average and

maximum lead time usage rates (per period) are found from experience. EOQ is a

fixed quantity which the square root of twice the period (say a year) requirement of

material times ordering cost per order divided by carrying cost of a unit of material

per period (a year). You may refer to cash management, where EOQ was

computed.

The different inventory levels are given by:

i) Reorder stock level = Maximum lead time x maximum usage rate

or

Minimum stock + (Average lead time X average usage rate)

ii) Maximum stock level = Reorder level + EOQ - (Minimum lead time X

Minimum Usage rate)

iii) Minimum stock level = Reorder level - (Average lead time X

Average Usage rate)

iv) Average stock level = Minimum level + ½ of EOQ

or

(Minimum level + Maximum level1)/2

v) Danger stock level = Minimum usage rate X Emergency lead time.

6.4,4 Inventory Management Techniques

BSPATIL

Several inventory management techniques are available. The above

referred to EOQ and inventory levels are themselves are some techniques of

management of inventory under conditions of certainty and uncertainty. These are

presented right now. Then the ABC control technique is presented.

6.4.4.1 EOQ Technique

When an organisation is operating under conditions of absolute

certainty, inventory planning is relatively a simple affair. By 'conditions of

certainty’, it is meant that the rate of usage of or demand for the item of inventory

in question is stable, the lead rime is fixed, and the supplier of the item is able to

execute orders any time. When all these conditions are satisfied, it would be

enough if the organisation maintains adequate inventory for its transactional

needs. In other words, there is no need to hold inventory for meeting

contingencies. All that it needs to do is to determine the optimum reorder quantity

and the reorder-level. Under certainty business conditions there is no need to carry

any safety stock at all and the minimum stock level is zero. The maximum stock

level shall be equal to the reorder-quantity. To determine the optimum order

quantity the costs of inventory are considered. Inventory holding involves two

types of costs, namely, carrying costs and non-carrying costs. Whatever the level

of inventory held there would involve certain amount of both these costs. Carrying

costs refer to cost of capital locked up in inventory, space and storage, insurance,

tax, etc. Non-carrying costs refer to ordering costs, lovt sales, lost quantity

discounts, etc. At optimum order quantity the two costs together are the minimum.

Given the total quantity needed during a certain period of time be ‘A’

units, the quantity to be ordered be ‘Q’ units each time, the cost of carrying one

unit of inventory being 'Cf rupees per period and the cost of placing an order be ‘O’

rupees, the total carrying costs would be QC/2 and total ordering costs would be

AO/Q.

At optimum order quantity the total inventory cost i.e. (AO/Q) -(QC/2)

would be the least. By differentiating (AO/Q) + (QC/2) with respect to

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quantity and setting the same as equivalent to Zero, we get —

_ AO + C by putting this is equal to zero, we get Q

Q2 2

AO = C Q2 2

i.e.; 2AO = Q2C

i.e.; Q2 = 2AO/2

i.e.; Q = 2AQC

Illustration 6.9

If the annual usage is 36000 units, cost per unit is Rs. 100, cost of

carrying one unit for one year is 20% of cost and cost of placing an order is Rs.

400, find the optimum order quantity.

Solution

EOQ = V2AO/C = V2x36000x400 / 20 - 12 0 units

Case l:

But in practice an organisation cannot always stick to the optimum

order quantity, due to limitations of facility or restricuons on the size of orders

imposed by the supplier or varying quantity discounts offered by the supplier

depending on the size of individual orders. In all these cases the relative costs of

all possible alternatives have to be found out before the decision is finally taken on

the size of reorder quantity or the EOQ.

Illustrative Cases

Continuing the example already given and assuming that the

organisation is having storage facility to accommodate only 1000 units but has

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facility to hire space to store additional 200 units at an extra cost of Rs. 2000 per

annum, the right quantity to be ordered would be calculated as given below:

TABLE 1

Items of Cost

Amount of cost

Ordering quantity

1000 units (Rs.) 1200 units

(Rs.)

Ordering Cost = (A/Q) x 0 14,400 12,000

Carrying Cost = (Q/2) x C 10,000 12,000

Additional Cost of facility hired - 2,000

Total 24,400 26,000

Obviously the organisation would fix its order quantity at 1000 units,

though its optimum order quantity is 1200 units originally. The cost saving is Rs.

1,600/- per annum.

2. Sometimes the supplier may stipulate that orders in multiples of say,

500 units only are acceptable to him. In such cases, the optimal order quantity is to

be calculated ignoring the restriction and then the total cost of inventory is

computed at ordering quantities satisfying the stipulation immediately above and

below the optimal order quantity level. In our case 1000 and 1500 units are the

alternative ordering quantities in question. The cost computations are as under

TABLE 2

Items of Cost

Amount of cost

Ordering quantity

1000 units (Rs.) 1200 units (Rs.)

Ordering Cost A xO/Q 14,400 9,600

Carrying Cost QxC/2 10,000 15,000

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Total 24,400 25,600

An order quantity of 1000 units is marginally economical.

3. The supplier may quote differing prices for different order quantities. Let us

assume that in our case the supplier quotes the following prices for different

quantities of order given under.

Quantity

Ordered

Price per Unit

Less than 1000 Rs. 100.00

1001-1500 Rs. 99.90

1501-2000 Rs. 99.75

2000 and above Rs. 99.60

The organisation considers order sizes of 1000, 1200, 1800, 2000 and

2400 units. The computation of optimal order quantity is carried out below:

TABLE 3

Order Size (Q) Carrying

cost Q/2 x

price x

20%

Ordering cost

A/QXO

Discount

earned AX

Discount

Rate

Net Cost

(2)+(3)-(4)

(1) (2)

(Rs.)

(3)

(Rs.)

(4)

(Rs.)

(5)

(Rs.)

1000 10000 14400 - 24400

1000 11988 12000 3600 20388

1800 17955 8000 9000 16955

2000 19950 7200 9000 18150

2400 23904 6000 14400 15504

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The optimum order quantity is that quantity level where the cost of

carrying and ordering less the discount earned is die minimum (Discount earned =

Annual purchases X Discount per unit). An order quantity of 2,400 units is the

optimum level since the net cost is the least here, namely Rs. 15,504.

6.4.4.2 Stock level techniques

When rate of usage and lead times are varying, then we say there is

uncertainty (Other uncertainties like price fluctuations, seasonal factors, etc., are

not considered). In such cases effective inventory management needs two factors

to be satisfied, namely, investment in inventory does not exceed a certain limit and

stock oat situation does not arise. In other words, the maximum stock level and

minimum stock level are to be scientifically fixed taking into account various

factors. In situations of this nature, the maximum, average and minimum lead

times and usage rates are first computed. Then the different levels of stocr are

determined.

Reorder level - Maximum lead time X Maximum usage rate

Maximum level - Recorded level + optimum order quantity -

(Minimum lead time X Minimum usage rate)

Minimum level or - Recorded level - (Average lead time X

Safety level Average usage rate)

Continuing our example given in the very beginning, let us assume the following.

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Usage Rate

(UR) in units

Lead Time in days

(LT)

Maximum 120 11

(MAX)

Average (AYR) 100 7

Minimum MIN) 80 5

Assuming an opening inventory of 2000 units the order schedule,

usage and inventory levels, under the most pessimistic, most optimistic and most

likely levels of usage rate and lead time would be as given in Table-4. In the most

pessimistic situation the stock level just prior to receipt of the reorder quantity is

zero, but there is no stock-out. However, as stock level approaches ‘Zero’ there is

the potential danger of running out of stock, i.e., as it reaches the danger level,

urgent measures to procure materials are called for. Investment in inventory is

best utilised here. In the most optimistic case, the usage rate is less and the

delivery of order quantity is most prompt, resulting in relatively maximum stock

position throughout. There is more safety here, but at the same time there is piling

up the stock. In the most likely situation, there is neither fasi depletion nor pile up

of stock. Fair level of safety and turnover of stock are ensured.

Table 4

Details Most pessimistic

situation

Most optimistic

situation

Most likely

situation

1. Assumption

on usage

Max. LT & Max

UR

Min. LT & Min.

UR

AVR.LT&

AVR.UR

2. Opening Stock 2000 2000 2000

3. Less usage to

reorder level

680 (reached in

5 days)

680 (reached in

8 ½ days)

680 (reached in

6.8 days)

4. Reorder level

(Max.LT & Max

UR)

(New order is

1320 1320 1320

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placed)

5. Less usage-

until the receipt

of the ordered

quantity

1320 (11 x 120) 400 (5 x 80) 700 (7 x 100)

6. Balance just

prior to receipt

of ordered

quantity

0 920 620

7. Add: receipt

of ordered

quantity

1200 1200 1200

8. Present stock

position

1200 2120 1820

9. Implications Potential danger

of running out

of stock

Stock turn over

is

very small and

cost of stock is

more

Fail degree of

usage and

safety are

assured

10. Time of next

order

Immediate,

since present

stock level is

below reorder

level

Relatively

long after since

the present

stock level is

the maximum

level

After

some breathing

time since we

present stock lies

between the

recorder level and

the maximum

It could be seen from the above that the end stock position is

influenced by the consumption during the lead time i.e., (URXLT). In the above

analysis the cases, with varying levels of consumption having different impact on

the end stock. The levels of consumption could be anything given by AVR LT X,

MAX UR, AVR LTXMIN UR, MAX LTXAVR UR, MAX LTXMIN UR, MIN LTXAVR UR OR

MIN LTXMAX UR. But in all these cases the consumptions would fall within the limits

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set by the most pessimistic and most optimistic situations. Hence, the organisation

will not run out of stock, though the stock carried may be slightly excessive in

certain cases.

6.4.43 ABC technique

Here, inventory items are analysed into three categories on the basis

of total annual cost of each item. ‘A’ category consists of inventory items whose

value outweighs their volume, i.e. value is more, several-fold, than the volume, ‘C’

category consists of inventory items whose volume outweighs their value, i.e.

volume is more, several fold, than value. The ‘B’ category comes in the middle with

moderate volume and moderate value. A rough and ready count puts that ‘A’

category accounts for 70% of value but only 10% of volume, B category accounts

for about 20% of value and 20% volume and 'C' for 10% of value and 70% of

volume. In the computation volume percentage different authors adopt different

methods. Some count the number of items while others take head-counts of

individual items.

‘A’ category is subjected to closer planning and control Less planning

and control is attached to ‘C’ Regarding ‘B’ categoiy a via-made course is adopted.

The reasons for this are not far to seek. By closer control of ‘A’ category inventory

costs are reduced. Table 5 gives the planning and control approaches to the

different categories of inventory.

TABLES 5

ABC CONTROL TECHNIQUE

Aspect A Category B Category Category

1. Nature

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a. Total Value High Medium Low

b. Volume Low Medium Low

2. Order

a. Size Low Medium High

b. Number More Medium Few

3. Storage

a. Care More Medium Less

b. Records Complete Some Few

4. Issue

a. Procedure Stringent Moderate Lenient

b. Quantity Low Moderate Large

5. Overall

a. Planning More Medium Low

b. Control More Medium Low

6.4.5 Safety stock and stock out cost concepts

Safety stock is the minimum stock which the business must cany so

that no stock-out situation arises. If the inventory levels are set and adhered to

stock-out situations (i.e. out of stock positions) would not arise. But in actual

practice however some organisations would like to take the risk of running out of

stock, by making a trade off between the costs of stock out situations and the

benefits of carrying lesser safety stock. A lesser safety stock level other than the

one so far we considered may be followed by the organisation. In determining this

reduced level of safety stock the costs of carrying different levels of minimum

stock and the associated stock out costs are taken into account. The least cost

alternative is chosen.

Principally there are two methods of calculating the optimum safety

stock level. The first method assumes a fixed amount of stock out cost irrespective

of the level of shortage in stock and the second method assumes a varying amount

of stock out cost depending on the extent of shortage in stock. The two methods

are adopted here. With hypothetical figures the "modus operandi' of the two

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methods is explained. Curiously enough almost similar results are obtained, though

the results need not necessarily be so.

6.4.6 Computation of stock-out cost and determination of optimal stock

In method I the stock out costs are computed by taking into account

the probabilities of stock-out at different levels of safety stock and the cost of stock

out. The stock out cost is assumed to be constant. The probability times the stock

out cost gives the expected stock out cost. The logic of the assumption that stock-

out cost is constant per occurrence is maintained here since the efforts involved to

replenish stock in the case of run-out situation are same irrespective of the

quantity of shortage assuming that perfect market conditions are prevailing. Here

with a hypothetical stock-out cost of Rs. 40,000 per occurrence and with a

probability distribution as given in Table 6.

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TABLES 6

UNIT AND STOCK OUT COST PER OCCURANCE Rs. 46000

Safety

Stock (S)

Probabilit

y of

stock-out

(P)

Carrying

cost

(SXRs.20)

(Rs.)

Expected stock

out cost

(PXRs.40000)

(Rs.)

Total cost

(Rs.)

620 0.0 12400 0 12400

500 0.03 10000 1200 11200

400 0.07 8000 2800 10800

300 0.13 6000 5200 11200

200 0.19 4000 7600 11600

100 0.25 2000 10000 12000

0 0.33 0 13200 13200

1.00

The expected stock-out costs for different alternative levels of safety

stock are computed in Table 6. T^e- least cost safety stock level is 400 units.

Method II assumes that stock-out costs vary with the quantity of stock-

out and the probability of stock-out situations given the safety stock. The quantity

of stock-out is equal to the excess of consumption during lead time over i the

normal consumption and the safety stock held. The point to be noted here is that

safety stock is held tameet the excess in consumption over and above the normal

consumption. In other words enough stock to meet normal consumption is always

to be carried on and this stock is distinct from the safety stock. We have to

consider an example here. Let the rates of usage and lead time with their

probability factors as under.

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Consumption Lead time

Units per day Probability Days Probability

Maximu m 120 .2 11 .25

Normal 100 .6 7 .5

Minimum 80 .2 5 .25

Note that the usage and lead times are the same as those used in an

earlier section of the lesson. The only addition is the probability factor. In table 7

the extent different safety stock levels, corresponding reorder point, lead time

inventory requirement, extent of stock out and probability of stock out are given.

TABLE 7

EXTENT AND PROBABILITY OF STOCK-OUT

Safety

stock (S)

Corresponding

reorder point =

(700+S)

Lead time

requirement

(Cases

exceeding Col.

2 only)

Extend of

Stock-out

Probability of

Stock-out

620 1320 Nil Nil -

500 1200 1320 120 .05

400 1100 1320 220 .05

300 1000 1320 320 .05

1100 100 15

200 900 1320 420 .05

1100 200 .15

100 800 1320 520 .05

1100 300 .15

880 80 .05

840 40 .1

0 700 1320 620 .005

1100 400 .15

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880 180 .05

840 140 .1

When the reorder point is fixed at 1320 units (i.e. normal consumption

during normal lead time + Full safety stock level = 700 + 620 units) there is no

stock-out at all, as it should be. When the reorder point is fixed at 1200 units (i.e.

normal usage 700 -f reduced Safety stock, 500), the stock-out will be to the extent

of 120 units with a joint probability of .05, i.e. .2 X .25. With successive lesser

safety stock, different levels of stock out arises with different joint probability

factors. Table 7 gives these figures in detail.

Now the cost of stock out has to be ascertained. The stock out cost per

unit of shortage may be taken as Rs. 200. It may be noted that stock-out cost per

unit shortage is more since a shortage in stock even by one unit causes stoppage

of production, loss of customer goodwill, closure and resetting of production, and

so on. Fixed expenses cannot be cut, though no utility is derived from them during

the period. Hence stock-out cost per unit of shortage is much more than the cost of

a unit of inventory. In manufacturing undertakings this is largely the case. In

trading concerns the stock-out costs may be lower.

Table 8 gives the cost of different alternative levels of safety stock. The

expected stock-out, the probability and stock-out cost per unit, viz., Rs. 200. Of

these three factors, the first and second are in Table 7 and the third one is

assumed. The summarised values are given in Table 8. The carrying costs are

obtained as usual, namely Safety Stock X Rs. 20. The least cost alternative is found

to be 400 units of safety stock. In the first method also we got the same result,

though the two approaches may differ in the results.

TABLES 8

COST COMPUTATION FOR DIFFERENT LEVELS OF SAFETY STOCK

Safety Stock

(S)

Expected Stock-

out cost (Rs.)

Carrying cost

(SXRs.20)

Total

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(Rs.)

620 0 12400 12400

500 1200 10000 11200

400 2200 8000 10200

300 6200 6000 12200

200 10200 4000 16200

100 15800 2000 17800

0 22800 0 22800

6.4.7 WORKED OUT PROBLEMS Illustration 6.10

a) A manufacturer uses 200 units of a component every month and we buys

them entirely from outside supplier. The order placing and receiving cost is

Rs. 100 and annual carrying cost is Rs. 12. From this set of data calculate the

economic order quantity.

b) Private Limited uses three types of materials A, B and C for production of ‘X’

the final product. The relevant monthly data for the components are as given

below.

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A B C

Normal Usage (In Units) 200 150 180

Minimum Usage (In Units) 100 100 90

Maximum Usage (In Units) 300 250 270

Reorder Quantity (In Units) 750 900 720

Reorder Period (In month) 2 to 3 3 to 4 2 to 3

Calculate for each component:

(i) Re-order Level

(ii) Minimum Level

(iii) Maximum Level

(iv) Average Stock Level

Solution

(a) Annual consumption = 200 x 12 2400 units

EOO = 2AO = 2x2400x100 = 200 units

C 12

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Particulars Materials

A B C

i) Reorder level =

maximum period

x maximum usage

3x300 =900 4x250

=1000

3x270

=810

ii) Minimum level =

Recorder level -

Normal usage

900-(200x2 ½)

= 400

1000- (150x 3

½ )

= 475

810 -180 x 2 ½

= 360

iii) Maximum level —

Recorder level -

minimum

consumption +

EOQ

900-(100x2) +

750 = 1450

1000 -(100x3)

+ 900-1600

810 -(90x2) +

720=1350

iv) Average stock

level= (Minimum

level + Maximum

level)/2

(400+1450)/2

= 925

(475 + 1600)/2

= 1038

(360 + 1350)/2 =

855

Illustration 6.11

Annual requirement is 24000 units. Unit price Rs. 6 ordering cost Rs. 100 per

order. Carrying cost 20% calculate EOQ. If the order size is 6000 units a price off of

5% given. Is it worm to order in lots of 6000 units,

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2ACSolution EOQ =

C

= 2 x 24000 x 100 4800000

20% of Rs.6 = 1.2

= 2000 units

Total cost of computation for the two alternative order sizes, viz the

EOQ of 2000 and the other one with 6000 units.

DetailsSIZE SIZE

2000 units 6000 units

Rs. Rs.

Ordering Cost: (A/order size) x 100 600.00 200.00

Carrying Cost: (order size/2) x c 1200.00 3420.00

Inventory cost 1800.00 3620.00

Add: Purchase cost 144000.00 136800.00

Total cost 145800.00 140420.00

Notes:

i) The purchase price per unit when the order size is 6000 i Rs, 5.70 (i.e.

Rs. 6 minus 5%)

ii) Carrying cost is Rs. 1.2 when the size of the order is 200 units and Rs.

1.14 when the size of the order is 6000 uni (i.e. 20% of respective unit

price)

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Illustration 6.12

A firm has several items of inventory. The average number of each of

these as well as their unit costs is listed below:

ItemAverage No. of units in inventory

Average cost per unit

(Rs.)Item

Average No. of units in inventory

Average cost per unit (Rs.)

1 4000 1.96 11 1800 25.00

2 200 10.00 12 130 2.70

3 440 2.40 13 4400 9.50

4 2000 16.80 14 3200 2.60

5 20 165.00 15 1920 2.00

6 800 6.00 16 800 1.20

7 160 76,00 17 3400 2.20

8 3000 3.00 18 2400 10.00

9 1200 1.90 19 120 21.00

10 6000 0.50 20 320 4.00

The firm wishes to adopt one ABC inventory system. How should the

items be classified into A, B and C?

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Solution:

Steps

1) Calculate the total cost item-wise (units x unit cost)

2) Arrange items in the decreasing total cost order (refer total cost

column which is so arranged)

3) Work out percentage to total - both for costs and the quantity (head

count is adopted).

4) Take to four items which together account for about 70% of costs and

categorize them as "A". Items 11,13,4 & 18 constitute about 68% of

cost and 30% quantity.

5) Take next few items which together account for about 20% of costs

and these are branded as "B". The rest belong to "C".

Item Units% of

total

Unit cost

(Rs.)

Total cost

(Rs.)

% of

total

Classificatio

n

11 1800 5.02 2.5 45000 21.79

13 4400 12.29 9.5 41800 19.75 A

4 2000 5.58 16.8 33600 15.88

18 2400 6.70 10.0 24000 11.34

7 160 0.44 76.0 12160 5.75

8 3000 8.37 3.0 9000 4.25

14 3200 8.93 2.6 8320 8.93 B

17 4000 11.17 1.96 7840 3.71

17 3400 9.49 2.20 7480 3.53

15 1920 5.36 2.00 3840 1.81

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5 20 0.05 165.00 3300 1.56

10 6000 16.76 0.50 3000 1.42

19 120 0.33 21.00 2520 1.19

9 1200 3.35 1,90 2280 1.08

2 200 0.56 10.00 2000 0.94 C

6 300 0.83 6.00 1800 0.85

20 320 0.89 4.00 1280 0.60

3 440 800 2.40 1056 0.50

16 800 2.23 1.20 960 0.45

12 130 0.36 2.70 351 0.16

35810 100.00 100.00 211587 100.00

* Totals may not totally on account of roundmg off the figures.

Illustration 6.12

The following information is available relating to fee stock out of a firm:

Stock-out (units) Number of times Probability

800 2 .04

600 3 .06

400 5 .1

200 10 .2

0 30 .6

50 1.00

The selling price of each unit is Rs. 200. The carrying costs are Rs. 20

per unit. The stock-out costs are Rs. 50 per unit.

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(i) If the firm wishes never to miss a sale, what should be its safety

stock? What is the total costs associated with this level of safety

stock?

(ii) What is the optimal safety stock level?

Solution

Say the firm wishes to cany no safety stock. Then if, demand is 800

units, for which there is a probability of .04, 800 units will be the stock out Then

the stock out of cost is 800 x 50 x .04 = Rs. 1600, if the demand is 600, the stock

out cost is 600 x 50 x .06 = Rs. 1800, if it is 400 and 200, the stock out costs are

Rs. 2000 each. If the safety stock is 200 and if the demand is 800, the stock out is

600 and stock out cost is 600 x 50 x 0.04 = 1200 and id demand is 600 units the

stock out is 400 and the cost is 400 x 50 x .06 = Rs. 1200 and if the demand is

400, the stock out is 200 units and the cost is Rs. 1000. Similarly for other safety

stock levels the cost are worked out.

Solution:

Computation of expected stock-out costs

Safety stock level

Stock-out (units)

(demand -safety stock

Stock-out cost (Rs. 50 per unit

Probability of stock-

out

Expected stock-out cost at this Jevel

(Rs.) (CoI.3xCol.4)

Total expected stock-out costs (Rs.)

0 800-0=800 40,000 0.04 1,600

600-0=600 30,000 0.06 1,800

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400-0=400 20,000 0.10 2,000

200-0-200 10,000 0,20 2,000 7,400

200 800-200-600

600-200=400

400-200=200

30,000

20,000

10,000

0.04

0.06

0.10

1,200

1,200

1,000 3,400

400 800-400=400

600-400=200

20,000

10,000

0.04

0.06

800

600 1,400

600 800-400=400 10,000 0.04 400 400

800 800-800=0 0 0 0 0

COMPUTATION OF TOTAL SAFETY

Safety stock f

(Units) (Rs.)

Expected

stock-out

costs (Rs.)

Carrying cost

(Rs. 10 per unit)

Total safety

stock cost (Rs.)

0 7400 0 7400

200 3400 3800 7200

400 1400 7600 9000

600 400 11400 11800

800 0 15200 15200

(i) The safety stock should be 800 units of the finn never wishes to miss a

sale. The total cost associated with this level of safety stock is Rs. 15,200.

(ii) The optimal safety stock is 200 units. It is because, at this level, total

costs are minimum at Rs. 7,200.

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6.5 SUMMARY

Cash and liquidity management is better carried out through cash

budgeting, EOQ model and Miller - Or model. Receivables management depends on

credit policy. There are four elements of credit policy, namely credit std. credit

oeriod, discount terms and collection efforts.

Inventory management is an essential and integral function of financial

management with linkages with production and marketing areas. Inventory

management aims at optimum inventory levels, reorder times and reorder

quantity. Certain fundamental quantitative tools-optimization techniques,

differential calculus, etc., help in setting the above different optima. Again different

techniques are needed depending on the business situations. In a certain business

situation with verifying rates of consumption, fluctuating lead time, etc. apart from

the basic EOQ model reorder quantity, minimum quantity and maximum quantity

models, etc. are needed. Again, the use of probabilities helps making further

economics in the inventory area. With the knowledge of probability distribution of

usage rates and lead times, the extent of stock-out situations and the chances

thereof can be ascertained for any given level of minimum stock. Given the stock-

out cost per occurrence of per unit of shortage the most economical minimum

stock level can be detennined. Thus with the aid of quantitative techniques

efficient inventory management .becomes possible.

6.6 SELF ASSESSMENT QUESTIONS

1. Bring out the scope and importance of cash and liquidity management.

2. Explain the objectives of cash management.

3. What are the motives for holding cash? What are the factors that influence

such motives and the size of cash needed for each?

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4. Explain cash budgeting as a tool of cash management and the different

methods of preparing cash budget.

5. XYZ Co., wishes to arrange overdraft facilities with its bankers during the

period April to June, 1996 when it will be manufacturing mostly for stock.

Prepare a cash budget for the above period from the following data,

indicating the extent of the bank facilities the company will require at the

end of each month.

(a) Sales

Rs.

Purchases

Rs.

Wages

Rs.

February 1996 1,80,000 1,24,800 12,000

March 1996 1,92,000 1,44,000 14,000

April 1996 1,08,000 2,43,000 11,000

May 1996 1,74,000 2,46,000 10,000

June 1996 1,26,000 2,68,000 15,000

b) 50 per cent of credit sales are realised in the month following the

sales, and the remaining 50 per cent in the second month following. Creditors are

paid in the month following the month of purchase.

c) Cash at bank on 1.4.1996 (estimated) is Rs. 25,000.

6. Using the information given below prepare a cash budget showing

expected cash receipts and disbursements for the month of May and

balance expected at May 31,1996.

Budgeted Cash Balance, May 1996 Rs. 60,000.

Sales

March Rs. 5,00,000

April Rs. 3,00,000

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May Rs. 8,00,000

-Half collected in the month of sale, 40% in the next month, 10% in the third

month.

-40% paid in the month of purchase, 60% paid in next month.

Wages due in May Rs. 88,000.

Three years insurance policy due in May for renewal Rs. 2,000 to be

paid in cash.

Other expenses for May, payable in December Rs. 6,000; Fixed Deposit

receipts due on May 15, Rs. 1,75,000 plus Rs, 10,000 interest.

7. Explain the use of inventory model of cash management? A firm expects

that its cash receipts during a year shall be Rs. 80,000 and cash payments

Rs. 5,20,000. Its transaction cost is Rs, 40 per transaction and interest rate

20% p.a Find the optimum cash balance.

8. Explain the Miller-Orr model of cash balances management. The variance

of daily cash balance of a firm is 64,00,000. The transaction cost is Rs. 40

and return on marketable security per day per rupee is 0 003. Find the

optimum cash balance and set the upper and lower boundaries cfcash

balance.

9. Explain how collections can be prompted and payments delayed?

10. Explain: i) Playing the float, ii) mailing float, iii) Cash flow statement, iv)

compensation balance, v) CHIPS, vi) SWIFT and vii) E-cash.

11. Bring out the need for effective receivables management.

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12. Assess the relative merits and demerits of liberal and stringent credit

policies.

13. What is credit policy? What are its variables? Explain each of the variables.

14. A company's current position is: Sales Rs. 80,00.000; Variable Cost Ratio =

V = 80%; ACP = 40 days K *= 13%. It wants to relax its credit standard

such that hither to cash-dealings-only-customers are extended credit

facility. As a result additional sales Rs. 20 lakh are expected. Bad debts

which were previously nil, is likely to become 1% of the additional sales.

Evaluate.

15. A firm is considering several alternative credit periods to choose the best

one. A 45 days alternative guarantees a sale of Rs. 56 lakh, 60 days a sale

of Rs. 60 lakh, 75 days a sale of Rs. 65 lakh and 90 days alternative is to

give a sales of Rs. 80 lakh. Variable cost ratio is 80% of sales. Fixed cost

Rs. 6 lakh p.a. If the firm wants 20% ROI, find the optimum credit period.

16. A firm with 2/30, net 60 days credit terms, nets a sale of Rs. 50 lakh p.a.

and incurs a capital cost of 12%, 80% of accounts are cleared on 30 days.

The firm wants to switch over to 1/30, net 60 days. This is likely to reduce

sales by 10% and the percentage of accounts availing cash discount to

60%. Assuming a variable cost to sales ratio of 85%, assess the new

proposal.

17. A company wants to liberalize its collection efforts. At present its sales are

Rs. 40 lakh, ACP is 40 days, contribution to sale ration are 15% and the

cost of capital 14% p.a. Bad debts are 1% and collection cost Rs. 25,000.

The proposed relaxation of collection efforts will raise sales by 20% and

raise ACP by 10%. Bad debts shall be 1.5% of sales and collection cost just

Rs. 5,000. Ascertain whether it will be beneficial to relax collection efforts.

18. What do you mean by control of accounts receivables? Why such control is

needed? What are the methods of control adopted?

BSPATIL

19. Two firms have the following age distribution of accounts receivable:

Month Old Firm A Firm B

(Proportion of Accounts)

Upto 1 month .1 .15

1-2 months .15 .15

2-4 months .50 .60

more than 4 months .25. .1

Compute the average age of accounts receivables and ascertain which firm is

relatively swifter in collection. Make own assumptions, if any, needed.

20. Calculate DTR and Debtors Velocity given the following: Credit sales Rs.

3,65,00,000. Opening Bills Receivable Rs. 18,00,000 and debtors Rs.

42,00,000. Closing Bills are Rs. 8,00,000 and debtors Rs. 32,00,000. If total

credit sales have not declined compared to previous years what inferences

do ; credit policy of the firm from the recent figures?

21. Give the meaning and significance of inventory and inventory

management.

22. Explain inventory costs and their behaviour with volume.

23. Explain the use of EOQ and stock levels in efficient management.

24. What is stock out cost? What are the methods of determination of stock-

out costs?

25. Can businesses manage with lesser minimum stock? if so, how?

REFRENCES

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1. Financial Management and Policy - Van Home

2. Financail Decision Making - Hampton

3. Management of Finance - Weston and Brigham

4. Financial Management - P. Chandra

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UNIT – VII

DIVIDEND MANAGEMENT

In this unit you will learn the nexu between dividend and share value,

dividend theories, determinants of dividend, dividend policies, dividend practices

and related issues.

INTRODUCTION

In this unit, we take up a very crucial decision area of financial management. The

result of successful investment and financing functions is profit, excess of income

over expenditure. Profit here refers to divisible profit i.e., profit that can be

distributed as dividend to the shareholders. Obviously, therefore the profit after tax

(i.e. PAT).

The profit has to be effectively utilized. There are two ways to utilize

the profit – pay dividend and plough back profit in the business, itself. When you

pay di investment in the company. When the profit is retained and ploughed back

into the business, the company makes use of the fund for its investment needs.

The return for the share holders, when profit is ploughed back is capital

appreciation reflected by increase in the value of share held by them.

Whether to distribute or retain the profit, is a difficult question to

answer, for there are very many conflicting opinions on the effect of the alternative

ways of application of profit. There are several theories, policies and dividend,

paying less or more dividend decision – paying or not paying dividend, paying less

or more dividend – affects the market valuation of the shaes. Another theory puts

that these are not related, i.e.. paying or not paying dividend or paying less or

more dividend on the one hand and value of the share on the other are not related

issus. So, dividend irrelevance, i.e., irrelevance of dividend as a factor affecting

market valuation of share is emphasized. Many theories on both the sides are thus

available.

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Apart theories, there are different dividend policies and dividend

tractices adopted by companies. There are different factors affecting dividend

ecisions. All these are dealt with in this lesson.

7.1 DIVIDEND AND VALUE NEXUS

Dividend is the current return provided on share capital. Payment the

rate of dividend affect market value of shares. Since wealth, i.e.. rising the market

of shares, is a foremost objective agement, the impact of dividend decision on

market valuation nee. Generally, regular and stable dividend has a positive effect

on share profit prices. The portion of profit that is retained also affects the share

price. This is an internal finance available free of floatation cost and time. This

money when utilized profitability, the benefits do go the shareholders. So, retained

jet share value. Hence dividend decision affects valuation of v is held by Graham

and Dodd, James Walter and Myron Gordon.

Graham and Dodd would say that liberal dividends as against niggardly

dividends have overwhelmingly positive effect on stock prices. Walter and observe

that the firm’s cost of capital, the internal rate of return, and the dividend payout

ratio (i.e.. the per cent of profit paid as dividend together influence market value of

shares. Modigliani and Miller would say that value of firm depends on the firm's

investment decision and not on the dividend (as well as the financing decision).

This view is referred to as “the dividend irrelevance” in valuation. So, the dividend-

valuation nexus is yet an

BSPATIL

7.2 DIVIDEND THEORIES

In this section we take up the different dividend theories for n-Dodd

theory, Walter theory, Gordon Theory and Modigliani y of dividend are dealt below:

7.2.1 Graham Dodd Theory

Graham - Dodd theory is in support dividend value nexus. As per their

P= m(D+E/3), where p = market price per share, D = dividend per share, E =

Earnings per shar and m is a multiplier. The above valuation formula can be

rewritten as follows:

(D(E-D))) or

P = m (D + 3

3D+D+(E-D)

P = m ( 3 ) or

P = m/3 (4D+R), where E-D = R = retained eanings per share.

As ‘m’ is a multiplier, m/3 becomes a constant.

Value, (P), is 4 times influenced by D compared to a unit time influence from

retained earnings. So liberal dividends would enhance share value leaps and

bounds.

Example: Let E = Rs. 10, D = Rs. and m = 6 then

P = m/3 (4D+R) = 6/3 [(4x6) + (10-6)] = 2 (24+4) = Rs. 56.

If D = rs. 8 given other things the same as before.

P = m/3 (4D+R) = 6/3 [(4x8) + (10-8)] = 2 (32+2) = Rs. 68.

7.2.2 James Walter’s Theory

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This theory holds that market value is influenced by dividend decision. The value of

the share (P) is given by:

P = [D + (E-D) r/k] » k where,

P = Price per share,

D = Dividend per share

E = Earningsp

r = internal rate

k = cost of capital and

E-D = retained earnings per share.

As per this theory, the present value of an infinite stream of D, i.e., and

the present value of an infinite stream of returns from retained ings, i.e..,

[(E-D)r/k]»k. constitute the value of the share. So both the dend paid and the

returns from retained earnings affect share value.

The assumptions of the theory are:

a) Cost of capital (k) of the firm remains constant

b) Return on investment (f) remains constant

c) Firm has an infinite life and

d) Retained earnings are the only source of finance.

According to Walter, a company can increase its share price by

declaring less dividend when its internal rate of return (r) is greater than its cost of

capital (k); and by declaring more or 100% dividend when its Y is less than it ‘k’. If

r=k, the share value remains the same whatever the value of D. So when r>k,

(here the firm is called a growth firm), less dividend or a nil payout ratio brings the

optimum result. For a declining firm i.e.., when r<k, the optimal payout ratio is

100%. For a normal firm, i.e.; when r=k, there is no optimal payout ratio, as

BSPATIL

dividend payout does not effect value of the share. Below is presented the working

of Walter's model, in table 7.1.

Table 7.1 WALTER'S MODEL - AN EXPLANATION

Growth firm

r>k

Normal firm

r=k

Declining firm

r<k

r = 20% r = 20% 10%

k = 10% k = 20% k = 20%

E = Rs.5 E = Rs.5 E = Rs.5

If D = Rs.5 If D = Rs.5 If D = Rs.5

P = [54<5-5).2/. 1] /.

1

= [5 + (5-5).2/.2] /.2 = [5 + (5-5). I/.2] / .2

= Rs.50 = Rs.25 = Rs.25

If D = Rs.3 If D = Rs.3 If D = Rs.3

P = [3+(5-3).2/. 1] /. 1 = [3 + (5-

3).2/.2] / .2

= [3 + (5-3). 1/.2] / .2

= Rs.70 = Rs.25 = Rs.20

If D = Rs.3 If D = Rs.3 If D = Rs.3

P = [0+ (5-0).2/.l] / .1 = [0 + (5-

0).2/.2] / .2

= [0 + (5-0).I/.2J / .2

= Rs.100 =Rs.25 = Rs.12.5

From the above explanation you know that when i>k, value increases

as D decreases; that when r=k, value remains constant; and that when r<k, nil

payout is optimal When r=k, dividend-value nexus is absent

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Illustration 7.1

From the following information supplied to you, ascertain whether the

firm’s dividend payout ratio is optimal according to Walter's theory. The firm was

started a year before with equity capital of Rs.20 lakhs (There is no debt capital).

Earnings of the firm Rs. 2,00,000

Dividend paid Rs. 1,50,000

Price - earnings ratio 12.5

Number of shares outstanding 20,000. The firm is expected to maintain its current

rate of earnings on investment.

i) What is the value of share?

ii) What should be the price-earning ratio at which dividend payout ratio will

have no effect on the value of share?

iii) Will your decision be changed if the P/E ratio is 8 instead of 12.5?

Solution:

First we have to compute, E, D, k and r.

E = Rs.2,00,000/20,000 = Rs,10; D = 1,50,000/20,000 = Rs.7.5,

k = inverse of price - earnings ratio - 1/12.5 - 8% and

r - earnings/capital = Rs. 2,00,000 / 20,00,000 = 10%.

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7.50 + (Rs.10-Rs.7.5) x (10%/8%)P =

8%

= 7.50+ (Rs.2.5) x (1.25)————————————

8%

= 7.50 + 3.125 Rs. 10.625————————— = ———————— = Rs.132.81

8% 8%

This is a growth firm, since r>k. So, zero payout ratio is optimal. So the

firm’s present dividend payout ratio is not optimal. At 75% dividend payout ratio

i.e.. the current payout, the price per share is Rs. 132,81. The zero percent divided

payout ratio would be optimum as at this ratio, the value of the share would be

maximum. This is shown in the following calculations:

0 + (Rs. 10-0) x (10% /8%)P = ——————————————————

8%

(10) 1.25 Rs. 12.50= ————————— = ————————— = Rs. 156.25

8% 8%

ii) P/E ratio of 10 times would have no effect on the value of the share because at

this rate k=10%. You know K = 1/PE Ratio - 1/10 = .1 = 10% you know r = 10%.

Hence r = k.

iii) If the P/E ratio is 8, k = 12.5% since k > r, the 100% dividend payout ratio would

maximize the value of the share. With the current 75% payout, P will be

7.50 + (Rs. 10-Rs. 7.5) x (10% / 12.5%)P = ————————————————————————

12.5%

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= 7.50 + (Rs. 2.5) x (0.8)—————————————————

12.5%

= 7.50 + 2.00 Rs. 9.5——————— = ——————— = Rs. 76 12.5% 12.5%

For 100% payout,

10 + (Rs. 10-Rs. 10) x (10% / 12.5%)

P = ———————————————————

12.5%

= 10 + 0 Rs. 10

————————— = ————————— = Rs. 80

12.5% 12.5%

So, 100% payout is optimal.

7.2.3 GORDON'S Theory

Myron Gordon’s theory of share valuation using dividend capitalisation

assumes that:

a) Retained earnings are the only source of finance for the firm.

b) r and k are both constant,

c) growth rate (g) of the firm is product of retention of ratio and rate of

return and g<k

d) the firm has an infinite life and

e) there is no tax.

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Y1 (1-b)

According to Gordon, P0 = ———————— Where,

k-br

P0 = price per share at time zero or the beginning of year 1

Y1 = earnings per share at the end of year 1

b = retention ratio

I-b = dividend payout ratio

k = cost of capital

br = growth rate (retention ratio x r)

Actually the above model is the dividend capitalisation approach which

was dealt with when we studied cost of capital in an earlier lesson. Y1 (l-b) is equal

to D1 and br = g.

(You remember we formulated there an equation, P0 = D1 / (ke-g) from which we

deduced that, ke = (D1/P0) + g in the lesson on cost of capital).

The nature of influence of dividend decision on the share price of

growth firm, normal firm and a declining firm is dealt below under Gordon’s theory,

in table 7.2

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Table 7.2s : GORDON THEORY - AN EXPLANATION

Growth firm Normal firm Declining firm

r>k r=k r<k

r = 20% or .2 r = 20% or .2 r =10% or.l

k =10% or.l k = 20% or .2 k = 20% or .2

E = Rs.5 E = Rs.5 E = Rs.5

If D = Rs.5 i.e.., b=0 If D = Rs.5 i.e.., b=0 If D = Rs.5 i.e.., b=0

P = [5(1-0)] / [.1-0] P = [5(1-0)] / [.2-0] P = [5(1-0)] / [.2-0]

= Rs.50 = Rs.25 = Rs.25

If D = 4, i.e.. b=.2 If D = 4, i.e.. b=.2 If D = 4, i.e.. b=.2

P = [5(1-.2)] / [.1-

0.4]

P = [5(1-.2)] / [.2-0.4] P = [5(1-.2)] / [.2-.02]

= 4/.06 = 67 = 4/.16 = 25 = 4/.18 = 22

If D = 3, i.e.. b=.4 If D = 3, i.e.. b=.4 If D = 3, i.e.. b=.4

P = [5(1-.4)] / [.1-

0.8]

P = [5(1-.4)] / [.2-0.8] P = [5(1-.4)] / [.2-0.4]

= 3/.02 = 150 = 3/.12 = 25 = 3/.16 = 19

You would understand that in the case of a growth firm, r>k as

retention ratio (b) increases the value (P) of the share rises. For a normal firm

value remains same. For the declining firm as ‘b’ increases ‘p’ decreases. All these

results are on the same lines as these found with the Walter’s theory.

Walter's theory permitted 100% retention, i.e.; nil dividend, whereas

Gordon's theory would not permit the same as the numerator then becomes zero.

This is one difference. The other is in the values of P as you would know on

comparison of the two tables 7. 1 and 7.2.

So, the optimal dividend payout for a declining firm is 100%; for a

normal firm the payout ratio is irrelevant and for a growth firm a lower payout

ratio. Consequent to a lower payout ratio (and hence a higher retention ratio) the

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br might become larger than k. Then ‘p’ becomes undefined. So, in the case of a

growth firm the optimal dividend payout ratio cannot be extremely low.

Illustration 7.2

The following information is available in respect the rate of return on

investments (r), the capitalisation rate (Ke) and earnings per share (E) of a

manufacturing company:

r = (i) 12% (ii) 1 1 % (iii) 8%

Ke = 11%

E = Rs.20

Determine the value of its shares as per Gordon's model each

alternative, assuming I) 10%, ii) 40% and iii) 70% payout ratios.

Solution

According to Gordon's model, the value of ^e ^ 1S given by the

following formula:

Y(l-b)

P = ————————

K-br

Alternative (i) when r = 12%

a) Payout ratio 10%; so, retention ratio 90%

br = (g) = 0.9x0.12 = 0.108

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Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 1,000

0.11-0.108 0.002

b) Payout ratio 40%; so, retention ratio 60%

br = (g) = 0.6 x 0.12 = 0.072

Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 210.52

0.11-0.072 0.038

c) Payout ratio 72%; so, retention ratio 30%

br = (g) = 0.3 x 0.12 = 0.036

Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 189.19

0.11-0.036 0.074

Alterntive (ii) when r= 11%

a) Payout ratio 10%; so, retention ratio 90%

br = (g) = 0.9 x 0.11 = 0.099

Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 181.82

0.11-0.099 0.011

b) Payout ratio 40%; so, retention ratio 60%

br = (g) = 0.6 x 0.11 = 0.066

Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 181.82

0.11-0.066 0.044

c) Payout ratio 70%; so, retention ratio 30%

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br = (g) = 0.3 x 0.11 = 0.033

Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 181.82

0.11-0.033 0.077

Alterntive (ii) when r= 10%

a) Payout ratio 10%; so, retention ratio 90%

br = (g) = 0.9 x 0.10 = 0.090

Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 100

0.11-0.090 0.02

a) Payout ratio 40%; so, retention ratio 60%

br = (g) = 0.6 x 0.10 = 0.060

Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 160.00

0.11-0.060 0.050

a) Payout ratio 10%; so, retention ratio 30%

br = (g) = 0.3 x 0.10 = 0.030

Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 175.00

0.11-0.030 0.080

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Thus far, the theories that support dividend - value nexus were seen.

The above theories hold that dividend payout is a relevant factor in share price

determination. The reasons are not far to seek.

A high payout ratio makes the shareholders feel certain about their

income. This is what is called as resolution of the uncertainty of future income.

There is an information content that the firm would make good profits in the future.

Shareholders with high current income prefer companies with high payout ratio.

Dividend income is exempted from taxation upto a limit. So, high payout increases

value. Similarly low payout might also increase value. This view is stressed by

Michael J. Brennan. As there is no floatation cost, the cost of internally generated

equity is less than cost of fresh equity, and capital gain ir taxed at a lower rate. So,

a preference for low payout ratio is also there.

The conclusion is that, dividend payout is relevant to valuation.

7.2.4 MM Theory

Now the M-M theory is taken up. According to this theofy dividend -

valuation nexus does not exist. Miller and Modigliani advanced their theory in

1961. Their assumptions are:

a. capital market is perfect,

b. investors are rational,

c. there is no transaction cost,

d. securities are divisible

e. information is freely available

f. no investor can influence market price singly,

g. there is no tax and

h. there is no floatation cost

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Their conclusion is that dividend decision is not significant in the

context of ssaFe-valuation. In other words, the shareholders get the same benefit

from dividend as from capital gain through retained earnings. So, the division of

earnings into dividend and retained earnings does not influence shareholders'

perceptions. So whether dividend is declared or not, and whether high or low

payout ratio is follows, it makes no difference on the value of the share.

MM Prove their argument quantitatively as follows:

1Po = -——— (D1 + P1) …(1)

1+k

Where, P0 - market price per share at the beginning of year 1

P1 - market price per share at the end of year 1

D1 - dividend per share at the end of year 1

k - discount rate applicable to the firm.

Equation 1 simply tells that the current price of a share is equal to the

sum of the discounted value of year - end dividend and market price at the end of

the year. From equation 1, the value of outstanding equity shares of the firm at

time 0, i.e.; beginning of the year is equal to :

1

nP0 = ——— [n D1 + (n+m) P1 - m P1] ....(2)

1+k

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where,

n = number of shares outstanding at time 0,

nP0 = total value of outstanding equity at time 0,

k = discount rate

m = number of additional shares issued at time 1

n+m = number of outstanding shares at time 1,

(n+m) P1 = value of all outstanding shares at time 1

mP1 = market value of fresh issue at time 1.

The value of equity issued at time 1, (mp1) is equal to total investment,

I, proposed at time 1, minus retained earnings. Retained earnings = Earnings, (X),

minus dividend, (nDi), i.e.., X - n D1

So, mP1 = I – (X-nD1) ....(3)

By substituting the value of mPj as in equation 3 in the equation 2

above, we get

1

nP0= ——— [nD1 + (n+m) P1 - (I-(X-nD1)]

1+k

1

= ——— [nD1 + (n+m)P1 - I + ( X-nD1)

1+k

1

= ——— [(n+m)P1 - I + X] ….(4)

1+k

In the equation (4), when gives valuation of current equity shares of

the company, you don't find a place for D1 i.e.. dividend at all. So, Modigliani and

Miller held that value is independent of dividend decision. Hence their dividend

irrelevance stand. The dividend irrelevance stand stems from their leverage

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irrelevance stand dealt with in an earlier lesson. You must note that M-M theory

tells that dividend decision does not alter the value of share, unlike the case with

Walter, Gordon and Graham-Dodd theories.

Illustration 7.3

A Ltd’s cost of equity is 10%. Its outstanding shares is 1,00,000, valued

each Rs.40. The company plans to invest Rs. 13,60,000 one year hence. Its

expressed earnings is Rs.3,00,000 and likely dividend one year after is Rs.2 per

share. Show dividend irrelevance as per MM theory.

Solution

1

Weknow, P0 = ———— (P1 + D1)

1+k

1

Rs.40 = ———— (P1+2)

1+10%

1

Rs.40 = ———— (P1+2)

1.1

Rs.44 = P1+2 or P1 = 42.

Amount required for new financing = I - (X - n D1)

= 13,60,000 - (3,00,000 - 2,00,000)

= 12,60,000 at 1 year end.

No. of shares needed to be issued = Rs. 12,60,000 / Rs.42 = 30,000 shares. So M =

30000. Value of the firm

1

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V = nP0 = ——— [n D1-(n+m)P1 - I + X - n D1]

1.1

1

= ——— [2,00,000+(1,00,000+30,000)42-13,60,000+3,00,000-

2,00,000]

1.1

= 1

——— [2,00,000+ 54,60,000 -12,60,000]

1.1

1

= ——— (44,00,000) = 40,00,000

1.1

To show that dividend payment has no value on V, we have to show

that non-payment of dividend also results in ‘V’ as same as V when dividend is

declared. Let us now show that ‘V’ when dividend is not declared is same at

Rs.40,00,000 found earlier as the value of the firm with dividend payment.

Now, P1 is got as follows :

P1 + zero

Rs.40 = ——————— or P1 = Rs.44

1.1

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Amount needed to finance new project is:

= I – (X-D)

= 13,60,000 - (3,00,000 - 0) = Rs. 10,60,000

No. of shares to be freshly issued is:

Rs. 10,60,000

——————— Shares

Rs.44

Value of the firm is

1

V = nP0 = ——— [nD1+(n+m) P1 - I + X- nD1)

1

= ——— [1,00,000+(10,60,000/44)] 44 +13,60,000-3,00,000

1.1

1

= ——— [44,00,000+10,60,000-13,60,000+3,00,000]

1.1

1

= ——— (44,00,000) = 40,00,000

1.1

See, the value of the firm is same as with dividend payment. Hence the

irrelevance of dividend decision on valuation of firm.

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Criticisms on MM Dividend theory

MM theory is criticized on the invalidity of most of its assumptions.

Some of the criticisms are presented below. First, perfect capital market is not a

reality. Second, transaction and floatation costs do exist. Third. Dividend has a

signaling effect. Dividend decision signals financial standing of the business,

earnings position of the business, and so on. All these are taken as uncertainty

reducers and that these influence share value. So, the stand of MM is not tenable.

Fourth MM assumed that additional shares are issued at the prevailing market

price. It is not so. Fresh issues - whether rights or otherwise, are made at prices

below the ruling market price. Fifth, taxation of dividend income is not the same as

that of capital gain. Dividend income upto Rs. 10000 is fully exempt, whereas

capital gain attracts a flat 20% tax in the case of individual assesses. So, investor

preferences between dividend and capital gain differ. Sixth, investment decisions

are not always rational. Some, sub-marginal projects may be taken up by firms if

internally generated funds are available in plenty. This would deflate ROI sooner

than later reducing share price. Seventh, investment decisions are tied up with

financing decisions. Availability of funds and external constrains might affect

investment decisions and rationing of capital, then becomes a relevant issue as it

affects the availability of funds. Eighth, in the equation (4) ‘D1’ is not there. So

dividend does not influence value, according to M-M. But in the equation there is P1

which is influenced by TV as in equation (3). M-M theory is wrong on this count.

7.3 DIVIDEND POLICIES

Now the dividend policies may be discussed. A policy is a guideline for

action. What are the guidelines followed in respect of dividend function? The

guidelines relate to forms, scale, stability and timing of dividend payment.

Accordingly dividend policies of diverse nature are available. Prominent of them

are dealt with below.

Dividend policies based on form of dividend

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From the point of view of form, dividend policies could be: cash

dividend policy, scrip dividend policy or combined policy. Cash dividend policy

stipulates that dividends are payable in cash only. This is the most predominant

method. Indian laws recognize only this form as dividend. Scrip dividend policy

underlies payment of dividend through issue of fully-paid-up bonus shares. Well

established companies make bonus issues. Conservation of firm's liquidity, to make

the balancesheet to present a realistic picture of its capital base, to widen baies in

the shares market, to finance expansion programmes, to enhance the corporate

image, to lower the rate of dividend per share on future occasions and to get some

tax benefits scrip dividend is issued. The combined policy, implies that both cash

and scrip dividends are periodically declared by the company.

Dividend policies based on scale of dividend

From the point of view of scale, the policy options are: high payout

policy, low payout policy and medium payout policy. The high payout policy is

supported by Graham and Dodd. The arguments in favour of such policy were

already dealt with. Low payout policy underlies lesser dividend and higher

retention. When r > k, this policy is suggested. And its strong points are already

discussed. The via media policy is also good as it combines the advantages of both

the other policies, without their disadvantages.

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Dividend policies based on stability of dividend

From the stability point of view we have: fixed divided or varying

payout ratio policy, varying dividend or fixed payout ratio policy, steadily changing

dividend policy, target dividend payout policy and residual dividend policy. Fixed

dividend policy ensures that a constant dividend per share (DPS) is paid

periodically. Shareholders are certain of their current dividend income dd can plan

their financial activities accordingly. This policy implies that the payout ratio is

changing and that a dividend equalization fund may be required. This policy might

ensure a high and stable share price. Such a condition favours investors. Varying

dividend per share policy implies that the DPS fluctuates. Perhaps this may be

due to that a constant payout ratio is adopted by the firm while its earnings

fluctuate year after year. Share prices might fluctuate and speculation might build

up. Chart 7.1 and 7.2 give a pictorial presentation of these two policies.

A policy of steadily changing dividend per share is a good

alternative to both the above policies. Here the DPS is not infinitely held constant

or allowed to scale peaks and fall into troughs alternatively. On the other hand the

DPS is gradually changing (increasing or decreasing). Unless and until an upswing

in EPS is stabilized, DPS is not scaled up and similarly only when a down-swing in

EPS is more or less constant, the DPS is scaled down.

When an upswing in EPS is expected to be maintained for a reasonably

long time, the DPS is scaled up.

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Chart 7.1 Chart 7.2

A company may adopt, a policy of target payment ratio, wherein it

fixes a payment ratio which it must reach over a period of time. This policy is also a

via media to fixed and fluctuating dividend policies. There is another policy called

residual dividend policy. Dividend is paid only when anything is left after

meeting all investment needs. So, dividends would be very much fluctuating or

mostly nil going hill up or valley down.

Dividend policies based on timing

From the timing point of view we have regular and irregular, interim

and annual and immediate and no-immediate dividend policies. Regular

dividend policy implies that payment of dividend is a regular feature. The irregular

dividend policy implies the opposite. Shareholders definitely prefer the former to

the latter policy. Interim dividend policy is that the company declares dividend

more man once in a year. As and when disposable profits are available dividend is

declared. Annual dividend policy means that only once in a year dividend is paid

Immediate dividend policy means that the company pays dividend right from

establishment. It adds value to the company. No immediate dividend policy is one

where the company does not start paying dividend until it has good earnings. To

finance expansion, growth and diversification the internal funds may be used. Cost

of fresh external capital may be high and that no-dividend policy is adopted.

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Generally, few companies adopt this policy. But they have to be very cautious in

this regard.

7.4 DIVIDEND PRACTICES AND LEGAL FORMALITIES

Dividend practices are as divergent as dividend policies. Cash dividend,

scrip dividend, interim dividend, annual dividend, regular and stable dividend, and

regular and extra dividend practices are widely adopted. These are all already

discussed.

The company has to first of all formulate its policy as to form, scale,

stability and timing of dividend payment. Once the formulation is over, dividend

practice becomes a routine affair with certain legal formalities to be fulfilled.

Provisions of Companies Act relating to declaration and payment of

dividend have to be followed. In fact, the declaration and payment of dividend is an

internal matter of the company and is governed by its Articles. The power

regarding appropriation of profits is given to the Board of Directors. However, they

are governed by the provisions of Companies Act. The Directors are TO follow table

A or the provisions of Articles and the provisions of the Companies Act 1956 in this

regard. The following are the rules regarding declaration and payment of dividend:

1) Dividend on paid up capital: A company may, if so authorized by its

Articles, pay dividend on the paid up value of snares under Section 93 of the

Companies Act.

2) Provisions of Articles of Association: Rules 85 to 94 of Table A provide

that:

i) A company may declare dividend in its general meeting provided it

does not exceed the amount recommended by the Board of Directors.

ii) The Board of directors may from time to time pay to the members such

interim dividends, as appears it to be justified by the profits of the company.

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iii) Notice of any dividend should be given to those who are entitled to receive

the same.

iv) The directors may transfer any amount they thing proper to the reserve fund

which may be utilised for any contingencies.

v) When a dividend has been declared, it becomes a liability of the company to

the shareholders from the date of its declaration, but no interest can be

claimed on it.

3) Dividends only put of profits : a) Dividend can only be declared or paid out

of (i) the current profits of the company, (ii) the past accumulated profits and (iii)

moneys provided by the Central or State Government for the payment of dividends

in pursuance of a guarantee given by that Government No dividend can be paid

out of capital (Sec.205(i)). Director who is responsible for payment of

dividend out of capital, shall K personally liable to make good such amount to

the company.

b) Companies are not entitled to pay any dividend unless present or arrears

of depreciation have been provided from out of the profits and an amount of 10%

of profits has been transferred to reserve. However, the Central Government

may allow any company to declare or pay dividends out of profits before

providing for any depreciation.

c) Capital profits may also be utilised for the declaration of dividend provided

(i) there is nothing in the article prohibiting the distribution of dividend out of

capital profits; (ii) they have been realized 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

made good.

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4) Payment of dividend only in cash : (Sec.205(iii)) Dividends are to be paid in

cash only except in the following circumstances:

i) 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 "

ii) 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 on the date of declaration of dividend of to the holders of

dividend warrant it issued by the company.

6) Payment of Dividend with 42 days (Sec.207)

Dividend must be paid within 42 days of its declaration except in the

following circumstances:

i) by operation of law of insolvency;

ii) in compliance of the directions of the shareholders;

iii) where right to receive dividend is pending decision;

iv) where it is not due to the default of the company; and

v) if company lawfully adjusts the amounts against any debt due from the

shareholder.

7) Payment of Interim Dividend. The Director of a company can pay interim

dividend subject to the provisions of Articles. Interim dividend can be paid at

any time between the two annual general meetings taking into account full

year’s accounts and after providing full year’s depreciation on fixed assets.

7.5 FACTORS INFLUENCING DIVIDEND DECISION

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Scores of factors affect dividend decision. These are enumerated below with

brief explanation.

Legal position

Section 205 of the Companies Act, 1956 which lays down the sources from

which dividend can be paid, provides for payment of dividend (i) out of past profits

and (ii) out of moneys provided by the Central/State Government, apart from

current profits. Thus, by law itself, a company may be allowed to declare a

dividend even in a year when the profits are inadequate or when there is absence

of profit. However in a year when there are meager profits, while one company

may skip the payemnt of dividend, another company may apply for the alternatives

offered by the law.

Concerning the declaration of dividend, two concepts are relevant, namely,

(i) "profits available for distribution" and (ii) "Profits available for dividend". While

the former refers to the maximum profits which can be legally distributed as

dividend, the latter denote profits which the directors recommend for distribution.

Even when there are no profits in commercial sense, yet mere can be divisible

profits. There is, legally, no prohibition against "profits from sale of fixed assets"

from being distributed as dividend. Whether such a course of action is prudent or

not is altogether a different matter, while one company may decide in favour of

distributing dividends out of such "profits", another company may disfavour it.

When a company declares dividend it has to transfer a certain percentage of

its profit to reserves, which of course, depends on the rate of dividend. Even after

transferring profits to reserves and declaring dividends still there may be a balance

in profit. Whether this residue is to remain in the Profit and Loss Account itself or

any higher percentage of profit is to be transferred to reserves depends largely on

the practical consideration and policy of the management. In a particular years

when there is absence of profit or inadequacy of profit, the profits of earlier years

(which remain in P & L A/c itself) are more freely available for distribution than the

earlier years' profits which are transferred to reserves. Because in the latter case,

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it would be declaration of dividend out of reserves and provisions of Section

205A(3) are applicable: company concerned is bounded by the restrictions and

conditions laid down in the "Companies (Declaration of dividend out of Reserves)

Rules 1975".

ii) Magnitude and Trend in EPS

EPS is the basis for dividend. The size of the EPS and the trend in

EPS in recent years set how much can be paid as dividend A high and

steadily increasing EPS enables a high and steadily increasing DPS. When

EPS fluctuates a different dividend policy has to be adopted.

iii) Taxability

According to Section 205(3) of the Companies Act, 1956 'no

dividend shall be payable except in cash'. However, the Income-Tax Act

defines the term dividend so as to include any distribution of property or

rights having monetary value. Even under Section 2(22) of the Income-Tax

Act (which treats certain distributions as dividend under Income Tax (Act

though they may not be regarded as dividend under the Companies Act).

Issue of bonus shares to equity shareholders is not at all treated as dividend

by company Act. Therefore liberal dividend policy becomes unattractive from

the point of view of the shareholders/investors in high income brackets. Thus

a company which considers the taxability of its shareholders, may not

declare liberal dividend though there may be huge profit, but may

alternatively go for issuing bonus shares later.

iv) Liquidity and Working Capital Position

Apparently, distribution of dividend results in outflow of cash and

as such a reduction in working capital position. Even in a year when a

company has earned adequate profit to warrant a dividend declaration, it

may confront with a week liquidity position. Under the circumstance, while

one company may prefer not to pay dividend since the payment may impair

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liquidity, another company following a stable dividend policy, may wish to

declare dividends even by resorting to borrowings for dividend payment in

cash. In the later case the company borrows money for the sake of pursuing

regular dividend policy. At the same time, one could visualize totally a

different phenomenon. There may be adequate profits and sufficiency of

cash for payment of dividend. Here, the payment of dividend depends on the

policy of management. The company may require funds to finance an

expansion programme, and the directors may decide to skip the payment of

dividend; and instead retain the earnings and invest them in the expansion

programme. But, if the management follows a stable dividend policy, it may

pay dividend and prefer to finance the expansion programme through

borrowings. This will be very much so, if the company enjoys an enviable

record of perennial dividend payments.

v) Impact on share price

The impact of dividends on market price of shares, though

cannot be precisely measured, still one could gauge the influence of dividend

on the market price of shares. The dividend policy pursued by a company

naturally depends on how far the management is concerned about the

market price of shares. Generally, an increase in dividend payout results in a

hike in the market price of shares. This is significant as it has a bearing on

new issues. For instance, a company which has a proposal to expand after

few years and has plans of issuing new shares for financing its expansion

may try to enhance the market price of its shares by maintaining a record of

increasing trend in dividends. Whether it is fair on the part of the

management to attempt to influence the market price of its shares is a

different question. On the other hand, established concerns may follow a

stable dividend policy, instead of varying dividend rates frequently. The

market price of shares of former companies is higher than that of companies

with fluctuating dividend payments.

vi) Control consideration

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Where the directors wish to retain control, they may desire to

finance growth programmes by retained earnings, since issue of fresh equity

shares for financing growth plan may lead to dilution of control of the

dominating group. So, low dividend payout is favoured by Board.

vii) Type of Shareholders

When the shareholders of the company prefer current dividend

rather man capital gain a high payment is desirable. This happens so, when

the shareholders are in low tax brackets, they are less moneyed and require

periodical income or they have better investment avenues than the

company. Retired persons, economically weaker sections and similarly

placed investors prefer current income i.e. dividend. If, on the other hand,

majority of the shareholders are moneyed people, and want capital gain,

then low payout ratio is desirable. This is known as clinentele effect on

dividend decision.

viii) Industry Norms

The industry norms have to be adhered to the extent possible. It

most firms in me industry adopt a high payout policy, perhaps others also

have to adopt such a policy.

ix) Age of the company

Newly formed companies adopt a conservative dividend policy so that

they can get stabilized and think of growth and expansion.

x) Investment opsportunities for the company

If the company has better investment opportunities, and it is

difficult to raise fresh capital quickly and at cheap costs, it is better to adopt

a conservative dividend policy. By better investment opportunities we mean

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those with higher 'r' relative to the 'k'. So, if r>k, low payout is good. And

vjce versa

xi) Restrictive covenants imposed by debt financiers

Debt financiers, especially term lending financial institutions, may impose

restrictive conditions on the rate, timing and form of dividends declared. So, that

consideration is also significant.

Floatation cost, cost of fresh equity and access capital market

When floatation costs and cost of fresh equity are high and capital

market conditions are not congenial for a fresh issue, a low payout ratio is adopted.

xii) Financial signaling

Dividends are the best medium to tell shareholder of better days ahead

of the company. When a company enhances the target dividend rate, it

overwhelmingly signals the shareholders that their company is on stable

growth path. Share prices immediately react positively.

7.6 SUMMARY

Dividend decision is an important decision area. Dividend valuation

nexus is still an unresolved issue. Dividend valuation nexus is supported by Walter,

Gordon and Graham, while Miller and Modigliani hold the contrary. Walter's theory

and Gordon's theory tell that if r>k, low payout ratio enhances value and vice

versa. When r=k, dividend is irrelevant to valuation. But MM view that altogether

valuation is not affected by dividend decision. There are many dividend policies

which could be classified from the points of view of form, stability, scale, timing of

dividend payment. Several factors like legal considerations, taxability, trend in EPS,

liquidity, shareholder's preferences, floatation costs, access to capital market and

the like influence dividend decision.

7.7 SELF ASSESSMENT QUESTIONS

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1) Bring out the dividend - valuation nexus

2) Is dividend decision relevant to valuation? Substantiate

3) Compare and contrast Walter's theory and Gordon's theory of dividend -

valuation.

4) Explain the MM theory of dividend irrelevance.

5) What are the different dividend policies? Briefly explain each.

6) Between stable and fluctuating dividend policies, which one would you

recommend. Why?

7) Explain dividend payment practices and the legal formalities in that

context.

8) Discuss clearly the factors that affect dividend decision.

9) Calculate the market price of X Ltd's share given the following under

Gordon's theory and under Walter's theory for different payout ratios: EPS

= Rs.4; K - 16% and r = 18% Dividend payout ratios: 0%, 25%, 50% 75%

and 100%. Also compute value under Graham - Dodd model, taking the

multiple as 8.

10) A company has 1,00,000 shares outstanding, with a current market value

of Rs.80 per share. Its earning for the ensuring year is Rs.20,00,000. It has

investment proposals of Rs.30,00,000 by the end of the year. The share

holders' expected return is 20% p.a. and they expect a DPS of Rs,10 per

share by year end. Show that under MM theory, the market value of the

shares is not affected by dividend decision.

11) A company's RE ratio is 12.5%. Its r = 10%. The company declares a

dividend of Rs.3 per share, with its EPS of Rs.5. Is the dividend policy

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optimum? If not why not? Will your answer differ, when r = 8% and r =

6%. Take Walter's model.

12) Explain i) Financial signaling, ii) Residual theory of dividend, iii) Scrip

dividend, iv) Stable DPS policy and v) Clientele effect.

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MBA DEGREE EXAMINATIONS

Paper 2.4: FINANCIAL MANAGEMENT

(MODEL QUESTION PAPER)

Time 3 His. Max. marks 100

PART -A (5x8 = 40 marks)

Answer any five questions

1) Give an account of Risk-Return trade off.

2) What is the significance of convertible debentures?

3) Distinguish fixed and varying working capital.

4) Examine the significance of simulation method.

5) A business has projected its turnover as Rs. 12 crs. As per Vaz committee find

its working capital need and extent of bank finance.

6) A project has an equity beta of 1 .2 and debt beta zero and is a have a debt -

equity ratio of 3:7. Given risk free rate of return of 10% and market return of

1 8%, Find the required return for the project per CAPM.

7) ABC Ltd. is a 100% equity firm with a Ke of 21%, XYZ Ltd, similar to ABC,

except in capital mix, has a debt - equity ratio of 2:1 and its Kd is 14%. Find

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the Ke of XYZ Ltd. as per MM Hypothesis and find the overall average cost of

capital. [Hint: Ke,L = Ke,u + (Ke,u – Kd) D/E]

8) Two firms have the following age distribution of accounts receivable:

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Month Old Firm A FirmB

(Proportion of Accounts)

Upto 1 month .1 .15

1-2 months .15 .15

2-4 months .50 .60

more than 4 months .25. .1

Compute the average age of accounts receivables and ascertain which

firm is relatively swifter in collection. Make own assumptions, if any, needed.

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PART-B (4x15 = 60 marks)

Answer any four questions

9) The cost structure for a firm is: Raw materials Rs. 10 per unit; labour Rs.8 per

unit; overhead Rs.10 per unit; profit Rs.7 per unit Credit allowed by creditors

is 2 months and allowed to debtors is 3 months. Time lag in payment of

expenses 1 month. Production and consumption are equal and even. For an

equal production of 1,80,000 units prepare working capital budget Cash

balance required is Rs. 50,000 and provision for contingency , is required at

5%

10) The P, V, Q, F, I, T and K of a project are as follows:

P = Rs. 300; Investment I = Rs. 20,00,000; N = 4 years, K = 10%, T =

30% fixed cost (excluding depreciation) - Rs. 15,00,000. The quantity of sales (a) is

a sensitive factor with the range 12,000 to 20,000 with most likely value 17000.

similarly, variable cost, V, is a sensitive factor with range Rs. 130 to Rs. 180, with

most likely value of Rs. 160 per unit perfonn sensitivity analysis w.r.t. quantity and

variable cost.

11) The Ke and Kd at different levels of D/E ratio are as follows.

D/E Ke (%) Kd (%)

0.0 21 0

0.4 21 12

0.8 22 12

1.2 22 14

1.6 24 14

2.0 24 16

2.4 28 20

Find the optimum capital structure.

12) A firm with 2/30, net 60 days credit terms, nets a sale of Rs. 50 lakh p.a. and

incurs a capital cost of 12%, 80% of accounts are cleared on 30 days. The

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firm wants to switch over to 1/30, net 60 days. This is likely to reduce sales by

10% and the percentage of account? availing cash discount to 60%. Assuming

a variable cost to sales ratio of 85%, assess the new proposal.

13) A company has 1,00,000 shares outstanding, with a current market value of

Rs.80 per share. Its earning for the ensuring year is Rs.20,00,000. It has

investment proposals of Rs.30,00,000 by the end of the year. The share

holders' expected return is 20% p.a. and they expect a DPS of Rs.10 per

share by year end. Show that under MM theory, the market value of the

shares is not affected by dividend decision.

14) Explain the Contemporary developments in business finance.

15) Bring out the significance institutional finance for industries.

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