FM Notes for IPCC

CA-IPCC Financial Management Theory Compiled by: CA Amit Thapa

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Meaning of Financial Management :

The primary task of a Chartered Accountant is to deal with funds, 'Management of Funds' is an important aspect of financial

management in a business undertaking or any other institution like hospital, art society, and so on. The term 'Financial Management'

has been defined differently by different authors.

According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital

funds." Phillippatus has given a more elaborate definition of the term, as , "Financial Management, is concerned with the managerial

decisions that results in the acquisition and financing of short and long term credits for the firm." Thus, it deals with the situations

that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected

inflows and outflows of funds and their effect on managerial objectives. The most acceptable definition of financial management is

that given by S.C.Kuchhal as, "Financial management deals with procurement of funds and their effective utilisation in the business."

Thus, there are 2 basic aspects of financial management :

a. Procurement of funds :

As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business

concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager

must consider while procuring funds. The funds should be procured at minimum cost, at a balanced risk and control factors.

Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on

winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than

prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of

new equity shares may dilute the control of the existing shareholders.

Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since

they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes

profits.

Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These

covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer

monitoring of 'end use' of resources mobilised through capital markets. Such restrictions are essential for the safety of funds provided

by institutions and investors. There are other financial instruments used for raising finance e.g. commercial paper, deep discount

bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in

lack of flexibility.

In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilisation is to be

undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can

be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign

Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR's) and

Global Depository Receipts (GDR's). The mechanism of procuring funds is to be modified in the light of requirements of foreign

investors. Procurement of funds inter alia includes :

- Identification of sources of finance

- Determination of finance mix

- Raising of funds

- Division of profits between dividends and retention of profits i.e. internal fund generation.

b. Effective use of such funds :

The finance manager is also responsible for effective utilisation of funds. He must point out situations where funds are kept idle or are

used improperly. All funds are procured at a certain cost and after entailing a certain amount of risk. If the funds are not utilised in the

manner so that they generate an income higher than cost of procurement, there is no meaning in running the business. It is an important

consideration in dividend decisions also, thus, it is crucial to employ funds properly and profitably. The funds are to be employed in

the manner so that the company can produce at its optimum level without endangering its financial solvency. Thus, financial

implications of each decision to invest in fixed assets are to be properly analysed. For this, the finance manager must possess sound

knowledge of techniques of capital budgeting and must keep in view the need of adequate working capital and ensure that while firms

enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash, etc.

Fixed assets are to financed from medium or long term funds, and not short term funds, as fixed assets cannot be sold in short term i.e.

within a year, also a large amount of funds would be blocked in stock in hand as the company cannot immediately sell its finished

goods.

Scope of financial management :

A sound financial management is essential in all type of financial organisations - whether profit oriented or not, where funds are

involved and also in a centrally planned economy as also in a capitalist set-up. Firms, as per the commercial history, have not

liquidated because their technology was obsolete or their products had no or low demand or due to any other factor, but due to lack of


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financial management. Even in boom period, when a company makes high profits, there is danger of liquidation, due to bad financial

management. The main cause of liquidation of such companies is over-trading or over-expanding without an adequate financial base.

Financial management optimises the output from the given input of funds and attempts to use the funds in a most productive manner.

In a country like India, where resources are scarce and demand on funds are many, the need for proper financial management is

enormous. If proper techniques are used most of the enterprises can reduce their capital employed and improve return on investment.

Thus, as men and machine are properly managed, finances are also to be well managed.

In newly started companies, it is important to have sound financial management, as it ensures their survival, often such companies

ignores financial management at their own peril. Even a simple act, like depositing the cheques on the day of their receipt is not

performed. Such organisations pay heavy interest charges on borrowed funds, but are tardy in realising their own debtors. This is due

to the fact they lack realisation of the concept of time value of money, it is not appreciated that each value of rupee has to be made use

of and that it has a direct cost of utilisation. It must be realised that keeping rupee idle even for a day, results into losses. A non-profit

organisation may not be keen to make profit, traditionally, but it does need to cut down its cost and use the funds at its disposal to their

optimum capacity. A sound sense of financial management has to be cultivated among our bureaucrats, administrators, engineers,

educationists and public at large. Unless this is done, colossal wastage of the capital resources cannot be arrested.

Objectives of financial management :

Efficient financial management requires existence of some objectives or goals because judgment as to whether or not a financial

decision is efficient is to be made in light of some objective. The two main objectives of financial management are :

1) Profit Maximisation :

It is traditionally being argued, that the objective of a company is to earn profit, hence the objective of financial management is profit

maximisation. Thus, each alternative, is to be seen by the finance manager from the view point of profit maximisation. But, it cannot

be the only objective of a company, it is at best a limited objective else a number of problems would arise. Some of them are :

a. The term profit is vague and does not clarify what exactly it means. It conveys different meaning to different people.

b. Profit maximisation has to be attempted with a realisation of risks involved. There is direct relation between risk and profit;

higher the risk, higher is the profit. For maximising profit, risk is altogether ignored, implying that finance manager accepts

highly risky proposals also. Practically, risk is a very important factor to be balanced with profit objective.

c. Profit maximisation is an objective not taking into account the time pattern of returns.

d. E.g. Proposal X gives returns higher than that by proposal Y but, the time period is say, 10 years and 7 years respectively.

Thus, the overall profit is only considered not the time period, nor the flow of profit.

e. Profit maximisation as an objective is too narrow, it fails to take into account the social considerations and obligations to

various interests of workers, consumers, society, as well as ethical trade practices. Ignoring these factors, a company cannot

survive for long. Profit maximisation at the cost of social and moral obligations is a short sighted policy.

2) Wealth maximisation : The companies having profit maximisation as its objective, may adopt policies yielding exorbitant profits in the short run which are

unhealthy for the growth, survival and overall interests of the business. A company may not undertake planned and prescribed shut-

downs of the plant for maintenance, and so on for maximising profits in the short run. Thus, the objective of a firm should be to

maximise its value or wealth.

According to Van Horne, "Value of a firm is represented by the market price of the company's common stock.......the market price of a

firm's stock represents the focal judgment of all market participants as to what the value of the particular firm is. It takes into account

present as also prospective future earnings per share, the timing and risk of these earning, the dividend policy of the firm and many

other factors having a bearing on the market price of stock. The market price serves as a performance index or report card of the firm's

progress. It indicates how well management is doing on behalf of stockholders." Share prices in the share market, at a given point of

time, are the result of a mixture of many factors, as general economic outlook, particular outlook of the companies under consideration,

technical factors and even mass psychology, but, taken on a long term basis, they reflect the value, which various parties, put on the

company.

Normally this value is a function, of :

- the likely rate of earnings per share of the company; and

- the capitalisation rate.

The likely rate of earnings per share (EPS) depends upon the assessment as to the profitably a company is going to operate in the future

or what it is likely to earn against each of its ordinary shares.

The capitalisation rate reflects the liking of the investors of a company. If a company earns a high rate of earnings per share through its

risky operations or risky financing pattern, the investors will not look upon its share with favour. To that extent, the market value of the

shares of such a company will be low. An easy way to determine the capitalisation rate is to start with fixed deposit interest rate of

banks, investor would want a higher return if he invests in shares, as the risk increases. How much higher return is expected, depends


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on the risks involved in the particular share which in turn depends on company policies, past records, type of business and confidence

commanded by the management. Thus, capitalisation rate is the cumulative result of the assessment of the various shareholders

regarding the risk and other qualitative factors of a company. If a company invests its funds in risky ventures, the investors will put in

their money if they get higher return as compared to that from a low risk share.

The market value of a share is thus, a function of earnings per share and capitalisation rate. Since the profit maximisation criteria

cannot be applied in real world situations because of its technical limitation the finance manager of a company has to ensure that his

decisions are such that the market value of the shares of the company is maximum in the long run. This implies that the financial

policy has to be such that it optimises the EPS, keeping in view the risk and other factors. Thus, wealth maximisation is a better

objective for a commercial undertaking as compared to return and risk.

There is a growing emphasis on social and other obligations of an enterprise. It cannot be denied that in the case of undertakings,

especially those in the public sector, the question of wealth maximisation is to be seen in context of social and other obligations of the

enterprise.

It must be understood that financial decision making is related to the objectives of the business. The finance manager has to ensure that

there is a positive impact of each financial decision on the furtherance of the business objectives. One of the main objective of an

undertaking may be to "progressively build up the capability to undertake the design and development of aircraft engines, helicopters,

etc." A finance manager in such cases will allocate funds in a way that this objective is achieved although such an allocation may not

necessarily maximise wealth.

Functions of a Finance Manager :

The twin aspects, procurement and effective utilisation of funds are crucial tasks faced by a finance manager. The financial manager is

required to look into the financial implications of any decision in the firm. Thus all decisions involve management of funds under the

purview of the finance manager. A large number of decisions involve substantial or material changes in value of funds procured or

employed. The finance manager, has to manage funds in such a way so as to make their optimum utilisation and to ensure their

procurement in a way that the risk, cost and control are properly balanced under a given situation. He may not, be concerned with the

decisions, that do not affect the basic financial management and structure.

The nature of job of an accountant and finance manager is different, an accountant's job is primarily to record the business transactions,

prepare financial statements showing results of the organisation for a given period and its financial condition at a given point of time.

He is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped,

classified and disclosed in the financial statements. Accountant is not concerned with management of funds that is a specialised task

and in modern times a complex one. The finance manager or controller has a task entirely different from that of an accountant, he is to

manage funds. Some of the important decisions as regards finance are as follows :

1. Estimating the requirements of funds : A business requires funds for long term purposes i.e. investment in fixed assets and so on. A careful estimate of such funds is

required to be made. An assessment has to be made regarding requirements of working capital involving, estimation of

amount of funds blocked in current assets and that likely to be generated for short periods through current liabilities.

Forecasting the requirements of funds is done by use of techniques of budgetary control and long range planning. Estimates of

requirements of funds can be made only if all the physical activities of the organisation are forecasted. They can be translated

into monetary terms.

2. Decision regarding capital structure : Once the requirements of funds is estimated, a decision regarding various sources from where the funds would be raised is to

be taken. A proper mix of the various sources is to be worked out, each source of funds involves different issues for

consideration. The finance manager has to carefully look into the existing capital structure and see how the various proposals

of raising funds will affect it. He is to maintain a proper balance between long and short term funds and to ensure that

sufficient long-term funds are raised in order to finance fixed assets and other long-term investments and to provide for

permanent needs of working capital. In the overall volume of long-term funds, he is to maintain a proper balance between

own and loan funds and to see that the overall capitalisation of the company is such, that the company is able to procure funds

at minimum cost and is able to tolerate shocks of lean periods. All these decisions are known as 'financing decisions'.

3. Investment decision: Funds procured from different sources have to be invested in various kinds of assets. Long term funds are used in a project for

fixed and also current assets. The investment of funds in a project is to be made after careful assessment of various projects

through capital budgeting. A part of long term funds is also to be kept for financing working capital requirements. Asset

management policies are to be laid down regarding various items of current assets, inventory policy is to be determined by the

production and finance manager, while keeping in mind the requirement of production and future price estimates of raw

materials and availability of funds.


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4. Dividend decision: The finance manager is concerned with the decision to pay or declare dividend. He is to assist the top management in deciding

as to what amount of dividend should be paid to the shareholders and what amount be retained by the company, it involves a

large number of considerations. Economically speaking, the amount to be retained or be paid to the shareholders should

depend on whether the company or shareholders can make a more profitable use of resources, also considerations like trend of

earnings, the trend of share market prices, requirement of funds for future growth, cash flow situation, tax position of share

holders, and so on to be kept in mind.

The principal function of a finance manager relates to decisions regarding procurement, investment and dividends.

5. Supply of funds to all parts of the organisation or cash management : The finance manager has to ensure that all sections i.e. branches, factories, units or departments of the organisation are

supplied with adequate funds. Sections having excess funds contribute to the central pool for use in other sections that needs

funds. An adequate supply of cash at all points of time is absolutely essential for the smooth flow of business operations. Even

if one of the many branches is short of funds, the whole business may be in danger, thus, cash management and cash

disbursement policies are important with a view to supplying adequate funds at all times and points in an organisation. It

should ensure that there is no excessive cash.

6. Evaluating financial performance : Management control systems are usually based on financial analysis, e.g. ROI (return on investment) system of divisional

control. A finance manager has to constantly review the financial performance of various units of the organisation. Analysis

of the financial performance helps the management for assessing how the funds are utilised in various divisions and what can

be done to improve it.

7. Financial negotiations: Finance manager's major time is utilised in carrying out negotiations with financial institutions, banks and public depositors.

He has to furnish a lot of information to these institutions and persons in order to ensure that raising of funds is within the

statutes. Negotiations for outside financing often requires specialised skills.

8. Keeping in touch with stock exchange quotations and behavior of share prices : It involves analysis of major trends in the stock market and judging their impact on share prices of the company's shares.

Various methods and tools for Financial Management:

Finance manager uses various tools to discharge his functions as regards financial management. In the area of financing there are

various methods to procure funds from long as also short term sources. The finance manager has to decide an optimum capital

structure that can contribute to the maximisation of shareholder's wealth. Financial leverage or trading on equity is an important

method by which a finance manager may increase the return to common shareholders.

For evaluation of capital proposals, the finance manager uses capital budgeting techniques as payback, internal rate of return, net

present value, profitability index, average rate of return. In the area of current assets management, he uses methods to check efficient

utilisation of current resources at the enterprise's disposal. An enterprise can increase its profitability without affecting its liquidity by

an efficient management of working capital. For instance, in the area of working capital management, cash management may be

centralised or de-centralised; centralised method is considered a better tool of managing the enterprise's liquid resources. In the area of

dividend decisions, a firm is faced with the problem of declaration or postponing declaration of dividend, a problem of internal

financing.

For evaluation of an enterprise's performance, there are various methods, as ratio analysis. This technique is used by all concerned

persons. Different ratios serving different objectives. An investor uses various ratios to evaluate the profitability of investment in a

particular company. They enable the investor, to judge the profitability, solvency, liquidity and growth aspects of the firm. A short-

term creditor is more interested in the liquidity aspect of the firm, and it is possible by a study of liquidity ratios - current ratio, quick

ratios, etc. The main concern of a finance manager is to provide adequate funds from best possible source, at the right time and at

minimum cost and to ensure that the funds so acquired are put to best possible use. Funds flow and cash flow statements and projected

financial statements help a lot in this regard.

Role of Finance Manager:

In the modern enterprise, a finance manager occupies a key position, he being one of the dynamic member of corporate managerial

team. His role, is becoming more and more pervasive and significant in solving complex managerial problems. Traditionally, the role

of a finance manager was confined to raising funds from a number of sources, but due to recent developments in the socio-economic


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and political scenario throughout the world, he is placed in a central position in the organisation. He is responsible for shaping the

fortunes of the enterprise and is involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance

manager, as other members of the corporate team cannot be averse to the fast developments, around him and has to take note of the

changes in order to take relevant steps in view of the dynamic changes in circumstances. E.g. introduction of Euro - as a single

currency of Europe is an international level change, having impact on the corporate financial plans and policies world-wide.

Domestic developments as emergence of financial services sectors and SEBI as a watch dog for investor protection and regulating

body of capital markets is contributing to the importance of the finance manager's job. Banks and financial institutions were the major

sources of finance, monopoly was the state of affairs of Indian business, shareholders satisfaction was not the promoter's concern as

most of the companies, were closely held. Due to the opening of economy, competition increased, seller's market is being converted

into buyer's market. Development of internet has brought new challenges before the managers. Indian concerns no longer have to

compete only nationally, it is facing international competition. Thus a new era is ushered during the recent years, in financial

management, specially, with the development of financial tools, techniques, instruments and products. Also due to increasing emphasis

on public sector undertakings to be self-supporting and their dependence on capital market for fund requirements and the increasing

significance of liberalisation, globalisation and deregulation.

Organizational Chart depicting the Financial Function of the Company:

The finance function is the same in all enterprises, details may differ, but major features are universal in nature. The finance function

occupies a significant position in an organisation and is not the responsibility of a sole executive. The important aspects of finance

manager are to carried on by top management i.e. managing director, chairman, board of directors. The board of directors takes

decisions involving financial considerations, the financial controller is basically meant for assisting the top management and has an

important role of contributing to good decision making on issues involving all functional areas of business. He is to bring out financial

implications of all decisions and make them understood. He may be called as the financial controller, vice-president (finance), chief

accountant, treasurer, or by any other designation, but has the primary responsibility of performing finance functions. He is to

discharge the responsibility keeping in view the overall outlook of the organisation.

BOARD OF DIRECTORS

PRESIDENT

V.P.(Product ion) V.P.(Finance) V.P.(Sales)

Treasurer Controller

Cred it

Mgmt.

Cash

Mgmt.

Banking

rela t ions

Portfo l io

Mgmt.

Corpora te

General &

Cost

Accounting

Taxes Interna l

Audi t

Budgeting

Organisatio n chart o f f inance function

The Chief finance executive works directly under the President or Managing Director of the company. Besides routine work, he keeps

the Board informed about all phases of business activity, inclusive of economic, social and political developments affecting the

business behaviour and from time to time furnishes information about the financial status of the company. His functions are :

(i)Treasury functions and

(ii) Control functions.

Relationship Between financial management and other areas of management: There is close relationship between the areas of financial and other management like production, sales, marketing, personnel, etc. All

activities directly or indirectly involve acquisition and use of funds. Determination of production, procurement and marketing

strategies are the important prerogatives of the respective department heads, but for implementing, their decisions funds are required.


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Like, replacement of fixed assets for improving production capacity requires funds. Similarly, the purchase and sales promotion

policies are laid down by the purchase and marketing divisions respectively, but again procurement of raw materials, advertising and

other sales promotion require funds. Same is for, recruitment and promotion of staff by the personnel department would require funds

for payment of salaries, wages and other benefits. It may, many times, be difficult to demarcate where one function ends and other

starts. Although, finance function has a significant impact on the other functions, it need not limit or obstruct the general functions of

the business. A firm facing financial difficulties, may give weightage to financial considerations and devise its own production and

marketing strategies to suit the situation. While a firm having surplus finance, would have comparatively lower rigidity as regards the

financial considerations vis-a-vis other functions of the management.

Pervasive Nature of Finance Function: Finance is the life blood of of an organisation, it is the common thread binding all organisational functions. This interface can be

explained as below:

* Production - Finance: Production function requires a large investment. Productive use of resources ensures a cost advantage for the

firm. Optimum investment in inventories improves profit margins. Many parameters of production have an impact on cost and can

possibly be controlled through internal management, thus enhancing profits. Important production decisions like make or buy can be

taken only after the financial implications are considered.

* Marketing - Finance: Various aspects of marketing management have financial implications, decisions to hold inventories on large

scale to provide off the shelf service to customers increases inventory holding cost and at the same time may increase sales, similar

with extension of credit facility to customers. Marketing strategies to increase sale in most cases, have additional costs that are to be

weighted carefully against incremental revenue before taking decision.

* Personnel - Finance: In the globalised competitive scenario, business organisations are moving to a flatter organisational structure.

Investments in human resource developments are also increasing. Restructuring of remuneration structure, voluntary retirement

schemes, sweat equity, etc. have become major financial decisions in the human resource management.

Instances indicating the changing scenario of financial management:

Answer: Modern financial management has come a long way from traditional corporate finance, the finance manager is working in a

challenging environment that is changing continuously. Due to the opening of the economies, global resources are being tapped, the

opportunities available to finance managers virtually have no limits, he must also understand the risks entailing all his decisions.

Financial management is passing through an era of experimentation and excitement is a part of finance activities now a days. A few

instances are as below :

a. Interest rates have been freed from regulation, treasury operations thus, have to be more sophisticated due to fluctuating

interest rates. Minimum cost of capital necessitates anticipating interest rate movements.

b. The rupee had become fully convertible on current account.

c. Optimum debt equity mix is possible. Firms have to take advantage of the financial leverage to increase the shareholder's

wealth, however, using financial leverage necessarily makes business vulnerable to financial risk. Finding a correct trade off

between risk and improved return to shareholders is a challenging task for a finance manager.

d. With free pricing of issues, the optimum price determination of new issues is a daunting task as overpricing results in under

subscription and loss of investor confidence, while under pricing leads to unwarranted increase in number of shares thereby

reducing the EPS.

e. Maintaining share prices is crucial. In the liberalised scenario the capital markets is the important avenue of funds for

business. Dividend and bonus policies framed by finance managers have a direct bearing on the share prices.

Ensuring management control is vital especially in light of foreign participation in equity, backed by huge resources making the firm

an easy takeover target. Existing managements might lose control in the eventuality of being unable to take up share entitlements,

financial strategies, are vital to prevent this.

In a resources constraint situation, the importance of financial management is highlighted as financial strategies are required to get the

company through the constraints position. The reasons for it, may be lack of demand, scarcity of raw materials, labour constraints, etc.

If the problem is not properly dealt with at initial stages, it could lead ultimately to bankruptcy and sickness. The financial manager's

role in such situations, would be first to ascertain, whether under the circumstances, the organisation is viable or not. If the viability of

the organisation, itself is in doubt, then the alternative of closing down operations must be explored. But, in major cases the problem

can be solved with proper strategies.

Relevance of Time Value of Money in Financial Decision Making:

A finance manager is required to make decisions on investment, financing and dividend in view of the company's objectives. The

decisions as purchase of assets or procurement of funds i.e. the investment/financing decisions affect the cash flow in different time

periods. Cash outflows would be at one point of time and inflow at some other point of time, hence, they are not comparable due to the


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change in rupee value of money. They can be made comparable by introducing the interest factor. In the theory of finance, the interest

factor is one of the crucial and exclusive concept, known as the time value of money.

Time value of money means that worth of a rupee received today is different from the same received in future. The preference for

money now as compared to future is known as time preference of money. The concept is applicable to both individuals and business

houses.

Reasons of time preference of money:

1) Risk:

There is uncertainty about the receipt of money in future.

2) Preference for present consumption:

Most of the persons and companies have a preference for present consumption may be due to urgency of need.

3) Investment opportunities:

Most of the persons and companies have preference for present money because of availabilities of opportunities of investment for

earning additional cash flows.

Importance of time value of money:

The concept of time value of money helps in arriving at the comparable value of the different rupee amount arising at different points

of time into equivalent values of a particular point of time, present or future. The cash flows arising at different points of time can be

made comparable by using any one of the following:

- by compounding the present money to a future date i.e. by finding out the value of present money.

- by discounting the future money to present date i.e. by finding out the present value(PV) of future money.

1) Techniques of compounding :

i) Future value (FV) of a single cash flow:

The future value of a single cash flow is defined as:

FV = PV (1 + r)n

Where, FV = future value

PV = Present value

r = rate of interest per annum

n = number of years for which compounding is done.

If, any variable i.e. PV, r, n varies, then FV also varies. It is very tedious to calculate the value of

(1 + r) n so different combinations are published in the form of tables. These may be referred for computation, otherwise one should

use the knowledge of logarithms.

ii) Future value of an annuity:

An annuity is a series of periodic cash flows, payments or receipts, of equal amount. The premium payments of a life insurance policy,

for instance are an annuity. In general terms the future value of an annuity is given as :

FVAn = A * ([(1 + r)n - 1]/r)

Where,

FVAn = Future value of an annuity which has duration of n years.

A = Constant periodic flow

r = Interest rate per period

n = Duration of the annuity

Thus, future value of an annuity is dependent on 3 variables, they being, the annual amount, rate of interest and the time period, if any

of these variable changes it will change the future value of the annuity. A published table is available for various combination of the

rate of interest 'r' and the time period 'n'.

2) Techniques of discounting :

i) Present value of a single cash flow :

The present value of a single cash flow is given as :

PV = FVn ( 1 )n

1 + r


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Where,

FVn = Future value n years hence

r = rate of interest per annum

n = number of years for which discounting is done.

ii) Present value of an annuity:

Sometimes instead of a single cash flow, cash flows of same amount is received for a number of years. The present value of an annuity

may be expressed as below:

PVAn = A/(1 + r)1 + A/(1 + r)

2 + ................ + A/(1 + r)

n-1 + A/(1 + r)

n

= A [1/(1 + r)1 + 1/(1 + r)

2 + ................ + 1/(1 + r)

n-1 + 1/(1 + r)

n ]

= A [ (1 + r)n - 1]

r(1 + r)n

Where,

PVAn = Present value of annuity which has duration of n years

A = Constant periodic flow

r = Discount rate.

Past Questions:

1. Outline the methods and tools of Financial Management.

Answer

Finance Manager has to decide optimum capital structure to maximise the wealth of the shareholders. For this judicious use of

financial leverage or trading on equity is important to increase the return to shareholders. In planning the capital structure, the aim is to

have proper mix of debt, equity and retained earnings. EPS Analysis, PE Ratios and mathematical models are used to determine the

proper debt-equity mix to derive advantages to the owners and enterprise.

In the area of investment decisions, pay back method, average rate of returns, internal rate of return, net present value, profitability

index are some of the methods in evaluating capital expenditure proposals.

In the area of working capital management, certain techniques are adopted such as ABC Analysis, Economic order quantities, Cash

management models, etc., to improve liquidity and to maintain adequate circulating capital.

For evaluation of firm’s performance, Ratio analysis is pressed into service-with the help of ratios an investor can decide whether to

invest in a firm or not. Funds flow statement, cash flow statement and projected financial statements help a lot to the finance manager

in providing funds in right quantities and at right time.

2. Explain as to how the wealth maximisation objective is superior to the profit maximisation objective.

Answer

A firm’s financial management may often have the following as their objectives:

a. The maximisation of firm’s profit.

b. The maximisation of firm’s value / wealth.

The maximisation of profit is often considered as an implied objective of a firm. To achieve the aforesaid objective various type of

financing decisions may be taken. Options resulting into maximisation of profit may be selected by the firm’s decision makers. They

even sometime may adopt policies yielding exorbitant profits in short run which may prove to be unhealthy for the growth, survival

and overall interests of the firm. The profit of the firm in this case is measured in terms of its total accounting profit available to its

shareholders.

The value/wealth of a firm is defined as the market price of the firm’s stock. The market price of a firm’s stock represents the focal

judgment of all market participants as to what the value of the particular firm is. It takes into account present and prospective future

earnings per share,the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the

market price of the stock.

The value maximisation objective of a firm is superior to its profit maximisation objective due to following reasons.

a. The value maximisation objective of a firm considers all future cash flows, dividends, earning per share, risk of a decision etc.

whereas profit maximisation objective does not consider the effect of EPS, dividend paid or any other returns to shareholders

or the wealth of the shareholder.


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b. A firm that wishes to maximise the shareholders wealth may pay regular dividends whereas a firm with the objective of profit

maximisation may refrain from dividend payment to its shareholders.

c. Shareholders would prefer an increase in the firm’s wealth against its generation of increasing flow of profits.

d. The market price of a share reflects the shareholders expected return, considering the long-term prospects of the firm, reflects

the differences in timings of the returns, considers risk and recognizes the importance of distribution of returns.

The maximisation of a firm’s value as reflected in the market price of a share is viewed as a proper goal of a firm. The profit

maximisation can be considered as a part of the wealth maximisation strategy.

3. Discuss the conflicts in Profit versus Wealth maximization principle of the firm.

Answer

Conflict in Profit versus Wealth Maximization Principle of the Firm

The company may pursue profit maximisation goal but that may not result into creation of shareholder value. The profits will be

maximized if company grows through diversification and expansion. But all growth may not be profitable. Only that growth is

profitable where

ROA > WACC or ROE > KE or Firms invest in positive NPV profits.

However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue

importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of

risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.

Whereas, on the other hand, wealth maximisation, as an objective, means that the company is using its resources in a good manner. If

the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of

wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.

4. “The information age has given a fresh perspective on the role of finance management and finance managers. With the

shift in paradigm it is imperative that the role of Chief Financial Officer (CFO) changes from a controller to a facilitator.”

Can you describe the emergent role which is described by the speaker/author?

Answer

The information age has given a fresh perspective on the role financial management and finance managers. With the shift in paradigm

it is imperative that the role of Chief Finance Officer (CFO) changes from a controller to a facilitator. In the emergent role Chief

Finance Officer acts as a catalyst to facilitate changes in an environment where the organisation succeeds through self managed teams.

The Chief Finance Officer must transform himself to a front-end organiser and leader who spends more time in networking, analysing

the external environment, making strategic decisions, managing and protecting cash flows. In due course, the role of Chief Finance

Officer will shift from an operational to a strategic level. Of course on an operational level the Chief Finance Officer cannot be

excused from his backend duties. The knowledge requirements for the evolution of a Chief Finance Officer will extend from being

aware about capital productivity and cost of capital to human resources initiatives and competitive environment analysis. He has to

develop general management skills for a wider focus encompassing all aspects of business that depend on or dictate finance.

5. Discuss the functions of a Chief Financial Officer.

Answer

Functions of a Chief Financial Officer

The twin aspects viz procurement and effective utilization of funds are the crucial tasks, which the CFO faces. The Chief Finance

Officer is required to look into financial implications of any decision in the firm. Thus all decisions involving management of funds

comes under the purview of finance manager. These are namely

a. Estimating requirement of funds

b. Decision regarding capital structure

c. Investment decisions

d. Dividend decision

e. Cash management

f. Evaluating financial performance

g. Financial negotiation

h. Keeping touch with stock exchange quotations & behaviour of share prices.

6. Explain two basic functions of Financial Management.

Answer

Two basic functions of Financial Management


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Financial Management deals with the procurement of funds and their effective utilization in the business. The first basic function of

financial management is procurement of funds and the other is their effective utilization.

i. Procurement of funds: Funds can be procured from different sources, their procurement is a complex problem for business

concerns. Funds procured from different sources have different characteristics in terms of risk, cost and control.

The funds raised by issuing equity share poses no risk to the company. The funds raised are quite expensive. The issue of new

shares may dilute the control of existing shareholders.

Debenture is relatively cheaper source of funds, but involves high risk as they are to be repaid in accordance with the terms of

agreement. Also interest payment has to be made under any circumstances. Thus there are risk, cost and control

considerations, which must be taken into account before raising funds.

Funds can also be procured from banks and financial institutions subject to certain restrictions.

Instruments like commercial paper, deep discount bonds, etc also enable to raise funds.

Foreign direct investment (FDI) and Foreign Institutional Investors (FII) are two major routes for raising funds from

international sources, besides ADR’s and GDR’s.

ii. Effective utilisation of funds: Since all the funds are procured at a certain cost, therefore it is necessary for the finance manager to

take appropriate and timely actions so that the funds do not remain idle. If these funds are not utilised in the manner so that they

generate an income higher than the cost of procuring them then there is no point in running the business.

7. Write short notes on the following:

a. Functions of Finance Manager.

b. Inter relationship between investment, financing and dividend decisions.

c. Finance function

Answer

a. Functions of Finance Manager

The Finance Manager’s main objective is to manage funds in such a way so as to ensure their optimum utilisation and their

procurement in a manner that the risk, cost and control considerations are properly balanced in a given situation. To achieve these

objectives the Finance Manager performs the following functions:

Estimating the requirement of Funds: Both for long-term purposes i.e. investment in fixed assets and for short-term i.e.

for working capital. Forecasting the requirements of funds involves the use of techniques of budgetary control and long-

range planning.

Decision regarding Capital Structure: Once the requirement of funds has been estimated, a decision regarding various

sources from which these funds would be raised has to be taken. A proper balance has to be made between the loan funds

and own funds. He has to ensure that he raises sufficient long term funds to finance fixed assets and other long term

investments and to provide for the needs of working capital.

Investment Decision: The investment of funds, in a project has to be made after careful assessment of various projects

through capital budgeting. Assets management policies are to be laid down regarding various items of current assets. For

e.g. receivable in coordination with sales manager, inventory in coordination with production manager.

Dividend decision: The finance manager is concerned with the decision as to how much to retain and what portion to pay

as dividend depending on the company’s policy. Trend of earnings, trend of share market prices, requirement of funds for

future growth, cash flow situation etc., are to be considered.

Evaluating financial performance: A finance manager has to constantly review the financial performance of the various

units of organisation generally in terms of ROI Such a review helps the management in seeing how the funds have been

utilised in various divisions and what can be done to improve it.

Financial negotiation: The finance manager plays a very important role in carrying out negotiations with the financial

institutions, banks and public depositors for raising of funds on favourable terms.

Cash management: The finance manager lays down the cash management and cash disbursement policies with a view to

supply adequate funds to all units of organisation and to ensure that there is no excessive cash.

Keeping touch with stock exchange: Finance manager is required to analyse major trends in stock market and their

impact on the price of the company share.

b. Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing and dividend decisions. It is correct to say

that these decisions are inter-related because the underlying objective of these three decisions is the same, i.e. maximisation of

shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated, one has to consider the joint impact


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of these decisions on the market price of the company’s shares and these decisions should also be solved jointly. The decision to

invest in a new project needs the finance for the investment. The financing decision, in turn, is influenced by and influences

dividend decision because retained earnings used in internal financing deprive shareholders of their dividends. An efficient

financial management can ensure optimal joint decisions. This is possible by evaluating each decision in relation to its effect on

the shareholders’ wealth.

The above three decisions are briefly examined below in the light of their inter-relationship and to see how they can help in

maximising the shareholders’ wealth i.e. market price of the company’s shares.

Investment decision:

The investment of long term funds is made after a careful assessment of the various projects through capital budgeting and

uncertainty analysis. However, only that investment proposal is to be accepted which is expected to yield at least so much return

as is adequate to meet its cost of financing. This have an influence on the profitability of the company and ultimately on its wealth.

Financing decision:

Funds can be raised from various sources. Each source of funds involves different issues. The finance manager has to maintain a

proper balance between long-term and short-term funds. With the total volume of long-term funds, he has to ensure a proper mix

of loan funds and owner’s funds. The optimum financing mix will increase return to equity shareholders and thus maximise their

wealth.

Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He assists the top management in deciding as

to what portion of the profit should be paid to the shareholders by way of dividends and what portion should be retained in the

business. An optimal dividend pay-out ratio maximises shareholders’ wealth.

The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to be taken jointly

keeping in view their joint effect on the shareholders’ wealth.

c. Finance Function

The finance function is most important for all business enterprises. It remains a focus of all activities. It starts with the setting up

of an enterprise. It is concerned with raising of funds, deciding the cheapest source of finance, utilization of funds raised, making

provision for refund when money is not required in the business, deciding the most profitable investment, managing the funds

raised and paying returns to the providers of funds in proportion to the risks undertaken by them. Therefore, it aims at acquiring

sufficient funds, utilizing them properly, increasing the profitability of the organization and maximizing the value of the

organization and ultimately the shareholder’s wealth.


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Working Capital Management: Credit Rating:

Meaning:

Credit Rating is an act of assigning values to credit instruments by assessing the solvency i.e. the ability of the borrower to repay

debt.Thus Credit Rating is:

An expression of opinion of a rating agency.

The opinion is in regard to a debt instrument.

The opinion is as on a specific date.

The opinion is dependent on risk evaluation.

The opinion depends on the probability of interest and principal obligations being met timely.

It has assumed an important place in the modern and developed financial markets. It is a boon to the companies as well as investors. It

facilitates the company in raising funds in the capital market and helps the investor to select their risk-return trade off. By indicating

creditworthiness of a borrower, it helps the investor in arriving at a correct and rational decision about making investments.

Credit rating system plays a vital role in investor protection. Fair and good credit ratings motivate the public to invest their savings.

As a fee based financial advisory service, credit rating is obviously extremely useful to the investors, the corporates (borrowers) and

banks and financial institutions. To the investors, it is an indicator expressing the underlying credit quality of a (debt) issue

programme. The investor is fully informed about the company as any effect of changes in business/economic conditions on the

company is evaluated and published regularly by the rating agencies. The corporate borrowers can raise funds at a cheaper rate with

good rating. It minimizes the role of the ‘name recognition’ and less known companies can also approach the market on the basis of

their rating. The fund ratings are useful to the banks and other financial institutions while deciding lending and investment strategies.

Credit-rating essentially reflects the probability of timely repayment of principal and interest by a borrower company. It indicates the

risk involved in a debt instrument as well its qualities. Higher the credit rating, greater is the probability that the borrower will make

timely payment of principal and interest and vice-versa.

What Credit Rating do not indicate

It may be noted that credit rating is only an opinion and not the guarantee or protection against default. It is not a recommendation to

buy, or sell or hold a security. Thus Credit Rating does not in any way linked with

Performance Evaluation of the rated entity unless called for.

Investment Recommendation by the rating agency to invest or not in the instrument to be rated.

Legal Compliance by the issuer-entity through audit.

Opinion on the holding company, subsidiaries or associates of the issuer entity.

Need of Credit Rating: A firm has to ascertain the credit rating of prospective customers to ascertain how much and how long can credit be extended. Credit

can be granted only to a customer who is reliably sound. This decision would involve analysis of the financial status of the party, his

reputation and previous record of meeting commitments.

How Credit Ratings are Expressed: Ratings are expressed in alphabetical or alphanumeric symbols like (AAA, BBB, P1, P2).

Usefullness of Credit Rating As a fee-based financial advisory service, credit rating is obviously extremely useful to the investors, the corporates (borrowers) and

banks and financial institutions.

To the investors

a. It is an indicator expressing the credit quality of the instruments

b. Fair and good Credit Rating motivate the public to invest their savings

c. It enables the investors to get superior information at low cost.

To the corporate borrowers

They can raise funds at a cheaper rate with good rating and enter the capital market confidently.

a. It minimize the role of name recognition and less known companies can also approach the market on the basis of their rating.

b. To banks and other financial institutions The fund ratings are useful to the banks and other financial institutions while

deciding lending and investment strategies.

Steps or Functions involved in Credit Rating:

The steps or functions involved in Credit Rating are:

1. To gather sufficient information to evaluate the credit risk of the specific issues. The main sources of information to the credit

rating agencies are :

Annual and Interim reports and other publised data

Prospectus, letter of offer etc of particular security

Industry,Sectoral and Economic data from industry groups


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Reports and data from Government agencies

2. To analyse and come to a conclusion on the appropriate rating

3. To monitor the credit quality of the rated issuer or security over time, deciding on the timely changes in rating if company

fundamentals changes and

4. To keep investors and market place informed

Hence we can say that Credit Rating has assumed an important place in the modern and developed financial market like India.

Treasury Management:

Treasury Management is concerned about the efficient management of liquidity and financial risk in business. Main activities which

are covered by Treasury management are as follows:

a. Cash management: Treasury management in a business organisation is concerned about the efficient collection and repayment

of cash to both insiders and to third parties.

b. Currency management: It manages the foreign currency risk, exchange rate risks etc. It may advise on the currency to be used

when invoicing overseas sales.

c. Funding management: Responsible for planning and sourcing firm’s short, medium and long term cash needs. It participates

in capital structure, forecasting of future interest and foreign currency rates decision-making process.

d. Banking: Maintains good relations with bankers and carry out initial negotiations with them for any short term loan.

e. Corporate finance: It advises on aspects of corporate finance including capital structure, mergers and acquisitions.

Ageing Schedule for Monitoring Receivables:

An important means to get an insight into collection pattern of debtors is the preparation of their ‘Ageing Schedule’. Receivables are

classified according to their age from the date of invoicing e.g. 0 – 30 days, 31 – 60 days , 61 – 90 days, 91 – 120 days and more. The

ageing schedule can be compared with earlier month’s figures or the corresponding month of the earlier year.

This classification helps the firm in its collection efforts and enables management to have a close control over the quality of individual

accounts. The ageing schedule can be compared with other firms also.

Miller – Orr Cash Management Model

According to this model the net cash flow is completely stochastic. When changes in cash balance occur randomly, the application of

control theory serves a useful purpose. The Miller – Orr model is one of such control limit models. This model is designed to

determine the time and size of transfers between an investment account and cash account. In this model control limits are set for cash

balances. These limits may consist of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower limit.

When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is invested in marketable securities account. When

it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash balance

stays between (h, z) and (z, 0) i.e. high and low limits, no transactions between cash and marketable securities account is made. The

high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transaction, the opportunities cost


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of holding cash and degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total

costs. The formula for calculation of the spread between the control limits is:

Spread =

3/1

rateInterest

Cashflows of VarianceCost nTransactio3/43

And, the return point can be calculated using the formula:

Return point = Lower limit + 3

Spread

Baumol’s Model of Cash Management.

William J. Baumol developed a model for optimum cash balance which is normally used in inventory management. The optimum cash

balance is the trade-off between cost of holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of converting

marketable securities in to cash). Optimum cash balance is reached at a point where the two opposing costs are equal and where the

total cost is minimum. This can be explained with the following diagram:

Transaction Cost

Holding CostCost(Rs.)

Total Cost

Optimum Cash Balance

The optimum cash balance can also be computed algebraically.

Optimum Cash Balance = H

AT2

A = Annual Cash disbursements

T = Transaction cost (Fixed cost) per transaction

H = Opportunity cost one rupee per annum (Holding cost)

The model is based on the following assumptions:

a. Cash needs of the firm are known with certainty.

b. The cash is used uniformly over a period of time and it is also known with certainty.

c. The holding cost is known and it is constant.

d. The transaction cost also remains constant.

Commercial Paper CP is a short term usance promissory note issued by a company, negotiable by endorsement and delivery, issued at such a discount on

face value as may be determined by the issuing company. It is a money market instrument issued by highly rated corporate borrowers

for meeting their working capital requirements.

The main features of CP are:

a. CP is a short term money market instrument with fixed maturity value.

b. It is a certificate evidencing an unsecured corporate debt of short term maturity.

c. It is generally issued at discount to face value but it can also be issued in interest bearing form.

d. CPs can be directly issued by a company to investors or through banks.


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e. It is an unsecured instrument.

Factors to be taken into consideration while determining the requirement of working capital:

(i) Production Policies (ii) Nature of the business

(iii) Credit policy (iv) Inventory policy

(v) Abnormal factors (vi) Market conditions

(vii) Conditions of supply (viii) Business cycle

(ix) Growth and expansion (x) Level of taxes

(xi) Dividend policy (xii) Price level changes

(xiii) Operating efficiency.

Impact of Inflation on Working Capital: The impact of inflation on working capital is direct. For the same quantity of sales, the value of sundry debtors, closing stock etc.

increases as a result of inflation. The valuation of closing stock progressively on higher amounts would result in the company not being

able to maintain its operating capability unless it finds extra funds to maintain the same stock level. The higher valuation results in

acute shortage of funds as it triggers profit related cash outflows in respect of income tax, dividends and bonus. Unless proper planning

is done, the business is likely to face a condition known as “technical insolvency”.

Different Kinds of Float with Reference to Management of Cash: The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process. Four

kinds of float can be identified:

Billing Float: An invoice is the formal document that a seller prepares and sends to the purchaser as the payment request for

goods sold or services provided. The time between the sale and the mailing of the invoice is the billing float.

Mail Float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery.

Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque after it has been

received by the company.

Bank processing float: This is the time from the deposit of the cheque to the crediting of funds in the seller’s account.

Factoring: Factoring is a new financial service that is presently being developed in India. Factoring involves provision of specialised services

relating to credit investigation, sales ledger management, purchase and collection of debts, credit protection as well as provision of

finance against receivables and risk bearing. In factoring, accounts receivables are generally sold to a financial institution (a subsidiary

of commercial bank-called “Factor”), who charges commission and bears the credit risks associated with the accounts receivables

purchased by it.

Its operation is very simple. Clients enter into an agreement with the “factor” working out a factoring arrangement according to his

requirements. The factor then takes the responsibility of monitoring, follow-up, collection and risk-taking and provision of advance.

The factor generally fixes up a limit customer-wise for the client (seller).

Factoring offers the following advantages which makes it quite attractive to many firms.

The firm can convert accounts receivables into cash without bothering about repayment.

Factoring ensures a definite pattern of cash in flows.

Continuous factoring virtually eliminates the need for the credit department. That is why receivables financing through

factoring is gaining popularly as useful source of financing short-term funds requirements of business enterprises because of

the inherent advantage of flexibility it affords to the borrowing firm. The seller firm may continue to finance its receivables on

a more or less automatic basis. If sales expand or contract it can vary the financing proportionally.

Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of relieving the

borrowing firm of substantially credit and collection costs and to a degree from a considerable part of cash management.

However, factoring as a means of financing is comparatively costly source of financing since its cost of financing is higher than the

normal lending rates.

Effect on Inflation on Inventory Management:

The main objective of inventory management is to determine and maintain the optimum level of investment in inventories. For

inventory management a moderate inflation rate say 3% can be ignored but if inflation rate is higher it becomes important to take into


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consideration the effect of inflation on inventory management. The effect of inflation on goods which the firm stock is relatively

constant can be dealt easily, one simply deducts the expected annual rate of inflation from the carrying cost percentage and uses this

modified version in the EOQ model to compute the optimum stock. The reason for making this deduction is that inflation causes the

value of the inventory to raise, thus offsetting somewhat the effects of depreciation and other carrying cost factors. Since carrying cost

will now be smaller, the calculated EOQ and hence the average inventory will increase. However, if rate of inflation is higher the

interest rates will also be higher, and this will cause carrying cost to increase and thus lower the EOQ and average inventories.

Thus, there is no evidence as to whether inflation raises or lowers the optimal level of inventories of firms in the aggregate. It should

still be thoroughly considered, however, for it will raise the individual firm’s optimal holdings if the rate of inflation for its own

inventories is above average and is greater than the effects of inflation on interest rates and vice-versa.

Commercial paper (CP):

To give a boost to the money market and reducing the dependence of highly rated corporate borrowers on bank finance for meeting

their working capital requirement, corporate borrowers were permitted to arrange short-term borrowing by issue of commercial paper

w.e.f. 1st Jan, 1990. It is being regulated by the RBI. The interest rates on such an instrument are determined by the market forces. The

companies which are allowed to issue ‘Commercial Paper’ must have a net worth of Rs.10 crores, maximum permissible bank finance

not less than Rs.25 Crore and are listed on the stock exchange. In India, the cost of a C.P. will include the following components:

Discount;

rating charges;

stamp duty;

issuing ; and

issuing paying agent (IPA) charges.

A commercial paper is a short-term issuance promissory note issued by a company negotiable by endorsement & delivery, issued at

such a discount on face value as may be determined by the company.

William J Baumal vs Miller- Orr Cash Management Model :

According to William J Baumal’s Economic order quantity model optimum cash level is that level of cash where the carrying costs and

transactions costs are the minimum. The carrying costs refers to the cost of holding cash, namely, the interest foregone on marketable

securities. The transaction costs refers to the cost involved in getting the marketable securities converted into cash. This happens when

the firm falls short of cash and has to sell the securities resulting in clerical, brokerage, registration and other costs.

The optimim cash balance according to this model will be that point where these two costs are equal. The formula for determining

optimum cash balance is:

C = S

PU 2 ,

Where

C = Optimum cash balance

U = Annual (monthly) cash disbursements

P = Fixed cost per transaction

S = Opportunity cost of one rupee p.a. (or p.m)

Miller-Orr cash management model is a net cash flow stochastic model. This model is designed to determine the time and size of

transfers between an investment account and cash account. In this model control limits are set for cash balances. These limits may

consist of h as upper limit, z as the return point, and zero as the lower limit.

When the cash balances reach the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When it

touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash balance

stays between (h,z) and (z, o ) i.e high and low limits no transactions between cash and marketable securities account is made. The

high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transactions, the opportunity cost

of holding cash and the degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible

total costs.


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Financial Statement Analysis:

Background:

The basis of financial analysis, planning and decision making is financial information. A firm prepares final accounts viz. Balance

Sheet and Profit and Loss Account providing information for decision making. Financial information is needed to predict, compare and

evaluate the firm's earning ability. Profit and Loss account shows the concern's operating activities and the Balance Sheet depicts the

balance value of the acquired assets and of liabilities at a particular point of time. However, these statements do not disclose all of the

necessary and relevant information. For the purpose of obtaining the material and relevant information necessary for ascertaining of

financial strengths and weaknesses of an enterprise, it is essential to analyse the data depicted in the financial statement. The financial

manager have certain analytical tools that help in financial analysis and planning. In addition to studying the past flow, the financial

manager can evaluate future flows by means of funds statement based on forecasts.

Financial Statement Analysis is the process of identifying the financial strength and weakness of a firm from the available accounting

data and financial statements. It is done by properly establishing relationship between the items of balance sheet and profit and loss

account as,

The task of financial analysts is to determine the information relevant to the decision under consideration from total

information contained in the financial statement.

To arrange information in a way to highlight significant relationships.

Interpretation and drawing of inferences and conclusion. Thus, financial analysis is the process of selection, relation and

evaluation of the accounting data/information.

Purposes of Financial Statement Analysis : Financial Statement Analysis is the meaningful interpretation of 'Financial Statements' for 'Parties Demanding Financial Information',

such as :

a. The Government may be interested in knowing the comparative energy consumption of some private and public sector cement

companies.

b. A nationalised bank may be keen to know the possible debt coverage out of profit at the time of lending.

c. Prospective investors may be desirous to know the actual and forecasted yield data.

d. Customers want to know the business viability prior to entering into a long-term contract.

There are other purposes also, in general, the purpose of financial statement analysis aids decision making by users of accounts.

Steps for financial statement analysis:

a. Identification of the user's purpose

b. Identification of data source, which part of the annual report or other information is required to be analysed to suit the purpose

c. Selecting the techniques to be used for such analysis

As such analysis is purposive; it may be restricted to any particular portion of the available financial statement, taking care to ensure

objectivity and unbiased. It covers study of relationships with a set of financial statements at a point of time and with trends, in them,

over time. It covers a study of some comparable firms at a particular time or of a particular firm over a period of time or may cover

both.

Types of Financial statement analysis :

The main objective of financial analysis is to determine the financial health of a business enterprise, which may be of the following

types:

a. External analysis: It is performed by outside parties, such as trade creditors, investors, suppliers of long term debt, etc.

b. Internal analysis:

It is performed by corporate finance and accounting department and is more detailed than external analysis.

c. Horizontal analysis:

This analysis compares financial statements viz. profit and loss account and balance sheet of previous year with that of current

year.

d. Vertical analysis:

Vertical analysis converts each element of the information into a percentage of the total amount of statement so as to establish

relationship with other components of the same statement.

e. Trend analysis :

Trend analysis compares ratios of different components of financial statements related to different period with that of the base

year.


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f. Ratio Analysis: It establishes the numerical or quantitative relationship between 2 items/variables of financial statement so that the strengths

and weaknesses of a firm as also its historical performance and current financial position may be determined.

g. Funds flow statement : This statement provides a comprehensive idea about the movement of finance in a business unit during a particular period of

time.

h. Break-even analysis : This type of analysis refers to the interpretation of financial data that represent operating activities.

Relevance of Financial Statement Analysis in Decision Making:

A popular technique of analysing the performance of a business concern is that of financial ratio analysis, it, as a tool of financial

management is of crucial significance. Its importance lies in the fact that it presents facts on a comparative basis and enables drawing

of inferences as regards a firm's performance. It is relevant in assessing the firm's performance in the below mentioned aspects :

a. Financial ratios for evaluation of performance :

i. Liquidity position : Ratio analysis assists in drawing conclusions as regards the firm's liquidity position. It would be satisfactory if the firm is able

to meet its current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities if

it has sufficient liquidity to pay interest on its short-maturing debt, usually within a year as also the principal. This ability is

reflected in the liquidity ratios of the firm and liquidity ratios are useful in credit analysis by banks and other suppliers of

short-term loans.

ii. Long-term solvency : Ratio analysis is equally helpful for assessing a firm's long-term financial viability. This aspect of the financial position of a

borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business. The

long-term solvency is measured by the leverage/capital structure and profitability ratios focusing on earning power and

operating efficiency and ratio analysis reveals the strength and weaknesses of a firm in respect thereto. The leverage ratios, for

example, indicates whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with

debt in which case its solvency is exposed to serious strain. In the same manner, various profitability ratios reveal whether or

not the firm is able to offer adequate return to its owners consistent with the risk involved.

iii. Operating efficiency : Ratio analysis throws light on the degree of efficiency in the management and utilisation of its assets. Various activity ratios

measure this kind of operational efficiency, a firm's solvency is, in the ultimate analysis, dependent on the sales revenues

generated by the use of its assets - total as well as its components.

iv. Over-all-profitability : Unlike outside parties, that are interested in one aspect of the financial position of a firm, the management is constantly

concerned about the overall profitability of the enterprise i.e. they are concerned about the firm's ability to meet its short-term

and long-term obligations to its creditors, to ensure reasonable return to its owners and secure optimum utilisation of the

firm's assets. It is possible if an integrated view is taken and all the ratios are considered together.

v. Inter-firm comparison : Ratio analysis not only throws light on the firm's financial position but also serves as a stepping stone to remedial measures. It

is made possible by inter-firm comparison/comparison with industry average. It should be reasonably expected that the firm's

performance is in broad conformity with that of the industry to which it belongs. An inter-firm comparison demonstrates the

relative position vis-à-vis its competitors. If the results are at variance either with the industry average or with that of the

competitors, the firm can seek to identify the probable reasons and in its light, take remedial measures. Ratios not only

perform post-mortem of operations, but also serves as barometer for future, they have predictory value and are helpful in

forecasting and planning future business activities and helps in budgeting.

b. Financial ratios for budgeting :

In this field ratios are able to provide a great deal of assistance, budget is only an estimate of future activity based on past experience,

in the making of which the relationship between different spheres of activities are invaluable. It is usually possible to estimate

budgeted figures using financial ratios. Ratios also can be made use of for measuring actual performance with budgeted figures and

indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other.


19

Limitations of financial ratios: a. Diversified product lines :

Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis

of aggregate data cannot be used for inter-firm comparisons.

b. Financial data are badly distorted by inflation : Historical cost values may be substantially different from true values, such distortions in financial data are also carried in

financial ratios.

c. Seasonal factors Seasonal Factors may also influence financial data

d. To give good shape to the financial ratios used popularly : The business may make some year-end adjustments, such window-dressing can change the character of financial ratios that

would be different had there been no change.

e. Differences in accounting policies and accounting period : Difference in accounting policies and accounting period make the accounting data of 2 firms non-comparable as also the

accounting ratios.

f. No Standard set of Ratios:

There is no standard set of ratios against which a firm's ratios may be compared, sometimes, if a firm decides to be above

average then, industry average becomes a low standard. On the other hand, for a below average firm, industry averages

become too high as standards to achieve.

g. Difficult to Generalise:

It is difficult to generalise whether a particular ratio is good or bad, for instance, a low current ratio may be 'bad' from the

view point of low liquidity, while a high current ratio may be 'bad' as it may result from inefficient working capital

management.

h. Inter relation and not inter dependence:

Financial ratios are inter-related and not independent, when viewed in isolation one ratio may highlight efficiency but, as a set

of ratios it may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis.

Financial ratios provide clues but not conclusions. These are tools in the hands of experts as there is no standard ready-made

interpretation of financial ratios.

Ratio Categories for Financial Analysis:

Ratio Analysis is a widely used tool of financial analysis. 'Ratio' is relationship expressed in mathematical terms between 2 individual

or group of figures connected with each other in some logical manner; selected from financial statements of the concern. Ratio

analysis is based on the fact that a single accounting figure by itself might not communicate meaningful information, but when

expressed in relation to some figure, it may definitely provide certain significant information, this relationship between accounting

figures is known as financial ratio. Financial ratio helps to express the relationship between 2 accounting figures in a manner that users

can draw conclusions about the performance, strengths and weaknesses of a firm.

Classification of Ratios :

1. According to source :

Financial ratios according to source from which the figures are obtained may be classified as below :

a. Revenue ratios : When 2 variables are taken from revenue statement the ratio so computed is known as, Revenue ratio.

b. Balance sheet ratio : When 2 variables are taken from the balance sheet, the ratio so computed is known as, Balance sheet ratio.

c. Mixed ratio : When one variable is taken from the Revenue statement and other from the Balance sheet, the ratio so computed is known as,

Mixed ratio.

2. According to usage :

George Foster of Stanford University gave seven categories of financial ratios that exhaustively cover different aspects of a business

organisation, they are :

a. Cash position

b. Liquidity

c. Working Capital/Cash Flow

d. Capital structure

e. Profitability

f. Debt Service Coverage


20

g. Turnover

While working on ratio analysis, it is important to avoid duplication of work, as same information may be provided by more than one

ratio, the analyst has to be selective in respect of the use of financial ratios. The operations and financial position of a firm can be

described by studying its short and long term liquidity position, profitability and operational activities. Thus, ratios may be classified as

follows :

Liquidity ratios

Capital structure/leverage ratios

Activity ratios

Profitability ratios

Ratio Analysis and its types: It is concerned with the calculation of relationships, which after proper identification & interpretation may provide information about

the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of

critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a

basis for sound judgments.

Types of Ratios

Liquidity

Measurement

Profitability

Indicators

Financial

Leverage/Gearing

Operating Performance Investment

Valuation

Current Ratio Profit Margin Analysis Equity Ratio Fixed Assets Turnover Price/Earnings

Ratio

Quick Ratio Return on Assets Debt Ratio Sales/ Revenue Price/Earnings to

Growth ratio

Return on Equity Debt-Equity Ratio Average Collection Period Dividend Yield

Return on Capital

Employed

Capitalization Ratio Inventory Turnover Dividend Payout

Ratio

Interest Coverage Ratio Total assets Turnover

Liquidity Measurement Ratios

Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern of

liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. The greater the coverage of liquid

assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future

and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red flag for investors as it

may be a sign that the company will have difficulty meeting running its operations, as well as meeting its obligations.

Ratio Formula Meaning Analysis

Current Ratio Current Assets/Current

Liabilities

Current assets includes cash,

marketable securities, accounts

receivable and inventories.

Current liabilities includes

accounts payable, short term

notes payable, short-term loans,

current maturities of long term

debt, accrued income taxes and

other accrued expenses

The number of times that the

short term assets can cover the

short term debts. In other

words, it indicates an ability to

meet the short term obligations

as & when they fall due

Higher the ratio, the better it is,

however but too high ratio

reflects an in-efficient use of

resources & too low ratio leads

to insolvency. The ideal ratio is

considered to be 2:1.,

Quick Ratio or

Acid Test Ratio

(Cash+Cash Equivalents

+Short Term Investments

+Accounts Receivables) /

Current Liabilities

Indicates the ability to meet

short term payments using the

most liquid assets. This ratio is

more conservative than the

current ratio because it

The ideal ratio is 1:1. Another

beneficial use is to compare the

quick ratio with the current

ratio. If the current ratio is

significantly higher, it is a clear


21

excludes inventory and other

current assets, which are more

difficult to turn into cash

indication that the company's

current assets are dependent on

inventory.

Profitability Indicators Ratios

Profitability is the ability of a business to earn profit over a period of time.The profitability ratios show the combined effects of

liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of a

business is the profitability which results from the effective use of its resources.


Gross Profit

Margin

(Gross Profit/Net Sales)*100 A company's cost of goods

sold represents the expense

related to labor, raw materials

and manufacturing overhead

involved in its production

process. This expense is

deducted from the company's

net sales/revenue, which

results in a company's gross

profit. The gross profit margin

is used to analyze how

efficiently a company is using

its raw materials, labor and

manufacturing-related fixed

assets to generate profits.

Higher the ratio, the higher is

the profit earned on sales

Operating Profit

Margin

(Operating Profit/Net

Sales)*100

By subtracting selling, general

and administrative expenses

from a company's gross profit

number, we get operating

income. Management has

much more control over

operating expenses than its

cost of sales outlays. It

Measures the relative impact of

operating expenses

Lower the ratio, lower the

expense related to the sales

Net Profit Margin (Net Profit/Net Sales)*100 This ratio measures the

ultimate profitability

Higher the ratio, the more

profitable are the sales.

Return on Assets Net Income / Average Total

Assets

( Earnings Before Interest &

Tax = Net Income)

This ratio illustrates how well

management is employing the

company's total assets to make

a profit.

Higher the return, the more

efficient management is in

utilizing its asset base

Return on Equity Net Income / Average

Shareholders Equity*100

It measures how much the

shareholders earned for their

investment in the company.

Higher percentage indicates the

management is in utilizing its

equity base and the better

return is to investors.

Return on Capital

Employed

Net Income / Capital

Employed

This ratio complements

the return on equity ratio by

adding a company's debt

liabilities, or funded debt, to

It is a more comprehensive

profitability indicator because

it gauges management's ability

to generate earnings from a


22

Capital Employed = Avg. Debt

Liabilities + Avg. Shareholders

Equity

equity to reflect a company's

total "capital employed". This

measure narrows the focus to

gain a better understanding of a

company's ability to generate

returns from its available

capital base.

company's total pool of capital.

Financial Leverage/Gearing Ratios

These ratios indicate the degree to which the activities of a firm are supported by creditors’ funds as opposed to owners as the

relationship of owner’s equity to borrowed funds is an important indicator of financial strength. The debt requires fixed interest

payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed time. A relatively

high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors against possible losses from

default in payment.

Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is greater

than the rate payable on borrowed funds.


Equity Ratio (Ordinary Shareholder’s

Interest / Total assets)*100

This ratio measures the

strength of the financial

structure of the company

A high equity ratio reflects a

strong financial structure of the

company. A relatively low

equity ratio reflects a more

speculative situation because

of the effect of high leverage

and the greater possibility of

financial difficulty arising

from excessive debt burden.

Debt Ratio Total Debt / Total Assets This compares a company's

total debt to its total assets,

which is used to gain a general

idea as to the amount of

leverage being used by a

company. This is the measure

of financial strength that

reflects the proportion of

capital which has been funded

by debt, including preference

shares.

With higher debt ratio (low

equity ratio), a very small

cushion has developed thus not

giving creditors the security

they require. The company

would therefore find it

relatively difficult to raise

additional financial support

from external sources if it

wished to take that route. The

higher the debt ratio the more

difficult it becomes for the

firm to raise debt.

Debt – Equity

Ratio

Total Liabilities / Total

Equity

This ratio measures how much

suppliers, lenders, creditors

and obligors have committed

to the company versus what

the shareholders have

committed.

This ratio indicates the extent

to which debt is covered by

shareholders’ funds.

A lower ratio is always safer,

however too low ratio reflects

an in-efficient use of equity.

Too high ratio reflects either

there is a debt to a great extent

or the equity base is too small


23

Capitalization

Ratio

Long Term Debt / (Long

Term Debt + Shareholder’s

Equity)

This ratio measures the debt

component of a company's

capital structure, or

capitalization (i.e., the sum of

long-term debt liabilities and

shareholders' equity) to

support a company's

operations and growth.

A low level of debt and a

healthy proportion of equity in

a company's capital structure is

an indication of financial

fitness.

A company too highly

leveraged (too much debt) may

find its freedom of action

restricted by its creditors

and/or have its profitability

hurt by high interest costs.

This ratio is one of the more

meaningful debt ratios because

it focuses on the relationship of

debt liabilities as a component

of a company's total capital

base, which is the capital

raised by shareholders and

lenders.

Interest Coverage

Ratio

EBIT / Interest on Long

Term Debt

This ratio measures the

number of times a company

can meet its interest expense

The lower the ratio, the more

the company is burdened by

debt expense. When a

company's interest coverage

ratio is only 1.5 or lower, its

ability to meet interest

expenses may be questionable.

Operating Performance Ratios:

These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash,

i.e how efficiently & effectively a company is using its resources to generate sales and increase shareholder value. The better these

ratios, the better it is for shareholders.

Ratios Formula Meaning Analysis

Fixed Assets

Turnover

Sales / Net Fixed Assets This ratio is a rough measure

of the productivity of a

company's fixed assets with

respect to generating sales

High fixed assets turnovers are

preferred since they indicate a

better efficiency in fixed

assets utilization.

Average Collection

Period

( Accounts

Receivable/Annual Credit

Sales )*365 days

The average collection period

measures the quality of

debtors since it indicates the

speed of their collection.

The shorter the average

collection period, the better

the quality of debtors, as a

short collection period implies

the prompt payment by

debtors. An excessively long

collection period implies a

very liberal and inefficient

credit and collection

performance. The delay in

collection of cash impairs the

firm’s liquidity. On the other

hand, too low a collection


24

period is not necessarily

favorable, rather it may

indicate a very restrictive

credit and collection policy

which may curtail sales and

hence adversely affect profit.

Inventory Turnover Sales / Average Inventory It measures the stock in

relation to turnover in order to

determine how often the stock

turns over in the business.

It indicates the efficiency of

the firm in selling its product.

High ratio indicates that there

is a little chance of the firm

holding damaged or obsolete

stock.

Total Assets

Turnover

Sales / Total Assets This ratio indicates the

efficiency with which the firm

uses all its assets to generate

sales.

Higher the firm’s total asset

turnover, the more efficiently

its assets have been utilised.

Investment Valuation Ratios:

These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.


Price Earning Ratio

( P/E Ratio )

Market Price per Share /

Earnings Per Share

This ratio measures how many

times a stock is trading (its

price) per each rupee of EPS

A stock with high P/E ratio

suggests that investors are

expecting higher earnings

growth in the future compared

to the overall market, as

investors are paying more for

today's earnings in

anticipation of future earnings

growth. Hence, stocks with

this characteristic are

considered to be growth

stocks. Conversely, a stock

with a low P/E ratio suggests

that investors have more

modest expectations for its

future growth compared to the

market as a whole.

Price Earnings to

Growth Ratio

( P/E Ratio ) / Earnings Per

Share

The price/earnings to growth

ratio, commonly referred to as

the PEG ratio, is obviously

closely related to the P/E ratio.

The PEG ratio is a refinement

of the P/E ratio and factors in

a stock's estimated earnings

growth into its current

valuation. By comparing a

stock's P/E ratio with its

projected, or

estimated, earnings per share

(EPS) growth, investors are

given insight into the degree

The general consensus is that

if the PEG ratio indicates a

value of 1, this means that the

market is correctly valuing

(the current P/E ratio) a stock

in accordance with the stock's

current estimated earnings per

share growth. If the PEG ratio

is less than 1, this means that

EPS growth is potentially able

to surpass the market's current

valuation. In other words, the

stock's price is being

undervalued. On the other


25

of overpricing or under pricing

of a stock's current valuation,

as indicated by the traditional

P/E ratio.

hand, stocks with high PEG

ratios can indicate just the

opposite - that the stock is

currently overvalued.

Dividend Yield

Ratio

( Annual Dividend per Share

/ Market Price per

Share ) *100

This ratio allows investors to

compare the latest dividend

they received with the current

market value of the share as an

indictor of the return they are

earning on their shares

This enables an investor to

compare ratios for different

companies and industries.

Higher the ratio, the higher is

the return to the investor

Dividend Payout

Ratio

(Dividend per Share /

Earnings per Share ) * 100

This ratio identifies the

percentage of earnings (net

income) per common share

allocated to paying

cash dividends to

shareholders. The dividend

payout ratio is an indicator of

how well earnings support the

dividend payment.

Financial ratios for evaluating performance on operational efficiency and liquidity position aspects: Operating Efficiency: Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios (such

as turnover ratios) measure this kind of operational efficiency. These ratios are employed to evaluate the efficiency with which the firm

manages and utilises its assets. These ratios usually indicate the frequency of sales with respect to its assets. These assets may be

capital assets or working capital or average inventory. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the

sales revenues generated by use of its assets – total as well as its components.

Liquidity Position: With the help of ratio analysis, one can draw conclusions regarding liquidity position of a firm. The liquidity position of a firm would

be satisfactory, if it is able to meet its current obligations when they become due. Inability to pay-off short-term liabilities affects its

credibility as well as its credit rating. Continuous default on the part of the business leads to commercial bankruptcy. Eventually such

commercial bankruptcy may lead to its sickness and dissolution. Liquidity ratios are current ratio, liquid ratio and cash to current

liability ratio. These ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.

Cash Flow Analysis: Cash flow analysis is an important tool with the finance manager for ascertaining the changes in cash in hand and bank balances as

from one date to another, during the accounting year and also between two accounting periods. It shows inflows and outflows of cash

i.e. sources and applications of cash during a particular period. The procedure for preparation of cash flow statement, its objectives and

requirements are covered in NAS-3. It is an important tool for short-term analysis, like other financial statements, it is analyzed to

reveal significant relationships. Two major areas that analysts examine while studying a cash flow statement are discussed as below:

1. Cash generating efficiency :

It is the ability of a company to generate cash from its current or continuing operations. Following ratios are used for the purpose.

Cash flow yield :

Cash flow yield = net cash flow from operating activities/net income

Cash flow to sales :

Cash flow to sales = net cash flow from operating activities/net sales

Cash flows to assets :

Cash flow to assets = net cash flow from operating activities/average total assets

2. Free cash flow :

Strictly cash flow is the amount of cash that remains after deducting funds that the company has to commit to continue operating at

its planned level. Such commitment has to cover current or continuing operations, interest, income tax, dividend, net capital

expenditures and so on. If the cash flow is positive, it means the company has met all its planned commitment and has cash


26

available to reduce debt or expand. A negative free cash flow means the company will have to sell investments, borrow money or

issue stock in short-term to continue at its planned level.

3. Others :

Besides measuring cash efficiency and free cash flow, with the help of cash flow statement, the financial analysts also calculates a

number of ratios based on cash figures rather than on earning figures. Some of which are as below:

Price per share/free cash flow per share

Operating cash flow/operating profit

It shows that accrual adjustments are not having severe effect on reported profits.

Self-financing investment ratio = internal funding/net investment activities

It indicates how much of the funds generated by the business are re-invested in assets.

Fund Flow Analysis: Funds flow analysis is an important long-term analysis tool in the hands of finance manager for ascertaining changes in financial

position of firm between two accounting periods. It analyses reasons for changes in financial position between two balance sheets and

shows the inflow and outflow of funds i.e. sources and application of funds during a particular period.

It provides information that balance sheet and profit and loss account fail to provide i.e. changes in financial position of an enterprise,

which is of great help to the users of financial information. It is of great help to management, shareholders, creditors, brokers, etc. as it

helps in answering the following questions:

where have the profits gone ?

why there is an imbalance existing between liquidity and profitability position of the enterprise ?

why is the concern financially solid inspite of losses ?

a. The projected funds flow statement can be prepared for budgetary control and capital expenditure control in the organisation. A

projected funds flow statement may be prepared and resources properly allocated after an analysis of present state of affairs.

b. The optimum utilisation of available funds is essential for overall growth of the enterprise. The funds flow statement prepared in

advance gives a clear-cut direction to the management in this regard.

c. It is also useful to management for judging the financial operating performance of the company and indicates working capital

position that helps the management in taking policy decisions regarding dividend, etc. It helps the management to test whether the

working capital is effectively used or not and that working capital level is adequate or inadequate for the requirements of business.

d. It helps investors to decide whether company has funds managed properly, indicates creditworthiness of a company that helps

lenders to decide whether to lend money to the company or not. It helps management to make decisions and decide about the

financing policies and capital expenditure programme for future.

Difference between Cash Flow and Funds Flow Statement:

Cash flow statement Funds flow statement

(i) It ascertains the changes in balance of

cash in hand and bank.

(i) It ascertains the changes in financial

position between two accounting

periods.

(ii) It analyses the reasons for changes in

balance of cash in hand and bank

(ii) It analyses the reasons for change in

financial position between two balance

sheets

(iii) It shows the inflows and outflows of

cash.

(iii) It reveals the sources and application of

finds.

(iv) It is an important tool for short term

analysis.

(iv) It helps to test whether working capital

has been effectively used or not.


27

CAPITAL BUDGETING

Meaning:

The term capital budgeting means planning for capital assets. Capital budgeting decision means the decision as to whether or not to

invest in long-term projects such as setting up of a factory or installing a machinery or creating additional capacities to manufacture a

part which at present may be purchased from outside and so on. It includes the financial analysis of the various proposals regarding

capital expenditure to evaluate their impact on the financial condition of the company for the purpose to choose the best out of the

various alternatives. The finance manager has various tools and techniques by means of which he assists the management in taking a

proper capital budgeting decision. Capital budgeting decision is thus, evaluation of expenditure decisions that involve current outlays

but are likely to produce benefits over a period of time longer than one year. The benefit that arises from capital budgeting decision

may be either in the form of increased revenues or reduced costs. Such decision requires evaluation of the proposed project to forecast

likely or expected return from the project and determine whether return from the project is adequate. Also as business is a part of

society, it is its moral responsibility to undertake only those projects that are socially desirable. Capital budgeting decision is an

important, crucial and critical business decision due to:

1. Substantial expenditure : Capital Budgeting decision involves the investment of substantial amount of funds and is thus it is necessary for a firm to make

such decision after a thoughtful consideration, so as to result in profitable use of scarce resources. Hasty and incorrect decisions

would not only result in huge losses but would also account for failure of the firm.

2. Long time period : Capital budgeting decision has its effect over a long period of time, they affect the future benefits and also the firm and influence

the rate and direction of growth of the firm.

3. Irreversibility : Most of such decisions are irreversible, once taken, the firm may not been in a position to reverse its impact. This may be due to

the reason, that it is difficult to find a buyer for second-hand capital items.

4. Complex decision : Capital investment decision involves an assessment of future events, which in fact are difficult to predict, further, it is difficult to

estimate in quantitative terms all benefits or costs relating to a particular investment decision.

Types of Capital Investment Decision:

1. On the basis of the firm's existence : Capital budgeting decisions are taken by both newly incorporated and existing firms. New firms may require to take decision

in respect of selection of plant to be installed, while existing firms may require to take decision to meet the requirements of

new environment or to face challenges of competition. These decisions may be classified into:

a. Replacement and modernization decisions : Replacement and modernisation decisions aim to improve operating efficiency and reduce costs. Usually, plants require

replacement due to they been economically dead i.e. no more economic life left or on they becoming technologically

outdated. The former decision is of replacement and latter one of modernization, however, both these decisions are cost

reduction decisions.

b. Expansion decision :

Existing successful firms may experience growth in demand of the product and may experience shortage or delay in

delivery due to inadequate production facilities and thus, would consider proposals to add capacity to existing product

lines.

c. Diversification decisions :

These decisions require evaluation proposals to diversify into new product lines, new markets, etc. to reduce risk of failure

by dealing in different products or operating in several markets. expansion and diversification decisions are revenue

expansion decisions.

2. On the basis of decision situation :

a. Mutually exclusive decisions :

Decisions are said to be mutually exclusive when two or more alternative proposals are such that acceptance of one would

exclude the acceptance of the other.

b. Accept-Reject decisions : The accept-eject decisions occurs when proposals are independent and do not compete with each other. The firm may

accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which have a

higher return than certain desired rate of return are accepted and rest rejected.

c. Contingent decisions :


28

Contingent decisions are dependable proposals, investment in one requires investment in another.

Project Evaluation Techniques:

At each point of time, business manager, has to evaluate a number of proposals as regards various projects where he can invest money.

He compares and evaluates projects and decides which one to take up and which to reject. Apart from financial considerations, there

are many other factors considered while taking a capital budgeting decision. At times a project may be undertaken only to establish

foothold in the market or for better welfare of the society as a whole or of the business or for increasing the safety and security of

workers, or due to requirements of law or because of emotional reasons for instance, many industrial sector projects are taken up at

home towns even if better locations are available. The major consideration in taking a capital budgeting decision is to evaluate its

returns as compared to its investments. Evaluation of capital budgeting proposals have two dimensions i.e. profitability and risk, which

are directly related. Higher the profitability, higher would be the risk and vice versa. Thus, the finance manager has to strike a balance

between profitability and risk. Following are some of the techniques used to evaluate financial aspects of a project:

1. Payback period :

It is one of the simplest method to calculate period within which entire cost of project would be completely recovered. It is the

period within which total cash inflows from project would be equal to total cash outflow of project, cash inflow means profit after

tax but before depreciation.

Merits:

a. This method of evaluating proposals for capital budgeting is simple and easy to understand, it has an advantage of making

clear that it has no profit on any project until the payback period is over i.e. until capital invested is recovered. When funds

are limited, they may be made to do more by selecting projects having shorter payback periods. This method is particularly

suitable in the case of industries where risk of technological services is very high. In such industries, only those projects

having a shorter payback period should be financed since changing technology would make the projects totally obsolete,

before all costs are recovered.

b. In case of routine projects also use of payback period method favours projects that generates cash inflows in earlier years,

thereby eliminating projects bringing cash inflows in later years that generally are conceived to be risky as this tends to

increase with futurity.

c. By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria. This is important in situations of

liquidity crunch and high cost of capital.

d. Payback period can be compared to break-even point, the point at which costs are fully recovered but profits are yet to

commence.

e. The risk associated with a project arises due to uncertainty associated with cash inflows. A shorter payback period means that

uncertainty with respect to project is resolved faster.

Limitations :

Technique of payback period is not a scientific one due to the following reasons:

a. It stresses capital recovery rather than profitability. It does not take into account returns from the project after its payback

period. For example : project A may have payback period of 3 years and project B of 8 years, according to this method project

A would be selected, however, it is possible that after 3 years project B earns returns @ 20 % for another 3 years while project

A stops yielding returns after 2 years. Thus, payback period is not a good measure to evaluate where the comparison is

between 2 projects, one involving long gestation period and the other yielding quick results but for a short period.

b. This method becomes an inadequate measure of evaluating 2 projects where the cash inflows are uneven.

c. This method does not give any consideration to time value of money, cash flows occurring at all points of time are simply

added. This treatment is in contravention of the basic principle of financial analysis that stipulates compounding or

discounting of cash flows and when they arise at different points of time.

Some accountants calculate payback period after discounting cash flows by a pre-determined rate and the payback period so

calculated is called "discounted payback period".

2. Payback reciprocal :

It is reciprocal of the payback period. A major drawback of the payback period method of capital budgeting is that it does not

indicate any cut off period for the purpose of investment decision. It is, argued that reciprocal of payback would be a close

approximation of the internal rate of return if the life of the project is at least twice the payback period and project generates equal

amount of final cash inflows. In practice, payback reciprocal is a helpful tool for quickly estimating rate of return of a project

provided its life is at least twice the payback period.

payback reciprocal = average annual cash inflows/initial investment

3. Accounting or Average Rate of Return method (ARR):

Accounting or average rate of return means average annual yield on the project. Under this method profit after tax and depreciation

as percentage of total investment is considered.


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rate of return = (total profit * 100)/(net investments in the project * number of years of profits)

This rate is compared with the rate expected on the projects, had the same funds been invested alternatively in those projects.

Sometimes, the management compares this rate with minimum rate known as cut-off rate.

Merits:

It is a simple and popular method as it is easy to understand and includes income from the project throughout its life.

Limitations:

It is based upon crude average profits of the future years. It ignores the effect of fluctuations in profits from year to year. And thus

ignores time value of money which is very important in capital budgeting decisions.

4. Net Present Value method :

The best method for evaluation of investment proposal is net present value method or discounted cash flow technique. This method

takes into account the time value of money. The net present value of investment proposal may be defined as sum of the present

values of all cash inflows as reduced by the present values of all cash outflows associated with the proposal. Each project involves

certain investments and commitment of cash at certain point of time. This is known as cash outflows. Cash inflows can be

calculated by adding depreciation to profit after tax arising out of that particular project.

NPV = CF 0 / (1+K)0 + CF 1 / (1+K)

1. . . . . . . . . . . . . . . . . . . . . . . . . . . . .+ CF n / (1+K)

n

Where,

NPV = Net present value of a project

CF0 = Cash outflows at the time 0(zero).

CFt = Cash flows at the end of year t(t = 0 to n) i.e. the difference between cash inflow and outflow).

K = Discount rate

n = Life of the project

Discounting cash inflows : Once cash inflows and outflows are determined, next step is to discount each cash inflow and work out its present value. For

the purpose, discounting rates must be known. Normally, the discounting rate equals the opportunity cost of capital as a project

must earn at least that much as is paid out on the funds locked in the project. The concept of present value is easy to

understand. To calculate present value of various cash inflows reference shall be had to the present value table.

Discounting cash outflows : The cash outflows also requires discounting as the whole of investment is not made at the initial stage itself and will be spread

over a period of time. This may be due to interest-free deferred credit facilities from suppliers of plant or some other reasons.

Another change in cash flows to be considered in the capital budgeting decision is the change due to requirement of working

capital. Apart from investment in fixed assets, each project involves commitment of funds in working capital. The commitment

on this account may arise as soon as the plant starts production. The working capital commitment ends after the fixed assets of

the project are sold out. Thus, while considering the total outflows, working capital requirement must also be considered in the

year the plant starts production. At the end of the project, the working capital will be recovered and can be treated as cash

inflow of last year.

Acceptance rule : A project can be accepted if NPV is positive i.e. NPV > 0 and rejected; if it is negative i.e. NPV < 0. If NPV = 0, project may

be accepted as it implies a project generates cash flows at the rate just equal to the opportunity cost of capital.

Merits:

a. NPV method takes into account the time value of money.

b. The whole stream of cash flows is considered.

c. NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in conformity with basic financial

objectives.

d. NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's of different projects therefore

can be compared. It implies that each project can be evaluated independent of others on its own merits.

Limitations :

a. It involves different calculations.

b. The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy of NPV depends

on accurate estimation of these 2 factors that may be quite difficult in reality.

c. The ranking of projects depends on the discount rate.


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5. Desirability factor/Profitability Index : In cases of, a number of capital expenditure proposals, each involving different amounts of cash inflows, the method of working out

desirability factor or profitability index is followed. In general terms, a project is acceptable if its profitability index value is greater

than 1.

Merits:

1) This method also uses the concept of time value of money.

2) It is a better project evaluation technique than NPV.

Limitations of Profitability index:

Profitability index fails as a guide in resolving 'capital rationing' where projects are indivisible. Once a single large project with

high NPV is selected, possibility of accepting several small projects that together may have higher NPV, then a single project is

excluded.

Situations may arise where a project selected with lower profitability index may generate cash flows in such a manner that

another project can be taken up one or two years later, the total NPV in such case being more than the one with a project having

highest Profitability Index.

The profitability index approach thus, cannot be used indiscriminately but all other type of alternatives of projects would have to be

worked out.

6. Internal Rate of Return(IRR) :

IRR is that rate of return at which the sum total of discounted cash inflows equals to discounted cash outflows. The IRR of a project

is the discount rate that makes the net present value of the project equal to zero.

CO 0 = CF 0 / (1+r)0 + CF 1 / (1+r)

1. . . . . . . . . . . . . . . . . . . . . . . . . . . . .+ CF n / (1+r)

n + (SV + WC)/(1+r)

n

Where,

CO0 = Cash outflows at the time 0(zero).

CFt = Cash flows at the end of year t.

r = Discount rate

n = Life of the project

SV & WC = Salvage value and Working capital at the end of 'n' years.

The discount rate i.e. cost of capital is assumed to be known in the determination of NPV, while in the IRR, the NPV is set at

0(zero) and discount rate satisfying this condition is determined.

IRR can be interpreted in 2 ways:

IRR represents the rate of return on the unrecovered investment balance in the project.

IRR is the rate of return earned on the initial investment made in the project.

It may not be possible for all firms to reinvest intermediate cash flows at a rate of return equal to the project's IRR, hence the first

interpretation seems to be more realistic. Thus, IRR should be viewed as the rate of return on unrecovered balance of project rather

than compounded rate of return on initial investment over the life of the project. The exact rate of interpolation as follows :

IRR = r + [(PV C F A T - PVC 0) / PV * r

Where,

PVCFAT = Present value of cash inflows (DFr * annuity)

PVC0 = Present value of cash outlay

r = Either of 2 interest rates used in the formula

r = Difference in interest rates

PV = Difference in present values of inflows

Acceptance Rule:

The use of IRR, as a criterion to accept capital investment decision involves a comparison of IRR with required rate of return called

as Cutoff rate. The project should the accepted if IRR is greater than cut off rate. If IRR is equal to cut off rate the firm is

indifferent. If IRR less than cut off rate the project is rejected.

Merits:

This method makes use of the concept of time value of money.

All the cash flows in the project are considered.

IRR is easier to use as instantaneous understanding of desirability is determined by comparing it with the cost of capital.

IRR technique helps in achieving the objective of minimisation of shareholders wealth.


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Demerits:

The calculation process is tedious if there are more than one cash outflow interspersed between the cash inflows then there

would be multiple IRR's, the interpretation of which is difficult.

The IRR approach creates a peculiar situation if we compare the 2 projects with different inflow/outflow patterns.

It is assumed that under this method all future cash inflows of a proposal are reinvested at a rate equal to IRR which is a

ridiculous assumption.

In case of mutually exclusive projects, investment options have considerably different cash outlays. A project with large

fund commitments but lower IRR contribute more in terms of absolute NPV and increases the shareholders' wealth then

decisions based only on IRR may not be correct.

Cut Off Rate: Cut off rate is the minimum that the management wishes to have from any project, usually it is based on cost of capital. The technical

calculation of cost of capital involves a complicated procedure, as a concern procures funds from any sources i.e. equity shares, capital

generated from its own operations and retained in general reserves i.e. retained earnings, debentures, preference share capital,

long/short term loans, etc. Thus, the firm's cost of capital can be known only by working out weighted average of the various costs of

raising various types of capital. A firm should not and would not invest in projects yielding returns at a rate below the cut off rate.

Difference between Desirability Factor, NPV and IRR for decision making: In case of an undertaking having 2 or more competing projects and a limited amount of funds at its disposal, the question of ranking

the projects arises. For every project, desirability factor and NPV method would give the same signal i.e. accept or reject. But, in case

of mutually exclusive projects, NPV method is preferred due to the fact that NPV indicates economic contribution of the project in

absolute terms. The project giving higher economic contribution is preferred.

As regards NPV vs.IRR method, one has to consider the basic presumption under each. In case of IRR, the presumption is that

intermediate cash inflows will be reinvested at the rate i.e. IRR, while that under NPV is that intermediate cash inflows are presumed

to be reinvested at the cut off rate. It is obvious that reinvestment of funds at cut off rate is possible than at the internal rate of return,

which at times may be very high. Hence the NPV obtained after discounting at a fixed cut off rate are more reliable for ranking 2 or

more projects than the IRR.

Capital Rationing: Usually, firms decide maximum amount that can be invested in capital projects, during a given period of time, say a year. The firm,

then attempts to select a combination of investment proposals, that will be within specific limits providing maximum profitability and

rank them in descending order as per their rate of return, this is a capital rationing situation. A firm should accept all investment

projects with positive NPV, with an objective to maximise the wealth of shareholders. However, there may be resource constraints due

to which a firm may have to select from amongst various projects. Thus, there may arise a situation of capital rationing where, there

may be internal or external constraints on procurement of funds needed to invest in all investment proposals with positiveNPV's.

Capital rationing can be experienced due to external factors, mainly imperfections in capital markets attributable to non-availability of

market information, investor attitude, and so on. Internal capital rationing is due to self-imposed restrictions imposed by management

as, not to raise additional debtor lay down a specified minimum rate of return on each project. There are various ways of resorting to

capital rationing. It may put up a ceiling when it has been financing investment proposals only by way of retained earnings i.e.

ploughing back of profits. Capital rationing can also be introduced by following the concept of 'Responsibility Accounting', whereby

management may introduce capital rationing by authorising a particular department to invest up to a specified limit, beyond which

decisions would be taken by the higher-ups.Selection of a project under capital rationing involves:

Identification of the projects that can be accepted by using evaluation technique as discussed.

Selection of the combination of projects.

Ways of implementing Capital Rationing

o It may be implemented through budgets.

o It can be done by putting up a ceiling when it has been financing investment proposals only by way of retained earnings.

o It can also be done by ‘Responsibility Accounting’, whereby management may authorise a particular department to make

investment only up to a specified limit, beyond which the investment decisions are to be taken by higher-ups.

In capital rationing, it would be desirable to accept several small investment proposals than a few large ones, for a fuller utilisation of

the budgeted amount. This would result in accepting relatively less profitable investment proposals if full utilisation of budget is a

primary consideration. It may also mean that the firm forgoes the next profitable investment following after the budget ceiling, even if

it is estimated to yield a rate of return higher than the required rate. Thus capital rationing does not always lead to optimum results.


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Estimation of Future Cash Flows: In order to use any technique of financial evaluation, data as regards cash flows from the project is necessary, implying that costs of

operations and returns from the project for a considerable period in future should be estimated. Future is always uncertain and

predictions can be made about it only with reference to certain probability levels, but, still would not be exact, thus, cash flows are at

best only a probability. Following are the various stages or steps used in developing relevant information for cash flow analysis :

1. Estimation of costs:

To estimate cash outflows, information as regards following are needed which may be obtained from vendors or contractors or by

internal estimates :

a. Cost of new equipment;

b. Cost of removal and disposal of old equipment less scrap value;

c. Cost of preparing the site and mounting of new equipment; and

d. Cost of ancillary services required for new equipment such as new conveyors or new power supplies and so on.

The vendor may have related data on costs of similar equipment or the company may have to estimate costs from its own

experience. But, cost of a new project specially the one involving long gestation period, must be estimated in view of the changes

in price levels in the economy. For instance high rates of inflation have caused very high increases in the cost of various capital

projects. The impact of possible inflation on the value of capital goods must thus, be assessed and estimated in working out

estimated cash outflow. Many firms work out a specific index showing changes in price levels of capital goods such as buildings,

machinery, plant and machinery, etc. The index is used to estimate the likely increase in costs for future years and as per it,

estimated cash outflows are adjusted. Another adjustment required in cash outflows estimates is the possibility of delay in the

execution of a project depending on a number of factors, many of which are beyond the management's control. It is imperative that

an estimate may be made regarding the increase in project cost due to delay beyond expected time. The increase would be due to

many factors as inflation increase in overhead expenditure, etc.

2. Estimation of additional working capital requirements: The next step is to ascertain additional working capital required for financing increased activity on account of new capital

expenditure project. Project planners often do not take into account the amount required to finance the increase in additional

working capital that may exceed amount of capital expenditure required. Unless and until this factor is taken into account, the cash

outflow will remain incomplete. The increase in working capital requirement arises due to the need for maintaining higher sundry

debtors, stock-in-hand and prepaid expenses, etc.The finance manager should make a careful estimate of the requirements of

additional working capital. As the new capital project commences operation, cash outflows requirement should be shown in terms

of cash outflows. At the expiry of the useful life of the project, the working capital would be released and can be thus, treated as

cash inflow. The impact of inflation is also to be brought into account, while working out cash outflows on account of working

capital. In an inflationary economy, working capital requirements may rise progressively even though there is increase in activity of

a new project. This is because the value of stock, etc. may rise due to inflation, hence, additional working capital requirements on

this account should be shown as cash outflows.

3. Estimation of production and sales:

Planning for a new project requires an estimate of the production that it would generate and the sale that it would entail. Cash

inflows are highly dependent on the estimation of production and sales levels. This dependence is due to peculiar nature of fixed

cost. Cash inflows tend to increase considerably after the sales are above the break-even point. If in a year, sales are below the

break-even point, which is quite possible in a large capital intensive project in the initial year of its commercial production, the

company may even have cash outflows in terms of losses. On the basis of additional production units that can be sold and price at

which they may be sold, the gross revenues from a project can be worked out. In doing so however, possibility of a reduction in

sale price, introduction of cheaper or more efficient product by competitors, recession in the market conditions and such other

factors are to be considered.

4. Estimation of cash expenses: In this step, the amount of cash expenses to be incurred in running the project after it goes into commercial production are to be

estimated. It is obvious that whichever level of capacity utilisation is attained by the project, fixed costs remains the same.

However, variable costs vary with changes in the level of capacity utilisation.

5. Working out cash inflows: The difference between gross revenues and cash expenses haste be adjusted for taxation before cash inflows can be worked out. In

view of depreciation and other taxable expenses, etc. the tax liability of the company may be worked out. The cash inflow would be

revenues less cash expenses and liability for taxation.


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One problem is of treatment of dividends and interest. Some accountants suggest that interest being a cash expense is to be

deducted and dividends to be deducted from cash inflows. However, this seems to be incorrect. Both dividends and interest involve

a cash outflow, the fact

Remains that these constitute cost of capital, hence, if discounting rate is itself based on the cost of capital, interest on long term

funds and dividends to equity or preference shareholders should not be deducted while working out cash inflows. The rate of return

yielded by a project at ascertains rate of return is compared with cost of capital for determining whether particular project can be

taken up or not. If the cost of capital becomes part of cash outflows, the comparison becomes vitiated. Thus, capital cost like

interest on long term funds and dividends should not be deducted from gross revenues in order to work out cash inflows. Cash

inflows can also be worked out backwards, on adding interest on long term funds and depreciation to net profits and deducting

liability for taxation for the year.

Social Cost Benefit Analysis: It is being increasingly recognized that commercial evaluation of industrial projects is not enough to justify commitment of funds to a

project specially, if it belongs tithe public sector and irrespective of its financial viability, it is to be implemented in the long term

interest of the nation. In the context of the national policy of making huge public investments in various sectors of the economy, the

need for a practical method of making social cost benefit analysis has acquired great urgency. Hundreds of crores of rupees are

committed every year to various public projects of all types - industrial, commercial and those providing basic infrastructure facilities,

etc. Analysis of such projects has tube done with reference to social costs and benefits as they cannot be expected to yield an adequate

commercial return on the funds employed, at least during the short run. Social cost benefit analysis is important for private

corporations having a moral responsibility to undertake socially desirable projects. In analyzing various alternatives of capital

expenditure, a private corporation should keep in view the social contribution aspect. It can thus be seen that the purpose of social cost

benefit analysis technique is not to replace the existing techniques of financial analysis but to supplement and strengthen them. The

concept of social cost benefit analysis has progressed beyond the stage of intellectual speculation. The planning commission has

already decided that in future, the feasibility studies for public sector projects will have to include an analysis of the social rate of

return. In case of private sector also, a socially beneficial project may be more easily acceptable to the government and thus, this

analysis would be relevant while granting various licenses and approvals, etc. Also, if the private sector includes social cost benefit

analysis in its project evaluation techniques, it will ensure that it is not ignoring its own long-term interest, as in the long run only those

projects will survive that are socially beneficial and acceptable to society.

Need for Social Cost Benefit Analysis (SCBA): a. Market prices used to measure costs and benefits in project analysis do not represent social values due to market

imperfections.

b. Monetary cost benefit analysis fails to consider the externalities or external effects of a project. The external effects can be

positive like development of infrastructure or negative like pollution and imbalance in environment.

c. Taxes and subsidies are monetary costs and gains, but these are only transfer payments from social viewpoint and thus

irrelevant.

d. SCBA is essential for measuring the redistribution effect of benefits of a project as benefits going to poorer section are more

important than one going to sections which are economically better off.

e. Projects manufacturing liqueur and cigarettes are not distinguished from those generating electricity or producing necessities

of life. Thus, merit wants are important appraisal criterion for SCBA.

The important publication on the technique of social cost benefit analysis is those by the United Nations Industrial Development

Organisation (UNIDO) and the Centre for Organisation of Economic Cooperation and Development (OECD). Both publication deals

with the problem of measuring social costs and benefits. In this context, it is essential to understand that actual cost or revenues do not

essentially reflect cost or benefit to the society. It is so, because the market price of goods and services are often grossly distorted due

to various artificial restrictions and controls from authorities. Thus, a different yardstick is to be adopted in evaluating a particular

proposal and its cost benefit analysis are usually valued at "opportunity cost" or shadow prices to judge the real impact of their burden

as costs to society. The social cost valuation sometimes completely changes the estimates of working results of project.

Relationship between Risk and Return: Risk: The term risk with reference to investment decision is defined as the variability in actual return emanating from a project in future over

its working life in relation to the estimated return as forecasted at the time of initial capital budgeting decisions. Risk is differentiated

with uncertainty and is defined as a situation where the facts and figures are not available or probabilities cannot be assigned.

Return:


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It cannot be denied that return is the motivating force and the principal reward to the investment process. The return may be defined in

terms of:

Realised return i.e. the return which was earned or could have been earned, measuring the realised return allows a firm to

assess how the future expected returns may be.

Expected return i.e. the return that the firm anticipates to earn over some future period. The expected return is a predicted

return and may or may not occur.

For, a firm the return from an investment is the expected cash inflows. The return may be measured as the total gain or loss to the firm

over a given period of time and may be defined as percentage on the initial amount invested.

Relationship between risk and return: The main objective of financial management is to maximise wealth of shareholders' as reflected in the market price of shares that

depends on risk-return characteristics of the financial decisions taken by the firm. It also emphasizes that risk and return are 2

important determinants of value of a share. So, a finance manager as also investor, in general has to consider the risk and return of each

and every financial decision. Acceptance of any proposal does not alter the business risk of firm as perceived by the supplier of capital,

but, different investment projects would have different degree of risk. Thus, the importance of risk dimension in capital budgeting can

hardly be over-stressed. In fact, risk and return are closely related; investment project that is expected to yield high return may be too

risky that it causes a significant increase in the perceived risk of the firm. This trade off between risk and return would have a bearing

on the investor' perception of the firm before and after acceptance of a specific proposal. The return from an investment during a given

period is equal to the change in value of investment plus any income received from investment. It isthmus, important that any capital or

revenue income from investments to investor must be included; otherwise the measure of return will be deficient. The return from

investment cannot be forecasted with certainty as there is risk that the cash inflows from project may not be as expected. Greater the

variability between the estimated and actual return, more risky is the project.

Difference between NPV and IRR:

NPV and IRR methods differ in the sense that the results regarding the choice of an asset under certain circumstances are mutually

contradictory under two methods. In case of mutually exclusive investment projects, in certain situations, they may give contradictory

results such that if the NPV method finds one proposal acceptable, IRR favours another. The different rankings given by the NPV and

IRR methods could be due to size disparity problem, time disparity problem and unequal expected lives.

The net present value is expressed in financial values whereas internal rate of return (IRR) is expressed in percentage terms.

In the net present value cash flows are assumed to be re-invested at cost of capital rate. In IRR reinvestment is assumed to be made at

IRR rates.

Do the profitability index and the NPV criterion of evaluating investment proposals lead to the same

acceptance-rejection and ranking decisions? In what situations will they give conflicting results? In the most of the situations the Net Present Value Method (NPV) and Profitability Index (PI) yield same accept or reject decision. In

general items, under PI method a project is acceptable if profitability index value is greater than 1 and rejected if it less than 1. Under

NPV method a project is acceptable if Net present value of a project is positive and rejected if it is negative. Clearly a project offering

a profitability index greater than 1 must also offer a net present value which is positive. But a conflict may arise between two methods

if a choice between mutually exclusive projects has to be made. Consider the following example:

Project A Project B

PV of Cash inflows 2,00,000 1,00,000

Initial cash outflows 1,00,000 40,000

Net present value 1,00,000 60,000

P.I 2

000,00,1

000,00,2

5.2

000,40

000,00,1

According to NPV method, project A would be preferred, whereas according to profitability index method project B would be

preferred.

This is because Net present value gives ranking on the basis of absolute value of rupees. Whereas profitability index gives ranking on

the basis of ratio. Although PI method is based on NPV, it is a better evaluation technique than NPV in a situation of capital rationing.

Decision Tree Analysis: Significance of Decision Tree Analysis: it is generally observed that the present investment decision may have several implications for

future investments decisions. Such complex investment decisions involve a sequence of decisions over time. It is also argued that

since present choices modify future alternatives, industrial activity can not be reduced to a single decision and must be viewed as a


35

sequence of decisions extending from the present time into the future. These sequential decisions are taken on the bases of decision

tree analysis. While constructing and using decision tree, some important steps to be considered are as follows:

a. Investment proposal should be properly defined.

b. Decision alternatives should be clearly clarified.

c. The decision tree should be properly graphed indicating the decision points, chances, events and other data.

d. The results should be analysed and the best alternative should be selected.

LEVERAGE

Meaning:

The term leverage generally, refers to a relationship between 2 interrelated variables. In financial analysis, it represents the influence of

one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, EBIT

(Earnings Before Interest and Tax), EPS (Earnings Per Share), etc.

Types of leverages :

Commonly used leverages are of the following type :

1. Operating Leverage :

It is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its EBIT ". When there is an

increase or decrease in sales level the EBIT also changes. The effect of changes in sales on the level EBIT is measured by operating

leverage.

Operating leverage = % Change in EBIT / % Change in sales

= [Increase in EBIT/EBIT] / [Increase in sales/sales]

Significance of operating leverage:

Analysis of operating leverage of a firm is useful to the financial manager. It tells the impact of changes in sales on operating

income. A firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on EBIT for even a small

change in sales level. Higher D.O.L. can dramatically increase operating profits. But, in case of decline in sales level, EBIT may be

wiped out and a loss may be operated. As operating leverage, depends on fixed costs, if they are high, the firm's operating risk and

leverage would be high. If operating leverage is high, it automatically means that the break-even point would also be reached at a

high level of sales. Also, in case of high operating leverage, the margin of safety would be low. Thus, it is preferred to operate

sufficiently above the break-even point to avoid the danger of fluctuations in sales and profits.

2. Financial Leverage :

It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on

the firm's earnings per share. The financial leverage occurs when a firm's capital structure contains obligation of fixed charges e.g.

interest on debentures, dividend on preference shares, etc. along with owner's equity to enhance earnings of equity shareholders.

The fixed financial charges do not vary with the operating profits or EBIT. They are fixed and are to be repaid irrespective of level

of operating profits or EBIT. The ordinary shareholders of a firm are entitled to residual income i.e. earnings after fixed financial

charges. Thus, the effect of changes in operating profit or EBIT on the level of EPS is measured by financial leverage.

Financial leverage = % change in EPS/% change in EBIT

or

= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}

The financial leverage is favourable when the firm earns more on the investment/assets financed by sources having fixed charges. It

is obvious that shareholders gain a situation where the company earns a high rate of return and pays a lower rate of return to the

supplier of long term funds, in such cases it is called 'trading on equity'. The financial leverage at the levels of EBIT is called

degree of financial leverage and is calculated as ratio of EBIT to profit before tax.

Degree of financial leverage = EBIT/Profit before tax

Shareholders gain in a situation where a company has a high rate of return and pays a lower rate of interest to the suppliers of long

term funds. The difference accrues to the shareholders. However, where rate of return on investment falls below the rate of interest,

the shareholders suffer, as their earnings fall more sharply than the fall in the return on investment.

Significance of Financial Leverage:

Financial leverage helps the finance manager in designing the appropriate capital structure. One of the objective of planning an

appropriate capital structure is to maximise return on equity shareholders' funds or maximise EPS. Financial leverage is double

edged sword i.e. it increases EPS on one hand, and financial risk on the other. A high financial leverage means high fixed costs and

high financial risk i.e. as the debt component in capital structure increases, the financial risk also increases i.e. risk of insolvency

increases. The finance manager thus, is required to trade off i.e. to bring a balance between risk and return for determining the


36

appropriate amount of debt in the capital structure of a firm. Thus, analysis of financial leverage is an important tool in the hands of

the finance manager who are engaged in financing the capital structure of business firms, keeping in view the objectives of their

firm.

3. Combined leverage :

Operating leverage explains operating risk and financial leverage explains the financial risk of a firm. However, a firm has to look

into overall risk or total risk of the firm i.e. operating risk as also financial risk. Hence, the combined leverage is the result of a

combination of operating and financial leverage. The combined leverage measures the effect of a % change in sales on % change in

EPS.

Combined Leverage = Operating leverage * Financial leverage

= (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT)

= % change in EPS/% change in sales

The ratio of contribution to earnings before taxes is given by a combined effect of financial and operating leverage. A high

operating and high financial leverage is very risky, even a small fall in sales would affect tremendous fall in EPS. A company must

thus, maintain a proper balance between these 2 leverages. A high operating and low financial leverage indicates that the

management is careful as higher amount of risk involved in high operating leverage is balanced by low financial leverage. But, a

more preferable situation is to have a low operating and a high financial leverage. A low operating leverage automatically implies

that the company reaches its break-even point at a low level of sales, thus, risk is diminished. A highly cautious and conservative

manager would keep both its operating and financial leverage at very low levels. The approach may, mean that the company is

losing profitable opportunities.

The study of leverages is essential to define the risk undertaken by the shareholders. Earnings available to shareholders fluctuate on

account of 2 risks, viz. operating risk i.e. variability of EBIT may arise due to variability of sales or/and expenses. In a given

environment, operating risk cannot be avoided. The variability of EPS or return on equity depends on the use of financial leverage

and is termed as financial risk. A firm financed totally by equity finance has no financial risk, hence it cannot be avoided by

eliminating use of borrowed funds. Thus, a company has to consider its likely profitability position set before deciding upon the

capital mix of the company, as it has far reaching implications on the financial position of the company.

Effect of Leverage on Capital Turnover and Working Capital Ratio: An increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I) to a higher level. This however, is not

possible in all situations, a rise in capital turnover is to be supported by adequate capital base. Thus, as capital turnover ratio

increases, working capital ratio deteriorates, thus, management cannot increase its capital turnover ratio beyond a certain limit. The

main reasons for a fall in ratios showing the working capital position due to increase in turnover ratios is that as the activity

increases without a corresponding rise in working capital, the working capital position becomes tight. As the sales increases, both

current assets and current liabilities also increases but not in proportion to current ratio. If current ratio and acid test ratio are high,

it is apparent that the capital turnover ratio can be increased without any problem. However, it may be very risky to increase capital

turnover ratio when, the working capital position is not satisfactory.


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Capital Structure

Concept:

A finance manager for procurement of funds, is required to select such a finance mix or capital structure that maximises shareholders

wealth. For designing optimum capital structure he is required to select such a mix of sources of finance, so that the overall cost of

capital is minimum. Capital structure refers to the mix of sources from where long term funds required by a business may be raised i.e.

what should be the proportion of equity share capital, preference share capital, internal sources, debentures and other sources of funds

in total amount of capital which an undertaking may raise for establishing its business. In planning the capital structure, following must

be referred to :

1. There is no definite model that can be suggested/used as an ideal for all business undertakings. This is due to varying

circumstances of various business undertakings. Capital structure depends primarily on a number of factors like, nature of

industry, gestation period, certainty with which the profits will accrue after the undertaking commences commercial

production and the likely quantum of return on investment. It is thus, important to understand that different types of capital

structure would be required for different types of undertakings.

2. Government policy is a major factor in planning capital structure. For instance, a change in the lending policy of financial

institutions may mean a complete change in the financial pattern. Similarly, rules and regulations for capital market

formulated by SEBI affect the capital structure decisions. The finance managers of business concerns are required to plan

capital structure within these constraints.

Optimum capital structure :

The capital structure is said to be optimum, when the company has selected such a combination of equity and debt, so that the

company's wealth is maximum. At this, capital structure, the cost of capital is minimum and market price per share is maximum. But, it

is difficult to measure a fall in the market value of an equity share on account of increase in risk due to high debt content in the capital

structure. In reality, however, instead of optimum, an appropriate capital structure is more realistic. Features of an appropriate capital

structure are as below :

1. Profitability: The most profitable capital structure is one that tends to minimise financing cost and maximise of earnings per

equity share.

2. Flexibility: The capitals structure should be such that the company is able to raise funds whenever needed.

3. Conservation: Debt content in capital structure should not exceed the limit which the company can bear.

4. Solvency: Capital structure should be such that the business does not run the risk of insolvency.

5. Control: Capital structure should be devised in such a manner that it involves minimum risk of loss of control over the

company.

Major Consideration in Capital Planning:

The 3 major considerations evident in capital structure planning are risk, cost and control, they assist the management in determining

the proportion of funds to be raised from various sources. The finance manager attempts to design the capital structure in a manner,

that his risk and cost are least and there is least dilution of control from the existing management. There are also subsidiary factors as,

marketability of the issue, maneuverability and flexibility of capital structure and timing of raising funds. Structuring capital, is a

shrewd financial management decision and is something that makes or mars the fortunes of the company. The factors involved in it are

as follows :

1. Risk :

Risks are of 2 kinds viz. financial and business risk. Financial risk is of 2 kinds as below :

a. Risk of cash insolvency :

As a business raises more debt, its risk of cash insolvency increases, as :

- the higher proportion of debt in capital structure increases the commitments of the company with regard to fixed charges.

i.e. a company stands committed to pay a higher amount of interest irrespective of the fact whether or not it has cash. And

- the possibility that the supplier of funds may withdraw funds at any point of time.

Thus, long term creditors may have to be paid back in installments, even if sufficient cash to do so does not exist. Such risk is

absent in case of equity shares.

b. Risk of variation in the expected earnings available to equity share-holders :

In case a firm has a higher debt content in capital structure, the risk of variations in expected earnings available to equity

shareholders would be higher; due to trading on equity. There is a lower probability that equity shareholders get a stable

dividend if, the debt content is high in capital structure as the financial leverage works both ways i.e. it enhances shareholders'

returns by a high magnitude or reduces it depending on whether the return on investment is higher or lower than the interest

rate. In other words, there is relative dispersion of expected earnings available to equity shareholders, that would be greater if

capital structure of a firm has a higher debt content.


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The financial risk involved in various sources of funds may be understood with the help of debentures. A company has to pay

interest charges on debentures even in case of absence of profits. Even the principal sum has to be repaid under the stipulated

agreement. The debenture holders have a charge against the company's assets and thus, they can enforce a sale of assets in

case of company's failure to meet its contractual obligations. Debentures also increase the risk of variation in expected

earnings available to equity shareholders through leverage effect i.e. if return on investment remains higher than interest rate,

shareholders get a high return and vice versa. As compared to debentures, preference shares entail a slightly lower risk for the

company, as the payment of dividends on such shares is contingent upon the earning of profits by the company. Even in case

of cumulative preference shares, dividends are to be paid only in the year in which company earns profits. Even, their

repayment is made only if they are redeemable and after a stipulated period. However, preference shares increase the

variations in expected earnings available to equity shareholders. From the company's view point, equity shares are least risky,

as a company does not repay equity share capital except on its liquidation and may not declare dividends for years. Thus, as

seen here, financial risk encompasses the volatility of earnings available to equity shareholders as also, the probability of cash

insolvency.

2. Cost of capital :

Cost is an important consideration in capital structure decisions and it is obvious that a business should be atleast capable of

earning enough revenue to meet its cost of capital and also finance its growth. Thus, along with risk, the finance manager has

to consider the cost of capital factor for determination of the capital structure.

3. Control :

Along with cost and risk factors, the control aspect is also an important factor for capital structure planning. When a company

issues equity shares, it automatically dilutes the controlling interest of present owners. In the same manner, preference

shareholders can have voting rights and thereby affect the composition of Board of directors, if dividends are not paid on such

shares for 2 consecutive years. Financial institutions normally stipulate that they shall have one or more directors on the

board. Thus, when management agrees to raise loans from financial institutions, by implication it agrees to forego a part of its

control over the company. It is thus, obvious that decisions concerning capital structure are taken after keeping the control

factor in view.

4. Trading on equity :

A company may raise funds by issue of shares or by borrowings, carrying a fixed rate of interest that is payable irrespective of

the fact whether or not there is a profit. Preference shareholders are also entitled to a fixed rate of dividend, but dividend

payment is subject to the company's profitability. In case of ROI the total capital employed i.e. shareholders' funds plus long

term borrowings, is more than the rate of interest on borrowed funds or rate of dividend on preference shares, the company is

said to trade on equity. It is the finance manager's main objective to see that the return and overall wealth of the company both

are maximised, and it is to be kept in view while deciding on the sources of finance. Thus, the effect of each proposed method

of new finance on EPS is to be carefully analysed. This, thus, helps in deciding whether funds should be raised by internal

equity or by borrowings.

5. Corporate taxation :

Under the Income tax laws, dividend on shares is not deductible while interest paid on borrowed capital is allowed as

deduction. Cost of raising finance through borrowings is deductible in the year in which it is incurred. If it is incurred during

the pre-commencement period, it is to be capitalised. Cost of share issue is allowed as deduction. Owing to such provisions,

corporate taxation, plays an important role in determination of the choice between different sources of financing.

6. Government Policies :

Government policies is a major factor in determining capital structure. For instance, a change in the lending policies of

financial institutions would mean a complete change in the financial pattern followed by companies. Also, rules and

regulations framed by SEBI considerably affect the capital issue policy of various companies. Monetary and fiscal policies of

government also affect the capital structure decisions.

7. Legal requirements :

The finance manager has to keep in view the legal requirements at the time of deciding as regards the capital structure of the

company.

8. Marketability :

To obtain a balanced capital structure, it is necessary to consider the company's ability to market corporate securities.


39

9. Maneuverability :

Maneuverability is required to have as many alternatives as possible at the time of expanding or contracting the requirement

of funds. It enables use of proper type of funds available at a given time and also enhances the bargaining power when dealing

with the prospective suppliers of funds.

10. Flexibility :

It refers to the capacity of the business and its management to adjust to expected and unexpected changes in circumstances. In

other words, the management would like to have a capital structure providing maximum freedom to changes at all times.

11. Timing :

Closely related to flexibility is the timing for issue of securities. Proper timing of a security issue often brings substantial

savings due to the dynamic nature of the capital market. Intelligent management tries to anticipate the climate in capital

market with a view to minimise cost of raising funds and the dilution resulting from an issue of new ordinary shares.

12. Size of the company :

Small companies rely heavily on owner's funds while large companies are usually considered, to be less risky by investors and

thus, they can issue different types of securities.

13. Purpose of financing :

The purpose of financing also, to some extent affects the capital structure of the company. In case funds are required for

productive purposes like manufacturing, etc. the company may raise funds through long term sources. On the other hand, if

the funds are required for non-productive purposes, like welfare facilities to employees such as schools, hospitals, etc. the

company may rely only on internal resources.

14. Period of Finance :

The period for which finance is required also affects the determination of capital structure. In case funds are required for long

term requirements say 8 to 10 years, it would be appropriate to raise borrowed funds. However, if the funds are required more

or less permanently, it would be appropriate to raise borrowed funds. However, if the funds are required more or less

permanently, it would be appropriate to raise them by issue of equity shares.

15. Nature of enterprise :

The nature of enterprise to a great extent affects the company's capital structure. Business enterprises having stability in

earnings or enjoying monopoly as regards their products may go for borrowings or preference shares, as they have adequate

profits to pay interest/fixed charges. On the contrary, companies not having assured income should preferably rely on internal

resources to a large extent.

16. Requirement of investors :

Different types of securities are issued to different classes of investors according to their requirement.

17. Provision for future :

While planning capital structure the provision for future requirement of capital is also required to be considered.

Capital Structure Theories:

A firm's objective should be directed towards the maximisation of the firm's value; the capital structure or leverage decision are to

examined from the view point of their impact on the value of the firm. If the value of the firm can be affected by capital structure or

financing decision, a firm would like to have a capital structure that maximises the market value of the firm. There are broadly 4

approaches in the regard, which analyses relationship between leverage, cost of capital and the value of the firm in different ways,

under the following assumptions :

a. There are only 2 sources of funds viz. debt and equity.

b. The total assets of the firm are given and the degree of leverage can be altered by selling debt to repurchase shares or selling

shares to retire debt.

c. There are no retained earnings implying that entire profits are distributed among shareholders.

d. The operating profit of firm is given and expected to grow.

e. The business risk is assumed to be constant and is not affected by the financing mix decision.

f. There are no corporate or personal taxes.


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g. The investors have the same subjective probability distribution of expected earnings.

The approaches are as below :

1. Net Income Approach (NI Approach) :

The approach is suggested by Durand. According to it, a firm can increase its value or lower the overall cost of capital by increasing

the proportion of debt in the capital structure. In other words, if the degree of financial leverage increases, the weighted average cost of

capital would decline with every increase in the debt content in total funds employed, while the value of the firm will increase. Reverse

would happen in a converse situation. It is based on the following assumptions :

There are no corporate taxes.

The cost of debt is less than cost of equity or equity capitalisation rate.

The use of debt content does not change the risk perception of investors as a result of both the Kd (Debt capitalisation rate)

and Ke (equity capitalisation rate) remains constant.

The value of the firm on the basis of Net Income Approach may be ascertained as follows :

V = S + D

Where,

V = Value of the firm

S = Market value of equity

D = Market value of debt

S = NI/K e

Where,

S = Market value of equity

NI = Earnings available for equity shareholders

Ke = Equity Capitalisation rate

Under, NI approach, the value of a firm will be maximum at a point where weighted average cost of capital is minimum. Thus, the

theory suggests total or maximum possible debt financing for minimising cost of capital.

Overall cost of capital = EBIT/Value of the firm

2. Net Operating Income Approach (NOI) :

This approach is also suggested by Durand, according to it, the market value of the firm is not affected by the capital structure changes.

The market value of the firm is ascertained by capitalising the net operating income at the overall cost of capital, which is constant.

The market value of the firm is determined as :

V = EBIT/Overall cost of capital

Where,

V = Market value of the firm

EBIT = Earnings before interest and tax

S = V - D

Where,

S = Value of equity


V = Market value of firm

Cost of equity = EBIT/(V - D)

Where,

V = Market value of the firm

EBIT = Earnings before interest and tax


It is based on the following assumptions:

The overall cost of capital remains constant for all degree of debt equity mix.

The market capitalises value of the firm as a whole. Thus, the split between debt and equity is not important.

The use of less costly debt funds increases the risk of shareholders. This causes the equity capialisation rate to increase. Thus,

the advantage of debt is set off exactly by increase in equity capitalisation rate.

There are no corporate taxes.

The cost of debt is constant.

Under, NOI approach since overall cost of capital is constant, thus, there is no optimal capital structure rather every capital structure is

as good as any other and so every capital structure is optimal.

3. Traditional Approach :


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The traditional approach, also called an intermediate approach as it takes a midway between NI approach, that the value of the firm can

be increased by increasing financial leverage and NOI approach, that the value of the firm is constant irrespective of the degree of

financial leverage. According to this approach the firm should strive to reach the optimal capital structure and its total valuation

through a judicious use of debt and equity in capital structure. At the optimal capital structure, the overall cost of capital will be

minimum and the value of the firm is maximum. It further states, that the value of the firm increases with financial leverage upto a

certain point. Beyond this, the increase in financial leverage will increase cost of equity, the overall cost of capital may still reduce.

However, if financial leverage increases beyond an acceptable limit, the risk of debt investor may also increase, consequently cost of

debt also starts increasing. The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall

cost of capital to increase. Thus, as per the traditional approach the cost of capital is a function of financial leverage and the value of

firm can be affected by the judicious mix of debt and equity in capital structure. The increase of financial leverage upto a point

favourably affect the value of the firm. At this point, the capital structure is optimal & the overall cost of capital will be the least.

4) Modigliani and Miller Approach (MM Approach):

According to this approach, the total cost of capital of particular firm is independent of its method and level of financing. Modigliani

and Miller argued that the weighted average cost of capital of a firm is completely independent of its capital structure. In other words,

a change in the debt equity mix does not affect the cost of capital. They argued, in support of their approach, that as per the traditional

approach, cost of capital is the weighted average of cost of debt and cost of equity, etc. The cost of equity, is determined from the level

of shareholder's expectations. That is if, shareholders expect a particular rate of return, say 15 % from a particular company, they do

not take into account the debt equity ratio and they expect 15 % as they find that it covers the particular risk which this company

entails. Suppose, the debt content in the capital structure of the company increases, this means, that in the eyes of shareholders, the risk

of the company increases, since debt is a more risky mode of finance. Thus, the shareholders would now, expect a higher rate of return

from the shares of the company. Thus, each change in the debt equity mix is automatically set-off by a change in the expectations of

the shareholders from the equity share capital. This is because, a change in the debt-equity ratio changes the risk element of the

company, which in turn changes the expectations of the shareholders from the particular shares of the company. Modigliani and Miller,

thus, argue that financial leverage has nothing to do with the overall cost of capital and the overall cost of capital is equal to the

capitalisation rate of pure equity stream of its class of risk. Thus, financial leverage has no impact on share market prices nor on the

cost of capital. They make the following propositions :

The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the

firm is given by capitalising the expected stream of operating earnings at a discount rate considered appropriate for its risk

class.

The cost of equity (Ke) is equal to the capitalisation rate of pure equity stream plus a premium for financial risk. The financial

risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of

less expensive sources of funds.

The cut off rate for investment purposes is completely independent of the way in which the investment is financed.

Assumptions :

a. The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities.

They are well-informed about the risk-return on all type of securities.

There are no transaction costs.

They behave rationally.

They can borrow without restrictions on the same terms as the firms do.

b. The firms can be classified into 'homogenous risk class'. They belong to this class, if their expected earnings have identical risk

characteristics.

c. All investors have the same expectations from a firms' EBIT that is necessary to evaluate the value of a firm.

d. The dividend payment ratio is 100 %. i.e. there are no retained earnings.

e. There are no corporate taxes, but, this assumption has been removed.

Modigliani and Miller agree that while companies in different industries face different risks resulting in their earnings being capitalised

at different rates, it is not possible for these companies to affect their market values, and thus, their overall capitalisation rate by use of

leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in

company's capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that

arbitrage will substitute personal leverage for corporate leverage.

For instance : There are 2 companies X and Y in the same risk class. Company X is financed by only equity and no debt, while

Company Y is financed by a combination of debt and equity. The market price of shares of Company Y would be higher than that of

Company X, market participants would take advantage of difference by selling equity shares of Company Y, borrowing money to

equate their personal leverage to the degree of corporate leverage in Company Y and use them for investing in Company X. The sale of


42

shares of Company Y reduces its price until the market value of the company Y, financed by debt and equity, equals that of Company

X, financed by only equity.

Criticism :

These propositions have been criticised by numerous authorities. Mostly criticism is as regards, perfect market and arbitrage

assumption. MM hypothesis argue that through personnel arbitrage investors would quickly eliminate any inequalities between the

value of leveraged firms and that of unleveraged firms in the same risk class. The basic argument here, is that individual arbitrageurs,

through the use of personal leverage can alter corporate leverage, which is not a valid argument in the practical world, as it is

extremely doubtful that personal investors would substitute personal leverage for corporate leverage, as they do not have the same risk

characteristics. The MM approach assumes availability of free and upto date information, this also is not normally valid.

To conclude, one may say that controversy between the traditionalists and the supporters of MM approach cannot be resolved due to

lack of empirical research. Traditionalists argue that the cost of capital of a firm can be lowered and the market value of shares

increased by use of financial leverage. But, after a certain stage, as the company becomes highly geared i.e. debt content increases, it

becomes too risky for investors and lenders. Thus, beyond a point, the overall cost of capital begins to rise, this point indicates the

optimal capital structure. Modigliani and Miller argues, that in the absence of corporate income taxes, overall cost of capital begins to

rise.

Relationship between Taxation and Capital Structure:

The leverage irrelevance theory of MM is valid only in perfect market conditions, but, in face of imperfections characterising the real

world capital markets, the capital structure of a firm may affect its valuation. Presence of taxes is a major imperfection in the real

world. When taxes are applicable to corporate income, debt financing is advantageous. This is because dividends and retained earnings

are not deductible for tax purposes, interest on debt is a deductible expense for tax purposes. As a result, the total available income for

both stock-holders and debt-holders is greater when debt capital is used. If the debt employed by a leveraged firm is permanent in

nature, the present value of the tax shield associated with interest payment can be obtained by applying the formula for perpetuity.

Present value of tax shield (TD) = (T * kd * D)/kd

Where,

T = Corporate tax rate


kd = Interest rate on debt

The present value of interest tax shields is independent of the cost of debt, it being a deductible expense. It is simply the corporate tax

rate times the amount of permanent debt.

Value of an unleveraged firm :

Vu = [EBIT ( 1 - t )]/K0

Value of leveraged firm :

Vl = Vu + Debt (t)

Greater the leverage, greater would be the value of the firm, other things being equal. This implies that the optimal strategy of a firm

should be to maximise the degree of leverage in its capital structure.

Calculation of Cost of Capital from Various Sources:

The cost of capital is a significant factor in designing the capital structure of an undertaking, as basic reason of running of a business

undertaking is to earn return at least equal to the cost of capital. Commercial undertaking has no relevance if, it does not expect to earn

its cost of capital. Thus cost of capital constitutes an important factor in various business decisions. For example, in analysing financial

implications of capital structure proposals, cost of capital may be taken as the discounting rate. Obviously, if a particular project gives

an internal rate of return higher than its cost of capital, it should be an attractive opportunity. Following are the cost of capital acquired

from various sources :

1. Cost of debt :

The explicit cost of debt is the interest rate as per contract adjusted for tax and the cost of raising debt.

- Cost of irredeemable debentures :

- Cost of debentures not redeemable during the life time of the company,

Kd = (I/NP) * (I - T)

Where,

Kd = Cost of debt after tax

I = Annual interest rate

NP = Net proceeds of debentures


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T = Tax rate

However, debt has an implicit cost also, that arises due to the fact that if the debt content rises above the optimal level, investors

would start considering the company to be too risky and, thus, their expectations from equity shares will rise. This rise, in the cost of

equity shares is actually the implicit cost of debt.

- Cost of redeemable debentures :

If the debentures are redeemable after the expiry of a fixed period the cost of debentures would be :

Kd = I (1 - t ) + [(RV - NP)] /N

[ (RV + NP)/2]

Where,

I = Annual interest payment


RV = Redemption value of debentures

t = tax rate

N = Life of debentures

2. Cost of preference shares :

In case of preference shares, the dividend rate can be taken as its cost, as it is this amount that the company intends to pay against the

preference shares. As, in case of debt, the issue expenses or discount/premium on issue/redemption is also to be taken into account.

- Cost of irredeemable preference shares :

Cost of irredeemable preference shares = PD/PO

Where,

PD = Annual preference dividend

PO = Net proceeds of an issue of preference shares

- Cost of redeemable preference shares :

If the preference shares are redeemable after the expiry of a fixed period, the cost of preference shares would be.

Kp = PD + [(RV - NP)] /N

[ (RV + NP)/2]

Where,

PD = Annual preference dividend


RV = Redemption value of debentures

N = Life of debentures

However, since dividend of preference shares is not allowed as deduction from income for income tax purposes, there is no question of

tax advantage in the case of cost of preference shares. It would, thus, be seen that both in case of debt and preference shares, cost of

capital is calculated by reference to the obligations incurred and proceeds received. The net proceeds received must be taken into

account in working cost of capital.

3. Cost of ordinary or equity shares :

Calculation of the cost of ordinary shares involves a complex procedure, because unlike debt and preference shares there is no fixed

rate of interest or dividend against ordinary shares. Hence, to assign a certain cost to equity share capital is not a question of mere

calculation, it requires an understanding of many factors basically concerning the behaviour of investors and their expectations. As,

there can be different interpretations of investor's behaviour, there are many approaches regarding calculation of cost of equity shares.

The 4 main approaches are :

a. D/P ratio (Dividend/Price) approach : This emphasises that dividend expected by an investor from a particular share determines its cost. An investor who invests in

the ordinary shares of a particular company, does so in the expectation of a certain return. In other words, when an investor

buys ordinary shares of a certain risk, he expects a certain return, The expected rate of return is the cost of ordinary share

capital. Under this approach, thus, the cost of ordinary share capital is calculated on the basis of the present value of the

expected future stream of dividends.

For example, the market price of the equity shares (face value Rs. 10) of a particular company is Rs. 15. If it has been paying

a dividend of 20 % and is expected to maintain the same, its cost of equity shares at face value is 0.2 * 10/15 = 13.3%, since it

is the maximum rate of dividend, at which the investor will buy share at the present value. However, it can also be argued that

the cost of equity capital is 20 % for the company, as it is on this expectation that the market price of shares is maintained at


44

Rs. 15. Cost of equity shares of a company is that rate of dividend that maintains the present market price of shares. As the

objective of financial management is to maximise the wealth of shareholders, it is rational to assume that the company must

maintain the present market value of its share by paying 20 % dividend, which then is its cost of equity capital. Thus, the

relationship between dividends and market price shows the expectation of the investors and thereby cost of equity capital.

This approach co-relates the basic factors of return and investment from view point of investor. However, it is too simple as it

pre-supposes that an investor looks forward only to dividends as a return on his investment. The expected stream of dividends

is of importance to an investor but, he looks forward to capital appreciation also in the value of shares. It may lead us to

ignore the growth in capital value of the share. Under, this approach, a company which declares a higher amount of dividend

out of a given quantum of earnings will be placed at a premium as compared to a company which earns the same amount of

profits but utilises a major part of the same in financing its expansion programmes. Thus, D/P approach may not be adequate

to deal with the problem of determining the cost of ordinary share capital.

b. E/P (Earnings/Price) ratio approach : The advocates of this approach co-relates the earnings of the company with the market price of its shares. As per it, the cost of

ordinary share capital would be based on the expected rate of earnings of a company. The argument is that each investor

expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests, thus, an

investor expects that the company in which he is going to subscribe for share should have at least 20 % of earning, the cost of

ordinary share capital can be construed on this basis. Suppose, a company is expected to earn 30 % the investor will be

prepared to pay Rs 150 (30/20 * 100) for each of Rs. 100 share. This approach is similar to the dividend price approach, only

it seeks to nullify the effect of changes in dividend policy. This approach also does not seem to be a complete answer to the

problem of determining the cost of ordinary share as it ignores the factor of capital appreciation or depreciation in the market

value of shares.

c. D/P + growth approach : The dividend/price + growth approach emphasises what an investor actually expects to receive from his investment in a

particular company's ordinary share in terms of dividend plus the rate of growth in dividend/earnings. This growth rate in

dividend (g) is taken to be good to the compound growth rate in earnings per share.

Ke = [D1/P0] + g

Where,

Ke = Cost of capital

D1= Dividend for the period 1

P0 = Price for the period 0

g = Growth rate

D/P + g approach seems to answer the problem of expectations of investor satisfactorily, however, it poses one problem that is

how to quantify expectation of investor relating to dividend and growth in dividend.

d. Realised yield approach : It is suggested that many authors that the yield actually realised for a period of time by investors in a particular company may

be used as an indicator of cost of capital. In other words, this approach takes into consideration the basic factor of the D/P + g

approach but, instead of using the expected values of the dividends and capital appreciation, past yields are used to denote the

cost of capital. This approach is based upon the assumption that the past behaviour would be repeated in future and thus, they

may be used to measure the cost of ordinary capital.

Which approach to use ? In case of companies with stable income and stable dividend policies the D/P approach may be a good way of

measuring the cost of ordinary share capital. In case of companies whose earnings accrue in cycles, it would be better if the E/P

approach is used, but representative figures should be taken into account to include complete cycle. In case of growth companies,

where expectations of growth are more important, cost of ordinary share capital may be determined as the basis of the D/P + g

approach. In the case of companies enjoying a steady growth rate and a steady rate of dividend, the realised value approach may be

useful. The basic factor behind determination of cost of ordinary share capital is to measure expectation of investors from ordinary

shares of that particular company. Thus, the whole question of determining the cost of ordinary shares hinges upon the factors which

go into the expectations of a particular group of investors in the company of a particular risk class.

4. Cost of reserves :

The profits retained by a company and used in the expansion of business also entail cost. Many people tend to feel that reserves have

no cost. However, it is not easy to realised that by depriving the shareholders of a part of the earnings, a cost is automatically incurred

on reserves. This may be termed as the opportunity cost of retained earnings. Suppose, these earnings are not retained and are passed

on to shareholders, suppose further that shareholders invest the same in new ordinary shares. This expectation of the investors from

new ordinary shares should be the opportunity cost of reserves. In other words, if earnings were paid out as dividends and

simultaneously an offer for right shares was made shareholders would have subscribed to the right share on the expectation of a certain


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return. This return may be taken as the indicator of the cost of reserves. People do not calculate the cost of capital of retained earnings

as above. They take cost of retained earnings as the same as that of equity shares. However, if the cost of equity shares is determined

on the basis of realised value approach or D/P + g approach, the question of working out a separate cost of reserves is not relevant

since cost of reserves is automatically included in the cost of equity share capital.

5. Cost of depreciation funds : Depreciation funds, cannot be construed as not having any cost. Logically speaking, they should be treated on the same footing as

reserves when it comes to their use, though while calculating the cost of capital these funds may not be considered.

Procedure for Calculating Weighted Average Cost of Capital:

The composite or overall cost of capital of a firm is the weighted average of the costs of various sources of funds. Weights are taken to

be proportion of each source of funds in the capital structure. While, making financial decisions this overall or weighted cost is used.

Each investment is financed from a pool of funds which represents the various sources from which funds have been raised. Any

decision of investment thus, has to be made with reference to the overall cost of capital and not with reference to cost of a specific

source of fund used in that investment decisions. The weighted average cost of capital (WACC) is calculated by :

Calculating cost of specific sources of funds, e.g. cost of debt, etc.

Multiplying the cost of each source by its proportion in capital structure.

Adding the weighted component costs to get the firm's WACC. Thus, WACC is ,

K0 = K1W1 + K2W2 +.............

Where,

K1, K2 are component costs and W1, W2 are weights.

The weights to be used can be either book value weights or market value weights. Book value weights are easier to calculate and can

be applied consistently. Market value weights are supposed to be superior to book value weights as component costs are opportunity

costs and market values reflect economic values. However, these weights fluctuate frequently and fluctuations are wide in nature.

Marginal Cost of Capital:

The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the capital is raised in

substantial amount in practice marginal cost is referred to as the cost incurred in raising new funds. Marginal cost of capital is derived,

when we calculate the average cost of capital using the marginal weights. The marginal weights represent the proportion of funds the

firm intends to employ. Thus, the problem of choosing between the book value weights and the market value weights does not arise in

the case of marginal cost of capital computation. To calculate the marginal cost of capital, the intended financing proportion should be

applied as weights to marginal component costs. The marginal cost of capital should, thus, be calculated in the composite sense. When

a firm raises funds in proportional manner and the component's cost remain unchanged, there will be no difference between average

cost of capital of total funds and the marginal cost of capital. The component's cost may remain unchanged, upto a certain level of

funds raised and then start increasing with amount of funds raised, e.g. The cost of debt remains 7 % after tax till Rs. 10 lakhs and

between Rs. 10 - 15 lakhs, the cost may be 8 % and so on. Similarly, if the firm has to use the external equity when the retained profits

are not sufficient, the cost of equity will be higher because of flotation costs. When the components cost starts rising, the average cost

of capital would rise and marginal cost of capital would however, rise at a faster rate.

Effect of Financing Decision on EPS:

One of the prime objective of a finance manager is to maximise both the return on ordinary shares and the total wealth of the company.

This objective has to be kept in view while, taking a decision on a new source of finance. Thus, the effect of each proposed method of

new finance on the EPS is to be carefully analysed. EPS denotes what has been earned by the company during a particular accounting

period, on each of its ordinary shares. This can be worked out by dividing net profit after interest, taxes and preference dividends by

the number of equity shares. If a company has a number of alternatives for new financing, it can compute the impact of the various

alternatives on earnings per share. It is obvious that, EPS would be the highest in case of financing that has the least cost to the

company.

1. Explicit cost of new capital :

It is a method that can compare the alternatives available for raising capital can be through the calculation of the explicit cost of

new capital. Explicit cost of new capital is the rate of return at which the new funds must be employed so that the existing EPS is

not affected. In other words, the rate of return of new funds must earn to maintain EPS at the existing levels. It is obvious that, if

EPS were Rs. 2 earlier, the rate of return required to be earned by the source of new capital to maintain it at the old level is to be

found. Long term debt would again be preferred as even if a lower rate of return is earned on the funds so raised, the old EPS will

be maintained.


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2. Range of earnings chart/Indifference point :

Another method of considering the impact of various financing alternatives on EPS is to prepare the EBIT chart or the range of

earnings chart. It shows the likely EPS at various probable EBIT levels. Thus, under one particular alternative, EPS may be Rs. 1 at

a given EBIT level. However, the EPS may reduce if another alternative of financing is chosen even though the EBIT under the

alternative may be drawn. Wherever this line intersects, it is known as break - even point. This point is a useful guide in

formulating the capital structure. This is known as EPS equivalency point or indifference point as, it shows that, between the 2

given alternatives of financing i.e. regardless of leverage in financial plans, EPS would be the same at the given EBIT level. The

equivalency or indifference point can also be calculated algebraically as below :

[X - B]/S1 = X/S2

Where,

X = Indifference point (EBIT)

S1 = Number of equity shares outstanding

S2 = Number of equity shares outstanding when only equity capital is used.

B = Interest on debt capital in rupees.

3. EPS Volatility :

EPS Volatility refers to the magnitude or extent of fluctuations in EPS of a company in various years as compared to the mean or

average EPS. In other words, EPS volatility shows whether a company enjoys a stable income or not. It is obvious that higher the

EPS Volatility, greater would be the risk attached to the company. A major cause of EPS Volatility would be the fluctuations in the

sales volume and the operating leverage. It is obvious that the net profits of a company would greatly fluctuate with small

fluctuations in the sales figures specially if the fixed cost content is very high. Thus, EPS will fluctuate in such a situation. This

effect may be heightened by the financial leverage.

Past Questions:

1. Discuss briefly the impact of taxation on Corporate Financing.

Tax is levied on the profits of the company. Tax is also levied on the dividends received by the shareholders in their hands though such

dividends are declared out of after tax profits. Thus the corporate entity and the owners suffer tax twice in a sense. This pushes the

cost of equity capital. On the other hand interest paid on the debt capital is a deductible expenditure and hence company does not pay

tax on interest on debt capital. This reduces the cost of debts. Debt is a less costly source of funds and if the finance manager prudently

mixes debt and equity, the weighted average cost of capital will get greatly reduced.

Depreciation is not an outgo in cash but it is deductible in computing the income subject to tax. There will be saving in tax on

depreciation and such savings could be profitably employed. Thus both interest and depreciation provide tax shield and have a

tendency to increase EPS. Further the unabsorbed depreciation can be carried forward indefinitely and this will be helpful for loss

making concerns which start earning profits in future. The depreciation loss of one company can be carried forward for set off in

another company’s profits in the case of amalgamations in specified circumstances and such a provision will help growth of companies

and rehabilitation of sick units. The finance manager of amalgamating company will bear this benefit for the tax shield it carries in

planning the activities.

Thus the impact of tax will be felt in cost of capital, earnings per share and the cash inflows which are relevant for capital budgeting

and in planning the capital structure.

Tax considerations are important as they affect the liquidity of the concerns. They are relevant in deciding the leasing of the assets,

transactions of sale and lease back, and also in floating joint venture in foreign countries where tax rate and concessions may be

advantageous. Tax implications will be felt in choosing the size and nature of industry and in its location as the tax laws give fillip to

small units producing certain products and incentives are given for backward areas. Tax considerations in these matters are relevant for

purposes of preserving and protecting internal funds.

2. Explain, briefly, Modigliani and Miller approach on Cost of Capital

Modigliani and Miller’s argue that the total cost of capital of a particular corporation is independent of its methods and level of

financing. According to them a change in the debt equity ratio does not affect the cost of capital. This is because a change in the debt

equity ratio changes the risk element of the company which in turn changes the expectations of the shareholders from the particular

shares of the company. Hence they contend that leverages has little effect on the overall cost of capital or on the market price.

Modigliani and Miller made the following assumptions and the derivations there from:

Assumptions:

a. Capital markets are perfect. Information is costless and readily available to all investors, there are no transaction costs; and all

securities are infinitely divisible. Investors are assumed to be rational and to behave accordingly.


47

b. The average expected future operating earnings of a firm are represented by a subjective random variable. It is assumed that

the expected values of the probability distributions of all investors are the same. Implied in the MM illustration is that the

expected values of the probability distributions of expected operating earnings for all future periods are the same as present

operating earnings.

c. Firms can be categorised into “equivalent return” classes. All firms within a class have the same degree of business risk.

d. The absence of corporate income taxes is assumed.

Their three basic propositions are :

a. The total market value of the firm and its cost of capital are independent of its capital structure. The total market value of a

firm is given by capitalising the expected stream of operating earnings at a discount rate appropriate for its risk class.

b. The expected yield of a share of stock, Ke is equal to the capitalisation rate of a pure equity stream, plus a premium for

financial risk equal to the difference between the pure equity capitalization rate and Kg times the ratio B/S. In other words, Ke

increases in a manner to exactly offset the use of cheaper debt funds.

c. The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. This

proposition alongwith the first implies a complete separation of the investment and financing decisions of the firm.

Conclusion: The theory propounded by them is based on the prevalence of perfect market conditions which are rare to find. Corporate

taxes and personal taxes are a reality and they exert appreciable influence over decision making whether to have debt or equity.

3. Discuss the relationship between the financial leverage and firms required rate of return to equity shareholders as per

Modigliani and Miller Proposition II.

Relationship between the financial leverage and firm’s required rate of return to equity shareholders with corporate taxes is given by

the following relation :

rE = r0 + )r(r )T(1E

DBOC

Where,

rE = required rate of return to equity shareholders

r0 = required rate of return for an all equity firm

D = Debt amount in capital structure

E = Equity amount in capital structure

TC = Corporate tax rate

r B = required rate of return to lenders

4. Write a short note on Pecking order theory of capital structure.

The pecking order theory was proposed by Donaldson in 1961. The pecking order theory suggests that firm rely for finance, as much

as they can, on internally generated funds. If internally generated funds are not enough then they will move to additional debt finance

then equity. This is because the issue cost of internally generated funds have the lowest issue cost and cost of new equity is the highest.

Myers has suggested that the firm follows a ‘modified pecking order’ in their approach to financing. Myers has suggested asymmetric

information as a reason for heavy reliance on internal generated funds. He demonstrates that with asymmetric information, equity

shares are interpreted by the market as bad news since managers are only motivated to issue equity share when share markets are

undeveloped. Further, the use of internal finance ensures that there is regular source of finance which might be in line with company’s

expansion programme. If additional funds are required over and above internally generated funds, then borrowings will be next

alternative in this theory.

Thus, pecking order theory rests on:

a. Stickly dividend policy,

b. A preference for internal funds,

c. An aversion to issue equity shares.

5. Explain the factors/determinants for determining Dividend Policy?

The factors that affect the dividend policy of a company are as follows :

a. Legal Considerations : The provisions of the Companies Act, 1956 must be kept in mind since they provide a major dimension to the dividend

decision. Section 205 of the Companies Act prescribes the quantum of distributable profits. Further the provisions of the

Income-tax Act specially as they relate to closely held companies may also be seen. In 1975, the Company Law Board issued

certain rules regarding the payment of dividend out of reserves and the transfer of profits to the reserves over and above a

stipulated amount.


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All these provisions provide the legal framework within which the dividend policy has to be formulated. Under no circum-

stances, it is possible to declare a dividend higher than the amount legally permissible.

b. Stability of Earnings : A firm having stable income can afford to have higher dividend pay-out ratio as compared to a firm which does not have such

stability in its earnings conditions.

c. Opportunities for Reinvestment and Growth : A company which sees a high growth potential for itself and, therefore, requires a large amount of funds for financing growth

will declare lower dividends to conserve resources and maintain its debt equity ratio at a proper level. If, however. a company

does not have immediate requirement for funds. it may decide to declare high dividends.

d. Cash flow : From the point of view of financial prudence, a company must consider its cash requirements before declaring a dividend. In

case it has a strained liquidity position. it may declare a lower dividend.

e. Level of Inflation in the Economy : The dividend decision is also linked up with the level of inflation in the economy. If a company declares a higher dividend.

than what is warranted by the inflation figure of profits, it will not have enough funds to replace its capital assets and maintain

its productivity and profitability. This will be harmful for the company in the long run.

f. Effect on Market Prices : Dividend decision is one of the major factors which affect the market price of shares. As per traditional approach the Market

Price of the share is considered to be the Present Value of the future dividend.

g. Tax Considerations : The tax status of the major shareholders also affects the dividend decision sometimes. For example. if a company is owned by

a few shareholders in the high income tax bracket, it would be in their interest not to receive too high an amount of dividends.

Such shareholders may be interested in taking their return from the investment in the form of capital gains rather than in the

form of dividends.

h. Other Factors : There are many other factors such as dividend policy of other firms in the same industry; attitude of management on dilution

of existing control; fear of being branded inefficient or conservative etc. which also affect the divi-dend policy of a company.

6. An Indian company is desirous of obtaining foreign technology. Write a brief note explaining the important financial considerations

it should take into account in this context.

Financial Consideration while Buying Foreign Technology:

Lump Sum vs. Royalty:

Whether to pay for the technology in a lump sum front-end or as royalty over a period of years, is an important issue.

Advantages of lump sum payment are

a. the amount will become certain

b. the amount can be discounted forward and therefore be less;

c. the forex exposure risk is avoided;

d. it provides an opportunity to reduce the per unit cost of technology by maximizing sales.

The main advantage of royalty payment is

a. it ensures that the sales benefit is realized before technology payment accrues;

b. it provides easy instalments for funding;

The advantages of lump sum model becomes the disadvantages of the royalty model and vice versa. It is for the organization to

choose what is best under its circumstances.

Tax Issues: Deduction of tax at source is mandatory. This should be important from the receipient’s point of view and should be made clear to

them If it is a lump sum upfront payment, tax also could be certain; whereas, in protracted royalty payment, there is a chance of tax

uncertainty.

As to allowability in the hands of the payer, there have been various case laws and it would be advisable for the payer to obtain

beforehand expert opinion as to how to plan its tax shield in the best manner possible.

Government Clearance:

Automatic permission will be given for foreign technology agreements upto certain limits - currently, USD 2 million or royalty at

5% for domestic sales and 8% for export sales. In other cases approval will have to be obtained.

Source of Finance:


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Background - Financial Needs:

One of the most important consideration for an entrepreneur-company in implementing a new project or undertaking expansion,

diversification, modernisation and rehabilitation scheme is ascertaining the cost of project and the means of finance. There are several

sources of finance/funds available to any company. An effective appraisal mechanism of various sources of funds available to a

company must be instituted in the company to achieve its main objectives. Such a mechanism is required to evaluate risk, tenure and

cost of each and every source of fund. This selection of fund source is dependent on the financial strategy pursued by the company, the

leverage planned by the company, the financial conditions prevalent in the economy & the risk profile of both i.e. the company and the

industry in which the company operates. Each and every source of fund has some advantages and disadvantages.

Financial needs of a business are grouped as follows :

a. Long term financial needs : Such needs generally refer to those requirements of funds which are for a period exceeding 5 - 10 years. All investments in

plant and machinery, land, buildings, etc. are considered as long term financial needs. Funds required to finance permanent or

hard core working capital should also be procured from long term sources.

b. Medium term financial needs : Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. Funds

required for deferred revenue expenditure (i.e benefit of expense expires after a period of 3 to 5 years), are classified as

medium term financial needs. Sometimes long term requirements, for which long term funds cannot be arranged immediately

may be met from medium term sources and thus the demand of medium term financial needs are generated, as and when the

desired long-term funds are available medium term loan may be paid off.

c. Short term financial needs : Such type of financial needs arise for financing current assets as, stock, debtors, cash, etc. Investment in these assets is known

as meeting of working capital requirements of the concern. Firms require working capital to employ fixed assets gainfully.

The requirement of working capital depends on a number of factors that may differ from industry to industry and from

company to company in the same industry. The main characteristic of short term financial needs is that they arise for a short

period of time not exceeding the accounting period i.e. one year.

The basic principle for categorising the financial needs into short term, medium term and long term is that they are met from the

corresponding viz. short term, medium term and long term sources respectively. Accordingly the source of financing is decided with

reference to the period for which funds are required. Basically, there are 2 sources of raising funds for any business enterprise viz.

owners capital and borrowed capital. The owners capital is used for meeting long term financial needs and it primarily comes from

share capital and retained earnings. Borrowed capital for all other types of requirement can be raised from different sources as

debentures, public deposits, financial institutions, commercial banks, etc.

Sources of finance of a business are :

1. Long term :

a. Share capital or Equity share capital

b. Preference shares

c. Retained earnings

d. Debentures/Bonds of different types

e. Loans from financial institutions

f. Loans from State Financial Corporation

g. Loans from commercial banks

h. Venture capital funding

i. Asset securitisation

j. International financing like Euro-issues, Foreign currency loans.

2. Medium term :

a. Preference shares

b. Debentures/Bonds

c. Public deposits /fixed deposits for a duration of 3 years

d. Commercial banks

e. Financial institutions

f. State financial corporations

g. Lease financing/Hire-purchase financing

h. External commercial borrowings


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i. Euro-issues

j. Foreign currency bonds

3. Short-term :

a. Trade credit

b. Commercial banks

c. Fixed deposits for a period of 1 year or less

d. Advances received from customers

e. Various short-term provisions

Financial sources of a business can also be classified as follows on using different basis :

1. According to period :

a. Long term sources

b. Medium term sources

c. Short term sources

2. According to ownership :

a. Owners capital or equity capital, retained earnings, etc.

b. Borrowed capital such as, debentures, public deposits, loans, etc.

3. According to source of generation :

a. Internal sources e.g. retained earnings and depreciation funds, etc.

b. External sources e.g. debentures, loans, etc.

However, for convenience, the different sources of funds can also be classified into the following :

Security financing - financing through shares and debentures

Internal financing - financing through retained earning, depreciation

Loans financing - this includes both short term and long term loans

International financing

Other sources.

Long Term Source of Finance:

There are different sources of funds available to meet long term financial needs of the business. These sources may be broadly

classified into share capital (both equity and preference) and debt (including debentures, long term borrowings or other debt

instruments). In India, many companies have raised long term finance by offering various instruments to public like deep discount

bonds, fully convertible debentures, etc. These new instruments have characteristics of both equity and debt and it is difficult to

categorise them into equity and debt. Different sources of long term finance are :

1. Owners' capital or equity capital :

A public limited company may raise funds from promoters or from the investing public by way of owners capital or equity capital

by issuing ordinary equity shares. Ordinary shareholders are owners of the company and they undertake risks of business. They

elect the directors to run the company and have the optimum control over the management of the company. Since equity shares can

be paid off only in the event in liquidation, this source has the least risk involved, and more due to the fact that the equity

shareholders can be paid dividends only when there are distributable profits. However, the cost of ordinary shares is usually the

highest. This is due to the fact that such shareholders expect a higher rate of return on their investments compared to other suppliers

of long term funds. The dividend payable on shares is an appropriation of profits and not a charge against profits, meaning that it

has to be paid only out of profits after tax. Ordinary share capital also provides a security to other suppliers of funds. Thus, a

company having substantial ordinary share capital may find it easier to raise funds, in view of the fact that the share capital

provides a security to other suppliers of funds. The Companies Act, 1956 and SEBI Guidelines for disclosure and investors'

protections and the clarifications thereto lays down a number of provisions regarding the issue and management of equity share

capital.

Advantages of raising funds by issue of equity shares are :

It is a permanent source of finance.

The issue of new equity shares increases the company's flexibility.

The company can make further issue of share capital by making a right issue.

There is no mandatory payments to shareholders of equity shares.


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2. Preference share capital :

These are special kind of shares, the holders of which enjoy priority in both, repayment of capital at the time of winding up of the

company and payment of fixed dividend. Long-term funds from preference shares can be raised through a public issue of shares.

Such shares are normally cumulative, i.e. the dividend payable in a year of loss gets carried over to the next till, there are adequate

profits to pay cumulative dividends. Rate of dividend on preference shares is normally higher than the rate of interest on

debentures, loans, etc. Most of preference shares now a days carry a stipulation of period and the funds have to be repaid at the end

of a stipulated period. Preference share capital is a hybrid form of financing that partakes some characteristics of equity capital and

some attributes of debt capital. It is similar to equity because preference dividend, like equity dividend is not a tax deductible

payment. It resembles debt capital as the rate of preference dividend is fixed. When preference dividend is skipped, it is payable in

future due to the cumulative feature associated with most of preference shares. Cumulative Convertible Preference Shares (CCPs)

may also be offered, under which the shares would carry a cumulative dividend of specified limit for a period of say 3 years, after

which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period. For normal

preference shares, the maximum permissible rate of dividend is 14 %. Preference share capital may be redeemed at a predecided

future date or at an earlier stage inter alia out of the company's profits. This enables the promoters to withdraw their capital from

the company which is now self-sufficient, and the withdrawn capital may be reinvested in other profitable ventures. Irredeemable

preference shares cannot be issued by any company. Preference shares gained importance after the Finance Bill 1997 as dividends

became tax exempted in the hands of the individual investor and are taxable in the hands of the company as tax is imposed on

distributable profits at a flat rate. The Budget, for 2000 - 01 has doubled the dividend tax from 10 % to 20 % besides a surcharge of

10 %. The budget for 2001 - 2002 has reduced the dividend tax from 20 to 10 %. Many companies followed this route during 1997

especially through private placement or preference shares as the capital markets were not vibrant.

The advantages of taking the preference share capital are as follows :

No dilution in EPS on enlarged capital base : If equity is issued it reduces EPS, thus affecting the market perception about the

company.

There is leveraging advantage as it bears a fixed charge.

There is no risk of takeover.

There is no dilution of managerial control.

Preference capital can be redeemed after a specified period.

3. Retained Earnings :

Long term funds may also be provided by accumulation of company's profits and on ploughing them back into business. Such funds

belong to the ordinary shareholders and increases the company's net worth. A public limited company must plough back a

reasonable amount of profit every year, keeping in view the legal requirements in this regard, and its own expansion plans. Such

funds entail almost no risk and the present owner's control is maintained as there is no dilution of control.

4. Debentures or bonds :

Loans can be raised from public on issue of debentures or bonds by public limited companies. Debentures are normally issued in

different denominations ranging from Rs. 100 to 1000 and carry different rates of interest. On issue of debentures, a company can

raise long term loans from public. Usually, debentures are issued on the basis of a debenture trust deed which lists terms and

conditions on which debentures are floated. They are normally secured against the company's assets. As compared with preference

shares, debentures provide a more convenient mode of long term funds. Cost of capital raised through debentures is low as the

interest can be charged as an expense before tax. From the investors' view point, debentures offer a more attractive prospect than

preference shares as interest on debentures is payable whether or not the company makes profits. Debentures are thus, instruments

for raising long term debt capital. Secured debentures are protected by a charge on the company's assets. While the secured

debentures of a well-established company may be attractive to investors, secured debentures of a new company do not normally

evoke same interest in the investing public.

Advantages :

The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax-deductible. Also,

investors consider debenture investment safer than equity or preferred investment and thus, may require a lower return on

debenture investment.

Debenture financing does not result in dilution of control.

In a period of rising prices, debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price

level increases.

Disadvantages of debenture financing are as below :

Debenture interest and capital repayment are obligatory payments.


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The protective covenants associated with a debenture issue may be restrictive.

Debentures financing enhances the financial risk associated with the firm.

These days many companies are issuing convertible debentures or bonds with a number of schemes/incentives like

warrants/options, etc. These bonds or debentures are exchangeable at the ordinary share holder's option under specified terms and

conditions. Thus, for the first few years these securities remain as debentures and later they can be converted into equity shares at

a pre-determined conversion price. The issue of convertible debentures has distinct advantages from the view point of the issuing

company.

such as issue enables the management to raise equity capital indirectly without diluting the equity holding, until the capital

raised starts earning an added return to support additional shares.

such securities can be issued even when the equity market is not very good.

convertible bonds are normally unsecured and, thus, their issuance may ordinarily not impair the borrowing capacity.

These debentures/bonds are issued subject to the SEBI guidelines notified from time to time. Public issue of debentures and

private placement to mutual funds, require that the issue be rated by a credit rating agency as CRISIL (Credit Rating and

Information Services of India Ltd.). The credit rating is given after evaluating factors as track record of the company, profitability,

debt service capacity, credit worthiness and the perceived risk of lending.

5. Loans from financial institutions :

In India specialised institutions provide long-term financial assistance to industries. Some of them are, Industrial Finance

Corporations, Life Insurance Corporation of India, National Small Industries Corporation Limited, Industrial Credit and Investment

Corporation, Industrial Development Bank of India and Industrial Reconstruction Corporation of India. Before sanctioning of a

term loan, a company has to satisfy the concerned financial institution regarding the technical, commercial, economic, financial and

managerial viability of the project for which the loan is required. Such loans are available at different rates of interest under

different schemes of financial institutions and are to be repaid as per a stipulated repayment schedule. The loans in many cases

stipulate a number of conditions as regards the management and certain other financial policies of the company. Term loans

represent secured borrowings and are an important source of funds for new projects. They generally, carry a rate of interest

inclusive of interest tax, depending on the credit rating of the borrower, the perceived risk of lending and cost of funds and

generally repayable over a period of 6 to 10 years in annual, semi-annual or quarterly installments. Term loans are also provided by

banks, State Financial/Development institutions and all India term lending financial institutions. Banks and State Financial

Corporations provide term loans to projects in the small scale sector while, for medium and large industries term loans are provided

by State developmental institutions alone or in consortium with banks and State financial corporations. For large scale projects All

India financial institutions provide bulk of term finance singly or in consortium with other such institutions, State level institutions

and/or banks. After independence, the institutional set up in India for the provision of medium and long term credit for industry has

been broadened. The assistance sanctioned and disbursed by these specialised institutions has increased impressively over the years.

A number of specialised institutions are established over the country.

6. Loans from commercial banks :

The primary role of the commercial banks is to cater to the short term requirement of industry. However, of late, banks have started

taking an interest in term financing of industries in several ways, though the formal term lending is, still, small and confined to

major banks. Terms lendings by bank is a controversial issue these days. It is argued that term loans do not satisfy the canon of

liquidity that is a major consideration in all bank operations. According to traditional values, banks should provide loans only for

short periods and operations resulting in automatic liquidation of such credits over short periods. On the other hand, it is contended

that the traditional concept needs modification. The proceeds of term loan are used for what are broadly known as fixed assets or

expansion in plant capacity. Their repayment is usually scheduled over a long period of time. The liquidity of such loans is said to

depend on the anticipated income of borrowers.

Working capital loan is more permanent and long term as compared to a term loan. The reason being that a term loan is always

repayable on a fixed date and ultimately, the account will be totally adjusted. However, in case of working capital finance, though

payable on demand, in actual practice it is noticed that the account is never adjusted as such and if at all the payment is asked back,

it is with a clear purpose and intention of refinance being provided at the beginning of next year or half year. This technique of

providing long term finance is known as, "rolled over for periods exceeding more than one year". Instead of indulging in term

financing by the rolled over method, banks can and should extend credit term after a proper appraisal of applications for term loans.

The degree of liquidity in the provision for regular amortisation of term loans is more than in some of these so called demand loans

which are renewed from year to year. Actually, term financing, disciplines both the banker and borrower as long term planning is

required to ensure that cash inflows would be adequate to meet the instruments of repayments and allow an active turnover of bank

loans. The adoption of the formal term loan lending by commercial banks will not hamper the criteria of liquidity, and will

introduce flexibility in the operations of the banking system.


53

The real limitation to the scope of bank activities is that all banks are not well equipped to appraise such loan proposals. Term loan

proposals involve an element of risk because of changes in conditions affecting the borrower. The bank making such a loan, thus,

has to assess the situation to make a proper appraisal. The decision in such cases depends on various factors affecting the concerned

industry's conditions and borrower's earning potential.

7. Bridge finance :

It refers to loans taken by a company from commercial banks for a short period, pending disbursement of loans sanctioned by

financial institutions. Normally, it takes time for financial institutions to disburse loans to companies. However, loans once

approved by the term lending institutions pending the signing of regular term loan agreement, that may be delayed due to non-

compliance of conditions stipulated by the institutions while sanctioning the loan. The bridge loans are repaid/adjusted out of term

loans as and when disbursed by the concerned institutions. They are secured by hypothecating movable assets, personal guarantees

and demand promissory notes. Generally, the interest rate on them is higher than on term loans.

Short Term Source of Finance: Following are the various sources of short term finance :

1. Trade credit :

It represents credit granted by suppliers of goods, etc. as an incident of sale. The usual duration of such credit is 15 to 90 days. It

generates automatically, in the course of business and is common to almost all business operations. It can be in the form of an 'open

account' or 'bills payable'. Trade credit is preferred as a source of finance as it is without any explicit cost and till a business is a

going concern, it keeps on rotating. It also, enhances automatically with the increase in the volume of business.

2. Advances from customers:

Manufacturers and contractors engaged in producing or constructing costly goods involving considerable length of manufacturing

or construction time usually, demand advance money from their customers at the time of accepting their orders for executing their

contracts or supplying the goods. This is a cost free source of finance and really useful.

3. Bank advances :

Banks receive deposits from public for different periods at varying rates of interest there are funds invested and lent in such a

manner that when required, they may be called back. Lending results in gross revenues out of which costs, such as interest on

deposits, administrative costs, etc. are met and a reasonable profit is made. A bank's lending policy is not merely profit motivated

but has to keep in mind the socio-economic development of the country. As a prudent policy, banks normally spread out their funds

as under :

i) About 9 - 10 % in cash.

ii) About 32 % in approved government and semi-government securities.

iii) About 58 % in advances to their credits.

Banks advances are in the form of loan, overdraft, cash credit and bills purchased/discounted, etc. Banks do not sanction advances

on long term basis beyond a small proportion of their demand and time liabilities. Advances are granted against tangible securities

such as goods, shares, government promissory notes, bills, etc. In rare cases, clean advances may also be allowed.

a. Loans : In a loan account, the entire advance is disbursed at one time in cash or by transfer to the current account of the borrower. It is

a single advance, except by way of interest and other charges, no further adjustments are made in this account. Loan accounts

are not running accounts like overdraft and cash credit accounts, repayment under the loan account, may be full amounts or by

way of schedule of repayments agreed upon as in case of terms loans. The securities may be shares, government securities, life

insurance policies and fixed deposit receipts and so on.

b. Overdrafts : Under this facility, customers are allowed to withdraw in excess of credit balance standing in their current deposit account. A

fixed limit is thus, granted to the borrower within which the borrower is allowed to overdraw his account. Opening of an

overdraft account requires that a current account is formally opened. Although overdrafts are repayable on demand, they

usually continue for long periods by annual renewals of limits. This is a convenient arrangement for the borrower, as he is in a

position to avail the sanctioned limit as per his requirements. Interest is charged on daily balances, cheque books are provided,

these accounts being operative as cash credit and current accounts. Security, as in case of loan accounts, may be shares,

debentures and government securities, life insurance policies and fixed deposit receipts are also accepted in special cases.

c. Clean overdrafts : Request for such facility is entertained only from financially sound parties that are reputed for their integrity. Bank is to rely on

personal security of the borrowers, thus, it has to exercise a good deal of restraint in entertaining such proposals, as they have

no backing of any tangible security. In case parties are already enjoying secured advance facilities, this may be a point in


54

favour and may be taken into account while screening such proposals. The turnover in the account, satisfactory dealings for

considerable period and reputation in the market are also considered by the bank. As a safeguard, banks take guarantees from

other persons who are credit worthy before granting this facility. A clean advance is generally granted for a short period and

must not be continued for long.

d. Cash credits : Cash credit is an arrangement under which, a customer is allowed an advance upto certain limit against credit granted by bank.

Under it, a customer need not borrow, the entire amount of advance at one time. He can only draw to the extent of his

requirements and deposit his surplus funds in his account. Interest is not charged on the full amount of advance but, on the

amount actually availed by him. Usually, credit limits are sanctioned against the security of goods by way of pledge or

hypothecation, though they are repayable on demand, banks usually do not recall them, unless they are compelled to do so by

adverse factors. Hypothecation is an equitable charge on movable goods for an amount of debt where neither possession nor

ownership is passed on to the creditor. For pledge, the borrower delivers the goods to the creditor as security for repayment of

debt. Since the banker, as creditor, is in possession of the goods, he is fully secured and in case of emergency he may fall back

on the goods for realisation of his advance under proper notice to the borrower.

e. Advances against goods : Advances against goods occupy an important place in total bank credit, goods as security have certain distinct advantages :

- they provide a reliable source of repayment

- advances against goods are safe and liquid

Generally, goods are charged to the bank by way of pledge or hypothecation. The term 'goods' includes all forms of movables

that are offered to the bank as security. They may be agricultural commodities, industrial raw materials, partly finished goods

and so on. RBI issues directives from time to time imposing restrictions on advances against certain commodities. It is

obligatory on banks to follow these directives in letter and spirit, they may sometimes, also stipulate changes in margin.

f. Bills purchased/discounted : These advances are allowed against the security of bills that may be clean or documentary. Bills are sometimes, purchased

from approved customer, in whose favour limits are sanctioned. Before granting a limit, the banker satisfies himself as to the

creditworthiness of the drawer. Although the term 'bills purchased' gives the impression that the bank becomes the owner or

purchaser of such bills, in reality, the bank holds the bills as security only, for the advance. In addition to the rights against the

parties liable on the bills, the banks can also exercise a pledgee's rights over the goods covered by the documents. Usuance

bills maturing at a future date or sight are discounted by the banks for approved parties. When a bill is discounted, the borrower

is paid the present worth. The bankers, however, collect the full amounts on maturity, the difference between the 2 i.e. the

amount of the bill and the discounted amount represents earnings of bankers for the period; it is termed as 'discount'.

Sometimes, overdraft or cash credit limits are allowed against the security of bills. A suitable margin is usually maintained.

Here the bill is not a primary security but, only a collateral one. In such case, the banker does not become a party to the bill, but

merely collects it as an agent for its customer. When a banker purchases or discounts a bill, he advances against the bill, he

thus, has to be very cautious and grant such facilities only to creditworthy customers, having an established steady relationship

with the bank. Credit reports are also complied on the drawees.

g. Advance against documents of title to goods : A document becomes of document of title to goods when its possession is recognised by law or business custom as possession

of the goods. These documents include a bill of lading, dock warehouse keeper's certificate, railway receipt, etc. A person in

possession of a document to goods can by endorsement or delivery or both of document, enables another person to take

delivery of the goods in his right. An advance against pledge of such documents is equivalent to an advance against the pledge

of goods themselves.

h. Advance against supply of bills : Advances against bills for supply of goods to government or semi-government departments against firm orders after

acceptance of tender fall under this category. Other type of bills under this category are bills from contractors for work

executed wholly or partially under firm contracts entered into with the herein mentioned government agencies. These are clean

bills, without being accompanied by any document of title of goods. But, they evidence supply of goods directly to

Governmental agencies. They may, sometimes, be accompanied by inspection notes from representatives of government

agencies for inspecting the goods before despatch. If bills are without inspection report, banks like to examine them with the

accepted tender or contract for verifying that the goods supplied under the bills strictly conform to the terms and conditions in

the acceptance tender. These supply bills represent debt in favour of suppliers/contractors, for goods supplied to government

bodies or work executed under contract from the Government bodies. This debt is assigned to the bank by endorsement of

supply bills and executing irrevocable power of attorney in favour of banks for receiving the amount of supply bills from the

Government departments. The power of attorney has got to be registered with the department concerned. The banks also take

separate letter from the suppliers/contractors instructing the Government body to pay the amount of bills direct to the bank.


55

Supply bills do not enjoy the legal status of negotiable instruments as they are not bills of exchange. The security available to a

banker is by way of assignment of debts represented by the supply bills.

i. Term loans by banks : It is an instalment credit repayable over a period of time in monthly/quarterly/half-yearly or yearly instalments. Banks grant

term loans for small projects falling under the priority sector, small scale sector and big units. Banks have now been permitted

to sanction term loan for projects as well without association of financial institutions. The banks grant loans for periods

normally ranging from 3 to 7 years and at times even more. These loans are granted on the security of fixed assets.

j. Financing of exports by banks : Advances by commercial banks for export financing are in the form of :

Pre-shipment finance i.e. before shipment of goods :

This usually, takes the form of packing credit facility, which is an advance extended by banks to an exporter for the purpose

of buying, manufacturing, processing, packing, shipping goods to overseas buyers. Any exporter, having at hand a firm

export order placed with him by his foreign buyer or an irrevocable letter of credit opened in his favour, can approach a bank

for availing packing credit. An advance so taken requires to be liquidated within 180 days from the date of its

commencement by negotiation of export proceeds in an approved manner. Thus, packing credit is essentially a short term

advance. Usually, banks insist on their customers to lodge with them irrevocable letters of credit opened in favour of the

customers by overseas buyers. The letter of credit and firm sale contracts not only serve as evidence of a definite

arrangement for realisation of the export proceeds but also indicate the amount of finance required by the exporter. Packing

credit in case of customers of long standing, may also be granted against firm contracts entered into by them with overseas

buyers. Following are the types of packing credit available :

Clean packing credit : This is an advance available to an exporter only on production of a firm export order or a letter of credit without exercising

any charge or control over raw material or finished goods. Each proposal is weighted according to particular requirements of

trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee

Corporation (E.C.G.C.) cover should be obtained by the bank.

Packing credit against hypothecation of goods : Export finance is made available on certain terms and conditions where the exporter has pledgeable interest and the goods

are hypothecated to the bank as security with stipulated margin. At the time of utilising the advance, the exporter is required

to submit, along with the firm export order or letter of credit, relative stock statements and thereafter continue submitting

them every fortnight and/or whenever there is any movement in stocks.

Packing credit against pledge of goods : Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the

banks with approved clearing agents who would ship the same from time to time as required by the exporter. Possession of

goods so pledged lies with the bank and are kept under its lock and key.

E.C.G.C. guarantee : Any loan given to an exporter for the manufacture, processing, purchasing or packing of goods meant for export against a

firm order qualifies for packing. Credit guarantee is issued by the Export Credit Guarantee Corporation (E.C.G.C.).

Forward exchange contract : Another requirement of packing credit facility is that if the export bill is to be drawn in a foreign currency, the exporter

should enter into a forward exchange contract with the bank, thereby avoiding risk involved in a possible change in the

exchange rate.

4. Inter corporate deposits :

The companies can borrow funds for a short period say 6 months from other companies having surplus liquidity. The rate of interest

on it varies depending on the amount involved and time period.

5. Certificate of deposit (CD) : It is a document of title similar to a time deposit receipt issued by a bank except, that there is no prescribed interest rate on such

funds. Its main advantage is that banker is not required to encash the deposit before maturity period and the investor is assured of

liquidity as he can sell it in the secondary market.

6. Public deposits :

They are important source of short and medium term finances particularly due to credit squeeze by the RBI. A company can accept

such deposits subject to the stipulations of the RBI from time to time maximum upto 35 % of its paid up capital and reserves, from

the public and the shareholders. These may be accepted for a period of 6 months to 3 years. Public deposits are unsecured loans,


56

and not meant to be used for acquisition of fixed assets, since, they are to be repaid within a period of 3 years. These are mainly

used to finance working capital requirements.

Other Sources of Financing:

Venture Capital Financing:

Venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs lacking experience and

funds to give shape to their ideas. Under it venture capitalist make investment to purchase equity or debt securities from inexperienced

entrepreneurs undertaking highly risky ventures with a potential of success. The venture capital industry in India is just a decade old.

The venture capitalist finance ventures that are in national priority areas such as energy conservation, quality upgradation, etc. The

Government of India in November 1988 issued the first set of guidelines for venture capital companies, funds and made them eligible

for capital gain concessions. In 1995, certain new clauses and amendments were made in the guidelines that require the venture

capitalists to meet the requirements of different statutory bodies and this makes it difficult for them to operate as they do not have

much flexibility in structuring investments. In 1999, the existing guidelines were relaxed for increasing the attractiveness of the

venture schemes and to induce high net worth investors to commit their funds to 'sunrise' sectors, particularly the information

technology sector. Initially the contribution to the funds available for venture capital investment in the country was from the All India

development financial institutions, State development financial institutions, commercial banks and companies in private sector. Lately

many offshore funds have been started in the country and maximum contribution is from foreign institutional investors. A few venture

capital companies operate as both investment and fund management companies, other set up funds and function as asset management

company. It is hoped that changes in the guidelines for implementation of venture capital schemes in the country would encourage

more funds to be set up to give the required momentum for venture capital investment in India. Some common methods of venture

capital financing are :

a. Equity financing :

The venture capital undertakings usually require funds for a longer period but, may not be able to provide returns to investors

during the initial stages. Thus, the venture capital finance is generally provided by way of equity share capital. The equity

contribution of venture capital firm does not exceed 49 % of the total equity capital of venture capital undertakings so that the

effective control and ownership remains with the entrepreneur.

b. Conditional loan : It is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India

venture capital financers charge royalty ranging between 2 and 15 %, actual rate depends on other factors of the venture as

gestation period, cash flow patterns, riskiness and other factors of the enterprise. Some venture capital financers give a choice

to the enterprise of paying a high rate of interest, which can be well below 20 %, instead of royalty on sales once it becomes

commercially sounds.

c. Income note : It is a hybrid security combining features of both conventional and conditional loan. The entrepreneur has to pay interest and

royalty on sales but, at substantially low rates. IDBI's Venture Capital Fund (VCF) provides funding equal to 80 - 87.5 % of

the project cost for commercial application of indigenous technology.

d. Participating debentures : Such security carries charges in 3 phases - in the start up phase no interest is charged, next stage - a low rate of interest is

charged upto a particular level of operation and after that, a high rate of interest is required to be paid.

Debt Securitisation:

Debt securitisation is a method of recycling of funds. It is especially beneficial to financial intermediaries to support the lending

volumes. Assets generating steady cash flows are packaged together and against this asset pool market securities can be issued. The

basic debt securitisation process can be classified in the following 3 functions :

The origination function : A borrower seeks a loan from a finance company, bank, housing company or a lease from a leasing company. The

creditworthiness of the borrower is evaluated and a contract is entered into with repayment schedule structured over the life of

the loan.

The pooling function : Similar loans or receivables are clubbed together to create an underlying pool of assets. This pool is transferred in favour of a

SPV (Special Purpose Vehicle), which acts as a trustee for the investor. Once the assets are transferred, they are held in the

originators' portfolio.

The securitisation function : It is the SPV's job now to structure and issue the securities on the basis of the asset pool. The securities carry a coupon and an

expected maturity which can be asset based or mortgage based. These are generally sold to investors through merchant


57

bankers. The investors interested in this type of securities are generally institutional investors like mutual funds, insurance

companies, etc. The originator usually keeps the spread available i.e. difference between yield from secured assets and interest

paid to investors. The process of securitisation is generally without recourse i.e. the investor bears the credit risk or risk of

default and the issuer is under an obligation to pay to investors only if the cash flows are received by him from the collateral.

The risk run by the investor can be further reduced through credit enhancement facilities as insurance, letters of credit and

guarantees. In a simple pass through structure, the investor owns a proportionate share of the asset pool and cash flows when

generated are passed on directly to the investor. This is done by issuing pass through certificates. In mortgage or asset backed

bonds, the investor has a lien on the underlying asset pool. The SPV accumulates payments from borrowers from time to time

and make payments to investors at regular predetermined intervals. The SPV can invest the funds received in short term

instruments and improve yield when there is a time lag between receipt and payment.

Benefits to the originator :

a. The assets are shifted off the balance sheet, thus, giving the originator recourse to off balance sheet funding.

b. It converts illiquid assets to liquid portfolio.

c. It facilitates better balance sheet management as assets are transferred off balance sheet facilitating satisfaction of capital

adequacy norms.

d. The originator's credit rating enhances.

For the investor, securitisation opens up new investment avenues. Though the investor bears the credit risk. The securities are tied up

to definite assets. As compared to factoring or bill discounting which largely solve the problems of short term trade financing.

Securitisation helps to convert a stream of cash receivables into a source of long term finance. For a developed securitisation market,

high quality assets with low default rate are essential with standardised loan documentation and stable interest rate structure and

sufficient data on asset performance, developed secondary debt markets are essential for this. In Indian context debt securitisation has

began to take off. The ideal candidates for this are hire purchase and leasing companies, asset finance and real estate finance

companies. ICICI, HDFC, Citibank, Bank of America, etc. have or are planning to raise funds by securitisation.

Lease Financing:

Leasing is a general contract between the owner and user of the asset over a specified period of time. The asset is purchased initially by

the lessor (leasing company) and thereafter leased to the user (lessee company) that pays a specified rent at periodical intervals. Thus,

leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease financing can be arranged much

faster as compared to term loans from financial institutions. In recent years, leasing has become a popular source of financing in India.

From the lessee's view point, leasing has the attraction of eliminating immediate cash outflow and the lease rentals can be deducted for

computing the total income under the Income tax act. As against this, buying has the advantages of depreciation allowance inclusive of

additional depreciation and interest on borrowed capital being tax deductible. Thus, an evaluation of the 2 alternatives is to be made in

order to take a decision.

Seed capital assistance : The seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons

possessing relevant experience, skills and entrepreneurial traits. All the projects eligible for financial assistance from IDBI, directly or

indirectly through refinance are eligible under the scheme. The project cost should not exceed Rs. 2 crores and the maximum

assistance under the project will be restricted to 50 % of the required promoter's contribution or Rs. 15 lakhs, whichever is lower. Seed

capital assistance is interest free, but carries a service charge of 1 % per annum for the first 5 years and at increasing rate thereafter.

However, IDBI will have the option to charge interest at such rate as determined by it on the loan if the financial position and

profitability of the company so permits during the currency of the loan. The repayment schedule is fixed depending on the repaying

capacity of the unit with an initial moratorium upto 5 years. For projects with cost exceeding Rs. 200 lakhs, seed capital may be

obtained from the Risk Capital and Technology Corporation Ltd. (RCTC). For small projects costing upto Rs. 5 lakhs, assistance

under the National Equity Fund of the SIDBI may be availed.

Internal cash accruals: Existing profit making companies undertaking an expansion/diversification programme may be permitted to invest a part of their

accumulated reserves or cash profits for creation of capital assets. In such cases, the company's past performance permits capital

expenditure from within the company by way of disinvestment of working/invested funds. In other words, the surplus generated from

operations, after meeting all the contractual, statutory and working requirement of funds, is available for further capital expenditure.

Unsecured loans: They are provided by promoters to meet the promoters' contribution norm. These loans are subordinate to institutional loans and

interest can be paid only after payment of institutional dues. These loans cannot be repaid without the prior approval of financial

institutions. Unsecured loans are considered as part of the equity for the purpose of calculating debt equity ratio.


58

Deferred payment guarantee: Many a time suppliers of machinery provide a deferred credit facility under which payment for the purchase of machinery may be

made over a period of time. The entire cost of machinery is financed and the company is not required to contribute any amount initially

towards acquisition of machinery. Normally, the supplier of machinery would insist that the bank guarantee be furnished by the buyer.

Such a facility does not have a moratorium period for repayment. Hence, it is advisable only for an existing profit making company.

Capital Incentives:

Backward area development incentives available often determine the location of a new industrial unit. They usually consist of a

lumpsum subsidy and exemption from or deferment of sales tax and octroi duty. The quantum of incentives is determined by the

degree of backwardness of the location. Special capital incentive in the form of a lumpsum subsidy is a quantum sanctioned by the

implementing agency as a percentage of the fixed capital investment subject, to an overall ceiling. This amount forms a part of the

long-term means of finance for the project. However, the viability of the project must not be dependent on the quantum and availability

of incentives. Institutions, while appraising the project, assess its viability per se, without considering the impact of incentives on the

cash flows and the project's profitability. Special capital incentives are sanctioned and released to the units only after they have

complied with the requirements of the relevant scheme. The requirements may be classified into initial effective steps, that include

formation of the firm/company, acquisition of land in the backward area and registration for manufacture of the products. The final

effective steps include obtaining clearances under FEMA, capital goods clearance/import license, conversion of Letter of Intent to

Industrial License, tie up of the means of finance, all clearances required for the setting up of the unit, aggregate expenditure incurred

for the project should exceed 25 % of the project cost and atleast 10 %, if the fixed assets should have been created/acquired at site.

The release of special capital incentives by the concerned State Government generally takes 1 to 2 years. Promoters thus, find it

convenient to avail the bridge finance against the capital incentives. Provision for the same should be made in the pre-operative

expenses considered in the project cost. As the bridge finance may be available to the extent of 85 %, the balance i.e. 15 % may have

to be brought in by the promoters from their own resources.

Various short term provisions/accruals account: Accruals accounts are a spontaneous source of financing as they are self-generating. The most common accrual accounts are wages and

taxes. In both cases, the amount becomes due but is not paid immediately.

Deep Discount Bonds:

It is a form of a zero interest bond, sold at a discounted value and on maturity face value is paid to the investors. In such bonds, there is

no interest paid during lock in period. IDBI was the first to issue a deep discount bond in India in January, 1992. It had a face value of

Rs. 1 lakh and was sold for Rs. 2700 with a maturity period of 25 years. The investor could hold the bond for 25 years or seek

redemption at the end of every 5 years with maturity value as below :

Holding period (years) 5 10 15 20 25

Maturity value (Rs.) 5700 12000 25000 50000 100000

Annual rate of interest (%) 16.12 16.09 15.99 15.71 15.54

The investor can sell the bonds in stock market and realise the difference between face value (Rs. 2700) and the market price as capital

gain.

Secured Premium Notes :

It is issued along with a detachable warrant and is redeemable after a notified period of say 4 to 7 years. The conversion of detachable

warrant into equity shares will have to be done within the time period notified by the company.

Zero interest fully convertible debentures :

These are fully convertible debentures which do not carry any interest. They are compulsorily and automatically converted after a

specified period of time and holders thereof are entitled to new equity shares of the company at predetermined price. From the

company's view point, this kind of instrument is beneficial in the sense, that no interest is to be paid on it, if the share price of the

company in the market is very high, then the investor tends to get equity shares of the company at a lower rate.

Zero Coupon Bonds :

A zero coupon bond does not carry any interest, but it is sold by the issuing company at a discount. The difference between the

discounted and maturing or face value represents the interest to be earned by the investor on them.


59

Double Option Bonds :

Double Option Bonds are recently issued by the IDBI. The face value of each bond is Rs. 5000, it carries interest at 15 % per annum

compounded half yearly from the date of allotment. The bond has a maturity period of 10 years. Each having 2 parts, in the form of 2

separate certificates, one for the principal of Rs. 5000 and other for interest, including redemption premium of Rs. 16500. Both these

certificates are listed on all major stock exchanges. The investor has the facility of selling either one or both parts anytime he likes.

Option bonds :

These are cumulative and non-cumulative bonds where interest is payable on maturity or periodically. Redemption premium is also

offered to attract investors. These were recently issued by IDBI, ICICI, etc.

Inflation bonds :

They are bonds in which interest rate is adjusted for inflation. The investor, thus, gets an interest free from the effects of inflation. For

instance, if interest rate is 12 % and inflation rate is 5 %, the investor will earn 17 %, meaning that the investor is protected against

inflation.

Floating Rate Bonds :

As the name suggests, Floating Rate Bonds are ones, where the rate of interest is not fixed and is allowed to float depending upon the

market conditions. This is an ideal instrument that can be resorted to by the issuer to hedge themselves against the volatility in interest

rates. This has become more popular as a money market instrument and has been successfully issued by financial institutions like

IDBI, ICICI, etc.

International Financing: The essence of financial management is to raise & utilise the funds raised effectively. There are various avenues for organisations to

raise funds either through internal or external sources.

External sources include :

1. Commercial banks : Like domestic loans, commercial banks all over the world extend Foreign Currency (FC) loans, for

international operations. These banks also provide to overdraw over and above the loan amount.

2. Development banks : offer long and medium term loans including FC loans. Many agencies at the national level offer a

number of concessions to foreign companies to invest within their country and to finance exports from their countries e.g.

EXIM Bank of USA.

3. Discounting of trade bills :This is used as a short term financing method widely, in Europe and Asian countries to finance

both domestic and international business.

4. International agencies : A number of international agencies have emerged over the years to finance international trade and

business. The more notable among them includes : International Finance Corporation (IFC), International Bank for

Reconstruction & Development (IBRD), Asian Development Bank (ADB), International Monetary Fund (IMF), etc.

International capital markets :

Modern organisations including MNC's depend upon sizeable borrowings in Rupees as also Foreign Currency. In order to cater to the

needs of such organisation , international capital markets have sprung all over the globe such as in London. In International capital

market, the availability of FC is assured under the 4 main systems, as :

Euro-currency market

Export credit facilities

Bonds issues

Financial Institutions

The origin of the Euro-currency market was with the dollar denominated bank deposits & loans in Europe particularly, London. Euro-

dollar deposits are dollar denominated time deposits available at foreign branches of US banks and at some foreign banks. Banks based

in Europe accept & make dollar denominated deposits to the clients. This forms the backbone of the Euro-currency market all over the

globe. In this market, funds are made available as loans through syndicated Euro-credit of instruments as FRN's, FR certificates of

deposits.

Below mentioned are some of the financial instruments :

1. Euro Bonds : Euro Bonds are debt instruments denominated in a currency issued outside the country of that currency, for instance : a yen

note floated in Germany.


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2. Foreign Bonds : These are debt instruments denominated in a currency which is foreign to the borrower and is sold in the country of that

currency.

3. Fully Hedged Bonds : In foreign bonds, the risk of currency fluctuations exists. They eliminate the risk by selling in forward markets the entire

stream of principal and interest payments.

4. Floating Rate Notes : They are issued upto 7 years maturity. Interest rates are adjusted to reflect the prevailing exchange rates. They provide

cheaper money than foreign loans.

5. Euro Commercial Papers (ECP) : ECP's are short term money market instruments, with maturity of less than 1 year and designated in US dollars.

6. Foreign Currency Option : A FC Option is the right to buy or sell, spot or future or forward, a specified foreign currency. It provides a hedge against

financial and economic risks.

7. Foreign Currency Futures : FC Futures are obligations to buy or sell a specified currency in the present for settlement at a future date.

8. Euro Issues : In the Indian context, Euro Issue denotes that the issue is listed on a European Stock Exchange. However, subscription can

come from any part of the world except India. Finance can be raised by Global Depository Receipts (GDR), Foreign Currency

Convertible Bonds (FCCB) and pure debt bonds. However, GDR's and FCCB's are more popular.

9. Global Depository Receipts : A depository receipt is basically a negotiable certificate, denominated in US Dollars representing a non US company's

publicly traded local currency (Indian Rupee) equity shares,. Theoretically, though a depository receipt can also signify debt

instrument, practically it rarely does so. DR's are created when the local currency shares of an Indian company are delivered

to the depository's local custodian bank, against which the depository bank issues DR's in US Dollars. These DR's may be

freely traded in the overseas- markets like any other dollar denominated security via either a foreign stock exchange or

through a over the counter market or among a restricted group as Qualified Institutional Buyers (QIB). Rule 144 A of the

Securities and Exchange Commission (SEC) of USA permits companies from outside USA to offer their GDR's to certain

institutional buyers, known as QIBs.

10. GDR with Warrant : These receipts are more attractive than plain GDR's in view of additional value of attached warrants.

11. American Depository Receipts (ADR's) : Depository Receipts issued by a company in USA is known as ADR's. Such receipts have to be issued in accordance with the

provisions stipulated by the SEC, USA that are stringent. In a bid to bypass such stringent disclosure norms mandated by the

SEC for equity shares, the Indian companies have, however, chosen the indirect route to tap the vast American financial

market through private debt placement of GDR's listed in London and Luxembourg stock exchanges.

Indian companies have preferred the GDR's and ADR's as the US market exposes them to a higher level or responsibility than a

European listing in the areas of disclosure, costs, liabilities and timing. The SECs regulations set up to protect the retail investor base

are some what more stringent and onerous, even for companies already listed and held by retail investors in their home country. Most

onerous aspect of a US listing for companies is to provide full, half yearly and quarterly accounts in accordance with or atleast

reconciled with US GAAPs. However, Indian companies are shedding their reluctance to tap the US markets as evidenced by Infosys

Technologies Ltd. recent listing in NASDAQ. Most of India's top notch companies in the pharmaceutical, info-tech and other sunrise

industries are planning forays into the US markets. Another prohibitive aspect of the ADR's vis-à-vis GDR's is the cost involved of

preparing and filling US GAAP accounts. Additionally, the initial SEC registration fees based on a percentage of issue size anmd 'Blue

Sky' registration costs, permitting the securities to be offered in all States of US, will have to be met. The US market is widely

recognised as the most litigious market in the world. Accordingly, the broader the target investor base in US, higher is the potential

legal liability. An important aspect of GDR is that they are non voting and hence spells no dilution of equity. GDRs are settled through

CEDEL and Euro-clear International Book Entry Systems.

Other types of International issues :

a. Foreign Euro Bonds : In domestic capital markets of various countries the Bond issues referred to above are known by different names as Yankee

Bonds in US, Swiss Frances in Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK.

b. Euro Convertible Bonds :


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A convertible bond is a debt instrument giving the holders of the bond an option to convert the bonds into a pre-determined

number of equity shares of the company. Usually, the price of equity shares at the time of conversion will have a premium

element. They carry a fixed rate of interest and if the issuer company so desires may also include a Call Option, where the

issuer company has the option of calling/buying the bonds for redemption prior to the maturity date, or a Put Option, which

gives the holder the option to put/sell his bonds to the issuer company at a pre-determined date and price.

c. Euro Bonds : Plain Euro Bonds are nothing but debt instruments. These are not very attractive for an investor who desires to have valuable

additions to his investments.

d. Euro Convertible Zero Bonds : These are structured as a convertible bond. No interest is payable on the bonds. But conversion of bonds take place on

maturity at a pre-determined price. Usually, there is a 5 years maturity period and they are treated as a deferred equity issue.

e. Euro Bonds with Equity Warrants : These carry a coupon rate determined by market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed

Income Funds Management may like to invest for the purposes of regular income.

Other Advanced Issues: External Commercial Borrowings

The foreign currency borrowings raised by the Indian corporates from confirmed banking sources outside India are called “External

Commercial Borrowings” (ECBs). These Foreign Currency borrowings can be raised within ECB Policy guidelines of Govt. of India/

Reserve Bank of India applicable from time to time.

External Commercial Borrowings (ECB) are defined to include

1. Commercial bank loans

2. Buyer’s credit

3. Supplier’s credit

4. Securitised instruments such as floating rate notes, fixed rate bonds

5. Credit from official export credit agencies etc

Multilateral financial institutions like IFC, ADB, AFIC, CDC are providing such facilities.

Benefits : The ECBs route is beneficial to the Indian corporates on account of following:-

It provides the foreign currency funds which may not be available in India.

The cost of funds at times works out to be cheaper as compared to the cost of rupee funds.

The availability of the funds from the International market is huge as compared to domestic market and corporates can raise

large amount of funds depending on the risk perception of the International market.

ECBs provided an additional source of funds to the Indian companies, allowing them to supplement domestically available

resources and to take advantage of lower international interest rates.

While the ECB policy provides flexibility in borrowing consistent with maintenance of prudential limits for total external

borrowings, its guiding principles are to keep borrowing maturities long, costs low and encourage infrastructure/core and

export sector financing which are crucial for overall growth of the economy.

End-use :

ECBs are to be utilised for foreign exchange costs of capital goods and services (on FOB and CIF basis).Proceeds should be utilized at

the earliest and corporates should comply with RBI’s guidelines on parking ECBs outside till actual imports. RBI would be monitoring

ECB proceeds parked outside.However, in the case of infrastructure projects in the power, telecommunications and railway sectors,

ECB can be utilised for project - related rupee expenditure. License fee payments would be an approved use of ECB in the telecom

sector. ECB proceeds may also be utilised for project - related rupee expenditure, as outlined above. Proceeds must be brought into the

country immediately.However, under no circumstances, ECB proceeds will be utilised for :

a. Investment in the stock market

b. Speculation in real estate

ECB may be raised to acquire ships/vessels from Indian shipyards

Limits:

With a view to manage the country’s external debt prudently, the Finance Ministry sets an annual cap on the total ECBs that Indian

corporates can access in a year.There have been reports that the Government plans to hike the cap on ECB currently fixed at $18

billion to about $22 billion. The government has been streamlining/liberalising ECB procedures from time to time to enable Indian

corporates have greater access to international financial markets.


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Recent Example : About 812 companies have raised about $20.24 billion through ECBs in the April 2006-February 2007 period. That

would be equivalent to about Rs 88,000 crore.The top fundraiser was Reliance Industries, which raised $700 million, followed by

Reliance Communication, which raised $500 million.Units in SEZ are permitted to use ECBs under a special window.

Factoring:

Meaning :

Factoring means an arrangement between a factor and his client which includes the following services to be provided by the factor.

a. Finance

b. Maintenance of debt

c. Collection of debts

d. Protection against credit risk

In other words Factoring is an arrangement in which a financial intermediary called ‘Factor’ collects the account receivables on behalf

of the seller of goods and services. Factoring is thus an alternative to in-house management of receivables.

Types/Forms of Factoring : Depending upon the features built into the factoring arrangement to cater to the varying needs of trade there can be different kinds of

factoring. Some of which are :

a. Recourse and Non-Recourse Factoring : Under a recourse factoring arrangement, the factor has recourse to the client (firm) if the purchased/receivable factored turns

out to be irrecoverable. In other words, the factor does not assume credit risks associated with the receivables. The factor does

not have the right to recourse in the case of non-recourse factoring. The loss arising out of irrecoverable receivables is borne

by him, as a compensation for which he charges a higher commission. Advance and Maturity Factoring : In advance factoring

the factor paid a pre specified portion, ranging between three-fourths to nine tenths, of the factored receivables in advance, the

balance being paid upon on the guaranteed payment date. The client has to pay interest on the advance between the date of

such payment and the date of actual collection from the customers or the guaranteed payment date, determined on the basis of

the prevailing short-term rate, the financial standing of the client and the volume of the turnover.

In maturity factoring the factor does not make any advance or prepayment. The factor pays the client either on a guaranteed

payment date or on date of collection from the customer.

b. Full Factoring : Full Factoring is the most comprehensive form of factoring combining the features of all the factoring specially those of non-

recourse and advance factoring. It is also known as old line factoring.In this type of factoring all the components of service

like short term finance,administration of sales ledger and credit protection are available to the client . Disclosed and

Undisclosed Factoring: In disclosed factoring, the name of the factor is disclosed in the invoice by the supplier manufacturer

of the goods asking the buyer to make payment to the factor.The name of the factor is not disclosed in the invoice in

undisclosed factoring although the factor maintains the sales ledger of the supplier-manufacturer. The entire realization of the

business transaction is done in the name of the supplier company but all control remains with the factor.

c. Domestic and Export/Cross Border Factoring:

If the three parties involved, namely, customer (buyer), client,(seller-sup-plier) and factor (financial intermediary) are

domiciled in the same country then it is known as domestic factoring. There are usually four parties involved to a cross border

factoring transaction. They are:

Exporter (client)

Importer ( customer)

Export factor

Import Factor

It is also known as two-factor system.

Functions of a Factor:

The main functions of a factor could be classified into five categories :

a. Maintenance/Administration of Sales Ledger: The factor maintains the clients’ sales ledgers. The ledger is generally maintained under the open-item method in which each

receipt is matched against the specific invoice. The factor also gives periodic reports to the client.

b. Collection Facility: The factor undertakes to collect the receivables on behalf of the client relieving him of the problems involved in collection,

and enables him to concentrate on other important functional areas of the business. It also enables the client to reduce the cost

of collection by way of savings in manpower, time and efforts. Also, the debtors are more responsive to the demands from a

factor being a credit institution.

c. Financing Trade Debts:


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The unique feature of factoring is that a factor purchases the book debts of its clients at a price and the debts are assigned in

favour of factor who is usually willing to grant advances to the extent of 80% of the assigned debts.

d. Credit Control and Credit Protection : Assumptions of credit risk is one of the most important functions of the factor. This service is provided where debts are

factored without recourse. The factor in consultation with the client fixes credit limits for approved customers. Within these

limits, the factor undertakes to purchase all trade debts of the customer without recourse.

e. Advisory Services : By virtue of their specialized knowledge and experience in finance and credit dealings and access to extensive credit

information; factors can provide the following information services to the clients:

Customer’s perception of the clients products, changing in marketing strategies, emerging trends etc.

Audit of the procedures followed for invoicing, delivery and dealing with sales returns.

Introduction to the credit department of a bank/subsidiaries of banks engaged in leasing, hire-purchase, merchant

banking.

Advantages of Factoring : Factoring offers the following advantages which makes it quite attractive to many firms :

Convertibility : The firm can convert receivables into cash without bothering about repayment.

Definite Pattern Of Cash Inflows :

Factoring ensures a definite pattern of cash inflows for the company.

Reduction in Collection & Administration Costs :

Continuous factoring virtually eliminates need for the credit department.

Compensating Balance are Not Required : Unlike an unsecured loan, compensating balances are not required in this case.

Forfaiting:

Forfaiting is a form of financing of receivables pertaining to international trade. It is French term and implies, ‘surrendering or

relinquishing rights to something’. In the field of exports, it implies surrender by an exporter of the rights to claim payment for goods

or services rendered to an importer in return for cash payment for those goods or services from the forfaiter (generally a bank), who

takes over the importer’s promissory note or the exporter’s bills of exchange.

Forfaiting arrangement eliminates virtually all

a. Credit Risks

b. Interest Rate Risk, that the interest rate may fluctuate

c. Foreign currency risk that of any adverse movement

d. Political Risk

e. Business Risk, that the business conditions may weaken in the importer’s country.

Features :

a. Forfaiter discounts the entire value of the note/bill.

b. The forfaiter’s decision to provide financing depends upon the financing standing of the avalling bank.

c. Forfaiting is a pure financial agreement

d. Forfaiting spreads over 3-5 years.

e. It is always without recourse

f. There exists a secondary market in forfaiting.This adds depth and liquidity to forfeiting.

Foreign banks are major players in the Forfeiting market.


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Difference between Factoring and Fortailing:

a. Extent of Finance :

Forfaiter discounts the entire value of the note/bill. In a factoring arrangement the extent of financing available is 75-80%.

b. Credit Worthiness :

The forfaiter’s decision to provide financing depends upon the financing standing of the avalling bank. On the other hand in

a factoring deal the export factor bases his credit decision on the credit standards of the exporter.

c. Services Provided :

Forfaiting is a pure financial agreement while factoring includes ledger administration and collection also.

d. Maturity :

Factoring is a short-term financial deal. Forfaiting spreads over 3-5 years.

e. Market :

Factoring is applicable to domestic receivables. However the forfaiting as a system of financing of receivables arising out of

export business or international business.

f. Recourse :

Factroing may be with or without recourse, while forfaiting is always without recourse.

g. Liquidity :

Factoring tends to be a case of sell of debt obligation to the factor, with no secondary market. There exists a secondary

maket in forfaiting. This adds depth and liquidity to forfaiting.

h. Cost :

The seller (client) bears the cost of factoring. The overseas buyer bears the cost of forfaiting.

Mutual Funds: Mutual Funds is a method of channeling the savings of a layman person directly to the productive capacities of the country. Though

still at a nascent stage, Indian MF industry offers a plethora of schemes and serves broadly all types of investors. Mutual Funds have

opened new doors to investors and imparted much needed liquidity to the system. In this process they have challenged the dominant

role of the commercial banks in the financial market and national economy.

a. Mutual Funds and Household Savings: They are the ideal route for many household to invest their savings for a higher return in Mutual Fund rather than normal

term deposits with Banks.

b. Mutual Funds and the Capital Market: Mutual funds have strongly supported the equity market.

c. Mutual Funds and the Money Market: Money market is an important part of financial market. It plays a crucial role in maintaining the equilibrium between the

short-term demand & supply of money. It is a market for short-term money. Such schemes invest in safe highly liquid

instruments included in commercial papers,certificates of deposits & governments securities.

Money market MF schemes generally provide high returns and highest safety to the ordinary investors. Money market MF schemes

are active players of the money market. They channelise the idle short funds, particularly of corporate world, to those who require

such funds. This process helps those who have idle funds to earn some income without taking any risk and with surety that that

whenever they will need their funds, they will get the same. Short-term / emergency requirements of various firms are met by such

MFs. participation of such MFs provide a boost to money market and help in controlling the volatility. Mutual Funds and Corporate

Finance Advantages:

The major advantages of investing in Mutual Fund are discussed below:

a. Professional Management One of the major advantage of the mutual fund is the availability of low cost highly professional and skilled management

services. The managers have sound knowledge and wide experience in investment.

b. Low Cost High Value Portfolio Diversification Market related risk can be reduced by diversification of portfolio. For a small investor appropriate portfolio diversification is

not possible due to shortage of minimum required funds. But with investments in mutual funds, portfolio of even a small

investor gets automatically diversified.

c. Reduction/Diversification of Risk When a investor, invest in a mutual fund he is actually investing in a pool of funds. These funds will in turn be invested in

securities. So the individual investor will share the losses with others investors.

d. Reduction in Transaction Cost A mutual fund can offer economies of search & verification due to size & scale of operations.

e. Liquidity

Mutual fund invests in a number of securities but not all the securities are easily sellable. When a investor invests in a

mutual fund, he can sell his units any time to the fund, in case of open ended schemes or cash his investment by selling in

secondary market, in case of close ended schemes, thus mutual fund investments are quite liquid.

f. Tax Benefits There are many tax benefits available under Income Tax Act for investing in Mutual Fund Schemes.

g. Convenient Administration Investing in a MF reduces paper work and helps investors to avoid many problems such as bad deliveries,delayed payments

and unnecessary follow up with brokers and Companies .

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h. Transparency Investors get regular information on the value of their investment in addition to disclosure on the specific investments made

by scheme , the proportion invested in each class of assets and the Fund Manager’s investment strategy and outlook.

i. Return Potential MF has the potential to provide a higher return as they invest in a diversified basket of selected securities.

Functions of Merchant Banker:

Meaning : In modern times, importance of merchant banker has gained legitimacy because it is the key intermediary between the

company and the issue of capital. Merchant Banker means a person who is engaged in the business of issue management either by

making arrangements regarding selling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate

advisory service in relation to such issue management.

The company has to select a Merchant Banker keeping in view the following points:

a. The support of financial institutions by participating in the issue.

b. Proposed size of the issue.

c. The background, expertise and infrastructure facilities of the Merchant banker.

d. The condition of primary and secondary markets.

The Merchant Banker will have to liaison with the company, institutions, bankers, Stock Exchange, underwriters, brokers, registrars

to the issue, the printers and establish rapport with all these persons to make the issue a success.

Activities/Functions of Merchant Banker: Merchant Banker may undertake the following activities:

a. Managing of Public Issue of securities.

b. Underwriting concerned with the aforesaid Public Issue Management Business.

c. Managing & Advising International offerings of Debt, Equity, i.e., GDRs, ADRs, bonds and other instruments.

d. Private Placement of securities.

e. Primary or Satellite dealership of Government Securities.

f. Corporate Advisory Services relating to Securities Market, e.g., takeovers, acquisitions, Disinvestment.

g. Stock-broking

h. Advisory services for projects

i. Syndication of rupee term loans

j. International Financial Advisory Services

Other Services which are generally performed by Merchant Bankers include :

1. Project promotion services.

2. Project finance.

3. Management and marketing of new issues.

4. Underwriting of new issue

5. Syndication of credit.

6. Leasing services.

7. Corporate advisory services.

8. Providing venture capital.

9. Operating mutual funds and off shore funds.

10. Investing management of portfolio management services

11. Bought out deals.

12. Providing assistance for technical and financial collaborations and joint ventures.

13. Management of and dealing in commercial papers.

14. Investment services for non-resident Indians.

Role of Merchant Bankers in Public Issue

In the present day capital market scenario the merchant bank plays an encouraging and supporting force to the entrepreneurs,

corporate sectors and the investors. Several new institutions have appeared in the financial spectrum and merchant bankers have

joined to expand the range of financial services. Moreover, the activities of these Merchant Bankers have developed considerably

both horizontally and vertically to cope with the changing environment . Merchant Banks help in promoting and sustaining capital

markets and money markets, and they provide a variety of financial services to the corporate sector. Management of the public issues

of shares, debentures or even an offer for sales, has been the traditional service rendered by merchant bankers. Some of the services

under issue management are:

Deciding on the size and timing of a public issue in the light of the market conditions.

Preparing the base of successful issue marketing from the initial documentation to the preparation of the actual launch.

Optimum underwriting support.

Appointment of bankers and brokers as well as issue houses.

Professional liaison with share market functionaries like brokers, portfolio managers and financial press for pre-selling and

media coverage.

Preparation of draft prospectus and other documents.

Wide coverage throughout the country for collection of applications.

Preparation of advertising and promotional material.

The merchant bankers presence in all the major centres as well his long established relationships with the underwriter and

broker fraternities, makes possible the high degree of synchronisation required to ensure the success of an issue.

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Reverse Bid or Reverse Takeover

Meaning:

It is the act of a smaller company gaining control over a larger one .In ordinary case, the company taken over is the smaller company;

in a ‘Reverse Takeover’, a smaller company gains control of a larger one. The concept of takeover by reverse bid, or of reverse

merger, is thus not the usual case of amalgamation of a sick unit which is non-viable with a healthy or prosperous unit but is a case

whereby the entire undertaking of the healthy and prosperous company is to be merged and vested in the sick company which is non

viable.

Tests For Indentifying Takeover by Reverse Bid :

The three tests in a takeover by reverse bid that are required to be satisfied are, namely,

a. the assets of the transferor company are greater than the transferee company,

b. equity capital to be issued by the transferee company pursuant to the acquisition exceeds its original issued capital, and

c. the change of control in the transferee company through the introduciton of a minority holder or group of holders.

Takeover by reverse bid could happen where already a significant percent of the shareholding is held by the transfer company, to

exploit economies of scale, to enjoy better trading advantages and other similar reasons.

Application of the concept of ‘takeover by reverse bid’ The concept of takeover by reverse bid has been successfully employed in schemes formulated for revival and rehabilitation of sick

industrial companies.

Recent Example: A recent example of a non-sick unit ‘reverse merger’ was that of ICICI Bank (smaller unit) merging with ICICI Ltd. (larger unit) to

form ICICI Bank Ltd. The aim was to give the company an identity of a ‘Universal Banking Company’.

Leveraged Buyouts:

A Leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed through debt. Typically

in the LBO 90% or more of the purchase price is financed with debt.

While some leveraged buyouts involve a company in its entirety most involve a buisness unit of a company. After the buyout, the

company invariably becomes a Private Company. A large part of the borrowings is secured by the firms assets, and the lenders,

because of a high risk, take a portion of the firms equity. Junk bonds have been routinely used to raise amounts of debt needed to

finance LBO transaction. The success of the entire operation depends on their abilty to improve the performence of the unit, curtail

its buisness risk, exercise cost controls and liquidate disposable asset. If they fail to do so, the high fixed financial costs can

jeopardize the venture.

An attractive candidate for acquisition through leveraged buyout should possess three basic attributes :

It firm have a good position in its industry with a solid profit history and reasonable expectations of growth.

The firm should have a relatively low level of debt and a high level of bankable assets that can be used as loan collateral.

It must have a stable and predictable cash flows that are adequate to meet interest and principle payment of the debt and

provide adequate working capital.

Recent example: India has experienced a number of buyouts and leveraged buyouts . A successful example of LBO is the acquisition of Tetley brand,

the biggest tea brand of Europe by TATA Tea of India at 271 million pounds. It was one of the biggest cross border acquisition by an

Indian Company. Another recent example of a leveraged buyout is Tata Steel ( India ) acquiring Corus ( United Kingdom ) for $11.3

billion .

Book Building: The book-building system is part of Initial Public Offer (IPO) of Indian Capital Market. It was introduced by SEBI on

recommendations of Mr. Y.H. Malegam in October 1995.It is most practical, fast and efficient management of Mega Issues. Book

Building involves sale of securities to the public and the institutional bidders on the basis of predetermined price range. Book

Building is a price discovery mechanism and is becoming increasingly popular as a method of issuing capital. The idea behind this

process is to find a better price for the issue. The issue price is not determined in advance.Book Building is a process wherein the

issue price of a security is determined by the demand and supply forces in the capital market. Book building is a process used for

marketing a public offer of equity shares of a company and is a common practice in most developed countries.

Book building is called so because it refers to the collection of bids from investors, which is based on an indicative price range. The

issue price is fixed after the bid closing date.The various bids received from the investors are recorded in a book,that is why the

process is called Book Building. Unlike international markets, India has a large number of retail investors who actively participate in

Intial Public Offer (IPOs) by companies. Internationally, the most active investors are the mutual funds and other institutional

investors, hence the entire issue is book built. But in India, 25 per cent of the issue has to be offered to the general public. Here there

are two options with the company. According to the first option, 25 percent of the issue has to be sold at a fixed price and 75 per cent

is through book building. The other option is to split the 25 % on offer to the public (small investors) into a fixed price portion of 10

percent and a reservation in the book built portion amounting to 15 % of the issue size. The rest of the book-built portion is open to

any investor.

Process:

Step 1: Company plans an IPO through book building route.

Step 2: Appoint Merchant banker as book runner

Step 3: Issue draft prospectus – Contains all necessary information except prices

Step 4: Draft prospectus is filed with regulatory bodies.

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Step 5: Book runner appoints syndicates member and registered intermediaries to garner subscription.

Step 6: Price discovery begins through bidding process.

Step 7: Upon closure of bidding process book runner and management decides upon allocation and allotment.

Advantage

The book building process helps in discovery of price & demand.

The costs of the public issue are much reduced.

The time taken for the completion of the entire process is much less than that in the normal public issue.

In book building, the demand for the share is known before the issue closes. Infact, if there is not much demand, the issue

may be deferred.

It inspires investors confidence leading to a large investor universe.

Issuers can choose investors by quality.

The issue price is market determined.

Disadvantage

There is a possibility of price rigging on listing as promoters may try to bail out syndicate members.

The book building system works very effeciently in matured market conditions. But, such conditions are not commonly

found in practice.

It is appropriate for the mega issues only.

The company should be fundamentally strong & well known to the investors without it book building process will be

unsuccessful.

Recent Example : Recent example of a book buliding process in Indian context is the IPO of Reliance Power. The issue was made through 100 % book

building process .The price band for the the book buliding pocesss was between Rs 405 and Rs 450 with Rs 20 discount for retail

investors .

Green Shoe Option: Green Shoe Option (GSO) means an option available to the company issuing securities to the public to allocate shares in excess of

the public issue and operating a post-listing price stabilising mechanism through a stabilising agent. This option acts as a safety net

for the investors and is a standard global practice. The name comes from the fact that Green Shoe Company was the first entity to use

this option.

The GSO is available to a company which is issuing equity shares through book-building mechanism for stabilising the post-listing

price of the shares. The following is the mechanism of GSO :

The Company shall appoint one of the leading book runners as the Stabilising Agent (SA), who will be responsible for the

price stabilising process. ‘The promoters of the company will enter into an agreement with SA to lend some of their shares

to the latter, not exceeding 15% of the total issue size.

The borrowed shares shall be in the dematerialised form. These shares will be kept in a separate GSO Demat A/c.

In case of over subscription, the allocation of these share shall be on pro-rata basis to all applicants.

The money received from allotment of these shares shall also be kept in a ‘GSO Bank A/c’, distinct from the issue account,

and the amount will be used for buying shares from the market during the stabilization period.

The shares bought from the market by SA for stabilization shall be credited to GSO Demat Account.

These shares shall be returned to the promoters within 2 days of closure of stabilisation process.

In order to stabilise post-listing prices, the SA shall determine the timing and quantity of shares to be bought.

If at the expiry of the stabilisation period, the SA does not purchase shares to the extent of over-allocated shares, then shares

to the extent of shortfall will be allotted by the company to the GSO Demat A/c multiplied by the issue price. Amount left in

the GSO Bank A/c (after meeting expenses of SA), shall be transferred to the Investors Protection Fund.

Examples of GSO issues in India

In April, 2004 the ICICI bank Ltd. became the first Indian company to offer GSO. The ICICI Bank Ltd. offered equity shares of Rs.

3050 crores through 100% book building process to the investors. The issue was over subscribed by 5.14 times. r►IDBI has also

come up with their Flexi Bonds (Series 4 and 5) under GSO.

More recently Infosys Technologies has also excercised GSO for its issue. This offer initially involved 5.22 million depository

shares, representing 2.61 million domestic equity shares.

Buyback of Shares:

In Nepal, buy back of Securities is governed by the Companies Act

Meaning :

Buyback is reverse of issue of shares by a company , where it offers to take back its shares owned by the investors at a specified

prices.

Objectives of Buyback : The following are the management objectives of buying back securities :

To return excess cash to shareholders, in absence of appropriate investment opportunities.

To give a signal to the market that shares are undervalued.

To increase promoters holding, as a percentage of total outstanding shares, without additional investment. Thus, buy back is

often used as a defence mechanism against potential takeover.

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To change the capital structure.

To Increase Earnings per share

Resources of Buy Back : A Company can purchase its own shares from

a. Free reserves;

b. Securities premium account; or

c. Proceeds of any shares or other specified securities.

A Company cannot buyback its shares or other specified securities out of the proceeds of an earlier issue of the same kind of shares

or specified securities.

Advantages of Buyback : The Advantages of Buyback of securities to investors, companies and economy are :

Revival of the Capital Market : Buyback may flare up the market value of shares in a bearish market. This can be shown with the help of diagram given

below. Buyback would also help the company to maintain the market price of its shares and to keep its stable. When

Buyback Takes Place Earning Per Share Increases Demand to Purchase the Share Increases Market Price of Share Increases

Liquidity to Dormant Shares : Most of the shares of the companies which are held by Employees and Executives are usually dormant By bringing in the

buyback option, the company would be able to purchase those shares from the employees & executives. And thus not only

increase the liquidity in the market but also would act as an incentive to the worthy employees.

Odd Lots : Odd Lots are generally dormant in nature and buyback could act as a relief to the shareholders by way of selling those

shares to the company.

Restructuring of capital base by Companies with special reference to public sector units : It is felt that buyback of shares by Public Sector Undertaking is an attractive option, for two reasons. One it gives PSUs

having a bloated equity base an opportunity to restructure their capital and in process add value for the remaining

shareholders.

Increasing the Earnings Per Share (EPS) and at the same time providing higher prices (P/E ratio) to Investors : The shareholders’ money can be maximised by optimising the current earnings on the share and at the same time increasing

the market value of the shares by way of capital appreciation.

Proper Utilisation of Excess Funds : Many small and mid range companies in this country sit upon so much cash without having any idea of where to put them

in. It would be better for them to return surplus cash to shareholders than go on spending simply for want of alternatives.

For ensuring price stability in share prices

For exercising control over the company

For saving the company from hostile takeover

Disadvantages of Buyback : Some of the disadvantages of Buyback are as follows :

Manipulation of share prices by its promoters

Speculation

Collusive trading

Conditions of Buy Back:

The buy-back is authorised by the Articles of Association of the Company;

A special resolution has been passed in the general meeting of the company authorising the buy-back.

The buy-back is of less than twenty-five per cent of the total paid-up capital and fee reserves of the company and that the

buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid-up equity capital in that

financial year;

The ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back;

There has been no default in any of the following :

a. In repayment of deposit or interest payable thereon,

b. Redemption of debentures, or preference shares or

c. Payment of dividend, if declared, to all shareholders within the stipulated time of 30 days from the date of declaration

of dividend or iv. repayment of any term loan or interest payable thereon to any financial institution or bank;

All the shares or other specified securities for buy-back are fully paid-up;

Inter Bank Participation Certificate:

Meaning : A IBPC is a deed of transfer through which a bank, sells or transfers to a third party (transferee) a part or all of a loan made its clients

(borrowers).In other words The Inter Bank Participation Certificates are short term instruments to even out the short term liquidity

within the Banking system particularly when there are imbalances affecting the maturity mix of assets in Banking Book.

Why it is called so ? :

It is called a participation certificate because through it, the PC holder participates in a bank loan, and so also in the interest, the

security of the loan, and risk of default on a proportionate basis.

Objective:

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The primary objective is to provide some degree of flexibility in the credit portfolio of banks & to smoothen the consortium

arrangements.

Who can Issue & Subscribe: The IBPC can be issued by scheduled commercial bank and can be subscribed by any commercial bank.

Issued against underlyng Advance :

The IBPC is issued against an underlying advance, classified standard during the currency of the participation. the aggregate amount

of participation should be covered by the outstanding balance in account.

Types : The participation can be issued in two types, viz. with and without risk to the lender.

While the participation without risk can be issued for a period not exceeding 90 days. Participation is with risk can be issued for a

period between 91 days and 180 days. Under ‘with risk participation’, the issuing bank will reduce the amount of participation from

the advances outstanding and participating bank will show the participation as part of its advances. Banks are permitted to issue

IBPC under ‘with risk’ nomenclature classified under Health Code-I status and the aggregate amount of such participation in any

account should not exceed 40% of outstanding amount at the time of issue. Under without risk participation, the issuing bank will

show the participation as borrowing from banks and participating bank will show it as advances to bank.

Benefits:

The scheme is beneficial both to the issuing and participating banks. The issuing bank can secure funds against advances without

actually diluting its asset-mix. A bank having the highest loans to total asset ratio and liquidity bind can square the situation by

issuing IBPCs. To the lender, it provides an opportunity to deploy the short term surplus funds in a secured and profitable

manner.The IBPC with risk can also be used for capital adequacy management.

Interest Rate: The interest rate on IBPC is freely determined in the market. The certificates are neither transferable nor prematurely redeemable by

the issuing bank.

Current Scenario : Despite its advantages, the IBPC scheme has not become a popular money market instrument one of the reason for this may be the

prohibition against transferability as the participants are not allowed to transfer the certificates. Secondly due to the absence of a

ceiling on the interest rate the borrower bank has to pay the issuing bank a rate higher than that agreed with the borrower.

Shareholder Value Analysis (SVA)

Meaning : SVA is an approach to Financial Management developed in 1980s. This approach focuses on the creation of economic value for

shareholders, as measured by share price performance and flow of funds. SVA is used as a way of linking management strategy and

decisions to the creation of value for shareholders.

Value Drivers : The factors, called ‘value drivers’ are identified which will influence the shareholder’s value. They may be : growth in sales,

improvement in profit margin, capital investment decisions, capital structure decisions etc. The management is required to pay

attention to such value drivers while taking investment & finance decisions.

Benefits:

SVA helps the management to concentrate on activities which create value to the shareholders rather than on short-term

profitability.

SVA helps to strengthen the competitive position of the firm,by focussing on wealth creation .

They provide an objective and consistent framework of evaluation and decision making across all functions,departments and

units of the company

The shareholders value analysis got recognition only after 1986, when Prof. Rappaport of USA published his book Creating

Shareholder Value. As per the concept of Shareholder Value Analysis (SVA), all business activity should aim to maximize

the value of company’s equity shares in the long run. As per SVA, the primary responsibility of management (not only of

the finance manager) is to create value for the shareholders. All the decisions of the management should have only one

target and that is value creation for the shareholders.

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Difference between Money Market and Capital Market:

Basics Money Market Capital Market

i. Tenure It is a market for lending and borrowing of short Capital markets deals in long term securi

term funds, upto one year . ties for a period beyond one year.

ii. Well defined It is a not a well-defined market where business It is a well defined market where busi

place is done . -ness is done e.g. stock exchange.

iii. Short Term It deals in short term financial assets e.g .interbank It deals in medium & long term financial

/Long Term call money, treasury bills,commercial paper, etc. assets e.g equity shares, debentures etc.

(iv) Classification There is no sub-division in money market . Capital Market is classified between

Primary Market and

Secondary Market.

(v) Volume of The total value of transaction in money market far Capital market lag behind the total value

business exceeds the capital market .According to DFHI of transaction done in money market.

only in call money market daily leading is Rs. 6000

crores arround

(vi)No. of The number of instruments dealt in money market are The number of instruments in capital

instrument various, e.g.(a) Interbank call money (b) Notice money market are shares and debentures.

upto 14 days (c) Short term deposits upto 3 months (d)

91 days treasury bill (e) 182 days treasury bill (f)

Commercial paper etc.

(vii)Participants The participants in money market are Bankers, RBI The participants in capital market are

and Government . general investors, brokers, merchant

bankers,registrars to issue, underwrit

ers,corporate investors,Flls & Bankers.

(viii)Liquidity The important features of money market Whereas Capital market are not as

instrument is that it is liquid. liquid as money market instrument.

(viii)Regulator It is regulated by the guidelines of RBI It is regulated by the guidelines of SEBI.

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