Department of Management Studies, BSAITM

FINANCIAL MANAGEMENT
UNIT -1
MEANING OF FINANCE – Finance may be defined as the art and science of
managing money. It includes financial service and financial instruments. Finance
also is referred as the provision of money at the time when it is needed. Finance
function is the procurement of funds and their effective utilization in business
concerns. The concept of finance includes capital, funds, money, and amount.
But each word is having unique meaning. Studying and understanding the
concept of finance become an important part of the business concern.

DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which
concerns with the acquisition and conversation of capital funds in meeting
financial needs and overall objectives of a business enterprise”.
According to the Gutmann and Dougall, “Business finance can broadly be
defined as the activity concerned with planning, raising, controlling,
administering of the funds used in the business”

Introduction to Financial Management

Financial management refers to efficient acquisition, allocation and usage of
funds by a company for its smooth working.
The main objectives of financial management are to reduce the expenses
involved in procuring funds, to control risk and to achieve effective deployment
of funds.
Financial management is the practice of handling a company's finances in a way
that allows it to be successful and compliant with regulations. That takes both a
high-level plan and boots-on-the-ground execution
The term financial management has been defined by Solomon, “It is concerned
with the efficient use of an important economic resource namely, capital funds”.
The most popular and acceptable definition of financial management as given
by S.C. Kuchal is that “Financial Management deals with procurement of funds
and their effective utilization in the business”.
Howard and Upton : Financial management “as an application of general
managerial principles to the area of financial decision-making.
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Weston and Brigham : Financial management “is an area of financial decision-

making, harmonizing individual motives and enterprise goals”. Joshep and
Massie : Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.
“Financial management is the activity concerned with planning, raising,
controlling and administering of funds used in the business.”
– Guthman and Dougal
“Financial management is that area of business management devoted to a
judicious use of capital and a careful selection of the source of capital in order
to enable a spending unit to move in the direction of reaching the goals.”
– J.F. Brandley
“Financial management is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for
efficient operations.” - Massie
Nature or Features or Characteristics of Financial Management
Nature of financial management is concerned with its functions, its goals, trade-
off with conflicting goals, its indispensability, its systems, its relation with other
subsystems in the firm, its environment, its relationship with other disciplines,
the procedural aspects and its equation with other divisions within the
organisation.
1. Financial Management is an integral part of overall management. Financial
considerations are involved in all business decisions. So financial management
is pervasive throughout the organisation.
2. The central focus of financial management is valuation of the firm. That is
financial decisions are directed at increasing/maximization/ optimizing the value
of the firm.
3. Financial management essentially involves risk-return trade-off Decisions on
investment involve choosing of types of assets which generate returns
accompanied by risks. Generally higher the risk, returns might be higher and vice
versa. So, the financial manager has to decide the level of risk the firm can
assume and satisfy with the accompanying return.
4. Financial management affects the survival, growth and vitality of the firm.
Finance is said to be the life blood of business. It is to business, what blood is to
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us. The amount, type, sources, conditions and cost of finance squarely influence
the functioning of the unit.
5. Finance functions, i.e., investment, rising of capital, distribution of profit, are
performed in all firms - business or non-business, big or small, proprietary or
corporate undertakings. Yes, financial management is a concern of every
concern.
6. Financial management is a sub-system of the business system which has
other subsystems like production, marketing, etc. In systems arrangement
financial sub-system is to be well-coordinated with others and other sub-
systems well matched with the financial subsystem.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management,
which is directly related with various functional departments like personnel,
marketing and production. Financial management covers wide area with
multidimensional approaches. The following are the important scope of
financial management.
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the
financial management approaches. Investment decisions, micro and macro
environmentalfactorsarecloselyassociatedwiththefunctionsoffinancialmanager.
Financial management also uses the economic equations like money value
discount factor, economic order quantity etc. Financial economics is one of the
emerging area, which provides immense opportunities to finance, and
economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern.
Hence, we can easily understand the relationship between the financial
management and accounting. In the olden periods, both financial management
and accounting are treated as a same discipline and then it has been merged as
Management Accounting because this part is very much helpful to finance
manager to take decisions. But now a day’s financial management and
accounting discipline are separate and interrelated.
3. Financial Management or Mathematics
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Modern approaches of the financial management applied large number of

mathematical and statistical tools and techniques. They are also called as
econometrics. Economic order quantity, discount factor, time value of money,
present value of money, cost of capital, capital structure theories, dividend
theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which
helps to multiple the money into profit. Profit of the concern depends upon the
production performance. Production performance needs finance, because
production department requires raw material, machinery, wages, operating
expenses etc. These expenditures are decided and estimated by the financial
department and the finance manager allocates the appropriate finance to
production department. The financial manager must be aware of the
operational process and finance required for each process of production
activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches.
For this, the marketing department needs finance to meet the requirements.
6. Financial Management and Human Resource
Financial management is also related with human resource department, which
provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each
department and allocate the finance to the human resource department as
wages, salary, remuneration, commission, bonus, pension and other monetary
benefits to the human resource department. Hence, financial management is
directly related with human resource management.

OBJECTIVES OF FINANCIALMANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of
the finance by the business concern. It is the essential part of the financial
manager. Hence, the financial manager must determine the basic objectives of
the financial management.
Objectives of Financial Management may be broadly divided into two parts such
as:
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1. Profit maximization
2. Wealth maximization.
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern
is also functioning mainly for the purpose of earning profit. Profit is the
measuring techniques to understand the business efficiency of the concern.
Profit maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern.
Profit maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads
to maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern.
So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favourable Arguments for Profit Maximization
The following important points are in support of the profit maximization
objectives of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Unfavourable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair
trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stakeholders
such as customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
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(i) It is vague: In this objective, profit is not defined precisely or correctly. It

creates some unnecessary opinion regarding earning habits of the business
concern.
(ii) It ignores the time value of money: Profit maximization does not consider
the time value of money or the net present value of the cash inflow. It leads
certain differences between the actual cash inflow and net present cash flow
during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business
concern. Risks may be internal or external which will affect the overall operation
of the business concern.

Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest
innovations and improvements in the field of the business concern. The term
wealth means shareholder wealth or the wealth of the persons those who are
involved in the business concern.
Wealth maximization is also known as value maximization or net present worth
maximization. This objective is an universally accepted concept in the field of
business.
Favourable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main
aim of the business concern under this concept is to improve the value or wealth
of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total cost
incurred for the business operation. It provides extract value of the business
concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it
may not be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect
name of the profit maximization.
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(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoys certain benefits.
(v) Theultimateaimofthewealthmaximizationobjectivesistomaximizetheprofit.
(vi) Wealth maximization can be activated only with the help of the profitable
position of the business concern.

Traditional Approach
The traditional approach is the first stage of financial management that was
used from 1920 to 1950. This strategy is based on previous experience and well-
established methodologies. The traditional strategy is primarily concerned with
raising finances for the business concern. The traditional approach includes the
following key areas.
 Obtaining funds from a lending institution.
 Arrangement of funds using various financial mechanisms.
 Identifying the many sources of funding.

Modern Approach
The modern method began in the mid-1950s. It has a broader scope since it
includes a conceptual and analytical framework for financial decision-making. In
other words, it encompasses both the acquisition and the allocation of funds.
Allocation is not just arbitrary allocation; it is efficient allocation among diverse
investments that will help enhance shareholder wealth.
In accordance with the modern approach, the Finance manager is supposed to
analyze the firm and determine the following:
 The firm’s overall capital need
 The assets to be acquired
 The pattern of financing the assets
Investment Decision
The decision relates to selection of assets which invest by firms and the assets
which firms acquire which might for long term or short term. Capital budgeting
is the process of selecting assets or investment proposals which yield for the
long term. They deal with assets of current which are highly liquid in nature.
Financing Decision
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The scope of finance indicates the possible sources of raising the finance. The
financial planning decision attempts sources and possible accumulation of
funds. As the decision to ensure the availability of funds whenever required.
As the financial decision made to raise funds at the right time, and financial
decision has to opt for various cost effective methods to run business smoothly.
Dividend Decision
The decision taken in regards to net profit distribution which divides into
dividend for shareholders and retained profits. This may concerned with
determining the percentage of profit earned and paid to every shareholder as
dividend. The financial manager makes decisions regarding such profits paid out
and works for a better firm.

FUNCTIONS OF FINANCE MANAGER

Finance function is one of the major parts of business organization, which
involves the permanent, and continuous process of the business concern.
Finance is one of the interrelated functions which deal with personal function,
marketing function, production function and research and development
activities of the business concern.
At present, every business concern concentrates more on the field of finance
because, it is a very emerging part which reflects the entire operational and
profit ability position of the concern. Deciding the proper financial function is
the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance
function. He must have entire knowledge in the area of accounting, finance,
economics and management. His position is highly critical and analytical to solve
various problems related to finance.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate
the financial
requirement of the business concern. He should estimate, how much finances
required to acquire fixed assets and forecast the amount needed to meet the
working capital requirements in future.
2. Acquiring Necessary Capital
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After deciding the financial requirement, the finance manager should

concentrate how the finance is mobilized and where it will be available. It is also
highly critical in nature.
3. Investment Decision
Thefinancemanagermustcarefullyselectbestinvestmentalternativesandconsider
the reasonable and stable return from the investment. He must be well versed
in the field of capital budgeting techniques to determine the effective utilization
of investment. The finance manager must concentrate to principles of safety,
liquidity and profitability while investing capital.
4. Cash Management
Present days cash management plays a major role in the area of finance because
proper cash management is not only essential for effective utilization of cash
but it also helps to meet the short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing,
production, personel, system, research, development, etc. Finance manager
should have sound knowledge not only in finance related area but also well
versed in other areas. He must maintain a good relationship with all the
functional departments of the business organization.

FINANCE FUNCTION
The Finance Function is a part of financial management. Financial Management
is the activity
concerned with the control and planning of financial resources.
In business, the finance function involves the acquiring and utilization of funds
necessary for
efficient operations. Finance is the lifeblood of business without it things
wouldn’t run smoothly.
It is the source to run any organization, it provides the money, it acquires the
money.

The Finance function has been classified into three:

Long-Term Finance– This includes finance of investment 3 years or more.
Sources of
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long-term finance include owner capital, share capital, long-term loans,

debentures, internal funds and so on.
Medium Term Finance– This is financing done between 1 to 3 years, this can be
sourced from bank loans and financial institutions.
Short Term Finance – This is finance needed below one year. Funds may be
acquired from bank overdrafts, commercial paper, advances from customers,
trade credit etc.

Why a Business Needs The Finance Functions

Helps Establish a Business– Without money, you cannot get labor, land and so
on with the finance function you can determine what is required to start your
business and plan for it.
Helps Run a Business– To remain in business you must cater to the day to day
operating costs such as paying salaries, buying stationery, raw material, the
finance function ensures you always have adequate funds to cater to this.
To Expand, Modernize, Diversify – A business needs to grow otherwise it may
become redundant in no time. With the finance function, you can determine
and acquire the funds required to do so.
Purchase Assets-You need money to purchase assets. This can be tangible assets
like furniture, buildings or intangible like trademarks, patents, etc. to get this
you need finances.Importance of Finance Functions
Identify Need of Finance-To starts a business you need to know how much is
required to open it. So, the finance function helps you know how much the initial
capital is, how much of it you have and how much you need to raise.
Identify Sources of Finance-Once you know what needs to be raised you look at
areas you can raise these funds from. You can borrow or get from various
shareholders.
Comparison of Various Sources of Finance– After identifying various fund
sources compare the cost and risk involved. Then choose the best source of
financing that suits your business needs.
Investment - Once the funds are raised it is time to invest them. Investment
decisions should be done in a manner that a business gets higher returns. Cost
of funds procurement should be lower than the return on investment, this will
show a wise investment was made.
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TYPES OF FINANCE FUNCTIONS

The following explanation will help in understanding each finance function in
detail
Investment Decision
One of the most important finance functions is to intelligently allocate capital to
long term assets.
This activity is also known as capital budgeting. It is important to allocate capital
in those long term assets so as to get maximum yield in future. Following are the
two aspects of investment decision
a. Evaluation of new investment in terms of profitability
b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of

expected return.
Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the
expected return of the prospective investment. Therefore while considering
investment proposal it is important to take into consideration both expected
return and the risk involved.
Investment decision not only involves allocating capital to long term assets but
also involves decisions of using funds which are obtained by selling those assets
which become less profitable and less productive. It wise decisions to
decompose depreciated assets which are not adding value and utilize those
funds in securing other beneficial assets. An opportunity cost of capital needs
to be calculating while dissolving such assets. The correct cut off rate is
calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision
Financial decision is yet another important function which a financial manger
must perform. It is important to make wise decisions about when, where and
how should a business acquire funds.
Funds can be acquired through many ways and channels. Broadly speaking a
correct ratio of an equity and debt has to be maintained. This mix of equity
capital and debt is known as a firm’s capital structure.
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A firm tends to benefit most when the market value of a company’s share
maximizes this not only is a sign of growth for the firm but also maximizes
shareholders wealth. On the other hand the use of debt affects the risk and
return of a shareholder. It is more risky though it may increase the return on
equity funds.
A sound financial structure is said to be one which aims at maximizing
shareholders return with minimum risk. In such a scenario the market value of
the firm will maximize and hence an optimum capital structure would be
achieved. Other than equity and debt there are several other tools which are
used in deciding a firm capital structure.

Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the
key function a financial manger performs in case of profitability is to decide
whether to distribute all the profits to the shareholder or retain all the profits or
distribute part of the profits to the shareholder and retain the other half in the
business.
It’s the financial manager’s responsibility to decide a optimum dividend policy
which maximizes the market value of the firm. Hence an optimum dividend
payout ratio is calculated. It is a common practice to pay regular dividends in
case of profitability Another way is to issue bonus shares to existing
shareholders.

Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency.
Firm’s
profitability, liquidity and risk all are associated with the investment in current
assets. In order to maintain a tradeoff between profitability and liquidity it is
important to invest sufficient funds in current assets. But since current assets do
not earn anything for business therefore a proper calculation must be done
before investing in current assets.
Current assets should properly be valued and disposed of from time to time once
they become non profitable. Currents assets must be used in times of liquidity
problems and times of insolvency.
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Organization of the Finance Functions

Today, finance function has obtained the status of a science and an art. As
finance function has far reaching significance in overall management process,
structural organization for further function becomes an outcome of an
important organization problem. The ultimate responsibility of carrying out the
finance function lies with the top management. However, organization of
finance function differs from company to company depending on their
respective requirements.
In many organizations one can note different layers among the finance
executives such as Assistant Manager (Finance), Deputy Manager (Finance) and
General Manager (Finance). The designations given to the executives are
different. They are
1. Chief Finance Officer (CFO)
2. Vice-President (Finance)
3. Financial Controller
4. General Manager (Finance)
5. Finance Officers

Treasurers and controllers

Treasurers and controllers both serve important financial functions within a
company, but their responsibilities are quite different. Financial controllers head
the accounting department, in a way, since they supervise the accountants and
manage the books of the company. They make sure that the financial reports
are done in a timely and proper manner for the management’s review.
Treasurers, on the other hand, are essentially financial advisors to their
management. They look into the economic atmosphere of the industry and
advise management on the proper way to handle possible economic changes.

WHAT ARE THE FUNCTIONS OF A CONTROLLER?

A controller is in charge of the company’s accountants. They are the highest in
the food chain, as far as accounting goes. A financial controller is in charge of
supervising the preparation of financial reports and presenting them to
management. In some governmental organizations, a controller is also known
as a financial comptroller.
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A controller reports to the chief financial officer (if the company has one),
formulates policies for the company and oversees the audit, budget and
accounting departments in their company.

WHAT IS THE ROLE OF A TREASURER?

While the controller is in charge of the accounting department, the treasurer
oversees the finance department. In some companies, controllers can be
referred to as the vice president of finance.
Their main responsibility is to help their company grow its funds and invest the
money they have wisely.
The treasurer is the person who helps the company grow its revenue. He or she
builds and nurtures relationships with banks and investment companies so that
they know where the best place is to invest the company’s money.

RISK-RETURN TRADEOFF
The risk-return trade off states that the potential return rises with an increase
in risk. Using this principle, individuals associate low levels of uncertainty with
low potential returns, and high levels of uncertainty or risk with high potential
returns. According to the risk-return trade off, invested money can render
higher profits only if the investor will accept a higher possibility of losses.
Understanding Risk-Return Trade off
The risk-return trade off is the trading principle that links high risk with high
reward. The appropriate risk-return trade off depends on a variety of factors
including an investor’s risk tolerance, the investor’s years to retirement and the
potential to replace lost funds. Time also plays an essential role in determining
a portfolio with the appropriate levels of risk and reward.
For example, if an investor has the ability to invest in equities over the long term,
that provides the investor with the potential to recover from the risks of bear
markets and participate in bull markets, while if an investor can only invest in a
short time frame, the same equities have a higher risk proposition.
Investors use the risk-return trade off as one of the essential components of
each investment decision, as well as to assess their portfolios as a whole. At the
portfolio level, the risk-return trade off can include assessments of the
concentration or the diversity of holdings and whether the mix presents too
much risk or a lower-than-desired potential for returns.
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 The risk-return trade off is an investment principle that indicates that the
higher the risk, the higher the potential reward.
 To calculate an appropriate risk-return trade off, investors must consider
many factors, including overall risk tolerance, the potential to replace lost
funds and more.
 Investors consider the risk-return trade off on individual investments and
across portfolios when making investment decisions.

TIME VALUE OF MONEY

The time value of money (TVM) is the concept that a sum of money is worth
more now than the same sum will be at a future date due to its earnings
potential in the interim. This is a core principle of finance. A sum of money in
the hand has greater value than the same sum to be paid in the future.
The time value of money is one of the basic theories of financial management,
it states that ‘the value of money you have now is greater than a reliable promise
to receive the same amount of money at a future date’.

REASONS FOR TIME VALUE OF MONEY

Risk and Uncertainty: Future is always uncertain and risky. Outflow of cash is in
our control as payments to parties are made by us. There is no certainty for
future cash inflows. As an individual or firm is not certain about future cash
receipts, it prefers receiving cash now.
Following this, Rs 1 now is certain, whereas Rs 1 receivable tomorrow is less
certain. This principle is also referred as bird- in- the- hand.
Inflation: In an inflationary economy, the money received today has more
purchasing power than the money to be received in future. In other words, a
rupee today represents a greater real purchasing power than a rupee at later
period.
Consumption: Individuals generally prefer current consumption to future
consumption. Thus, individuals give more value to the received money today as
compared to be received in future.
Investment opportunities: An investor can profitably employ a rupee received
today to give him a higher value to be received tomorrow or after a certain
period of time. For example, an investor can deposit Rs 1000/- in the Bank and
can earn 8% return after a fixed period say one year.
 Department of Management Studies, BSAITM

APPLICATION OF TIME VALUE OF MONEY

1. Sinking Fund Problems:
A financial manager may have to determine the amount of annual payments so
as to accumulate a specified sum of money on a future date to redeem an
existing liability or provide funds for replacement of an existing asset.
2. Capital Recovery Problems:
A financial manager may also be interested to know the amount of equal
instalment to be paid every year to discharge a specified amount of loan raised
from some financial institution at a given rate of interest and in a fixed period
3. Compound Growth Rate Problems:
Sometimes a finance manager may have to calculate the compound rate of
growth over a period of time, e.g.; for sales or profits. He can easily calculate
such compound rate of growth by making use of Compound Factor Tables
4. Interest Rate Problems:
The time value techniques of compounding and present value can also be
applied to calculate the implicit rate of interest in certain situations,
5. Valuation Problems:
The techniques of time value of money are also applied in dealing with the
valuation problems of bonds, debentures, etc.

TECHNIQUES OF TIME VALUE OF MONEY

The preceding discussion has revealed that in order to have logical and
meaningful comparisons between cash flows that result in different time
periods it is necessary to convert the sums of money to a common point in time.
There are two approaches for adjusting time value of money. These are:
1.Compounding Techniques/Future Value Techniques
2.Discounting/Present Value Techniques

COMPOUNDING TECHNIQUES/FUTURE VALUE TECHNIQUES

Compounding techniques are used to calculate the future value of present cash
flows. This concept is based on the principle of compound interest. Under this
principle, the interest earned on the initial principal amount becomes a part of
the principal at the end of the compounding period.
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Calculation of Future Value

To know the future value of a sum, the principle of compounding is used.
Essentially, practical problem related to present value calculation can be
categories as follow:
 Future Value of a Single Amount
 Future Value of a Series of Payment
 Future Value of an Annuity

Future Value of a Single Amount

The Future value (FV) of an investment with compound interest i earned in a
given period of n number of years can be calculated using the compound
interest principle.
A generalized procedure for calculating the future value of a single amount
compounded annually is as follows :
FVn = PV (1 + r)(n)
Where, FVn = Future value of the initial flow n year hence
PV = Initial cash flow
r = Annual rate of Interest
n = number of years
By considering the above example , we get the same result.
FVn = PV (1 + r)(n)
= 1,000 (1.10)(3), FVn = 1331
Multiple Compounding Periods: Interest can be compounded monthly, quarterly
and half yearly. If compounding is quarterly, annual interest rate is to be divided
by 4 and the number of years is to be multiplied by 4. Similarly, if monthly
compounding is to be made, annual interest rate is to be divided by 12 and
number of years is to be multiplied by 12.
The formula to calculate the compound value is
Fvn = Pv (1+ r/m)mn
Where,
FVn = Future value after ‘n’ years
PV = Present value of cash flow today
r = Interest rate per annum
m = Number of times compounding is done during a year
n = Number of years for which compounding is done
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Future Value of a Series of Payment

So far we have considered only the future value of a single payment at time zero.
In many instance, we may be interested in the future value of a series of
payments made at different time periods.
Future Value of an Annuity
An annuity is defined as a series of equal payments (fixed) or receipts that occur
at evenly spaced intervals. Lease and rental payments are examples. The
payments or receipts occur at the end of each period for an annuity.
The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of
expected or promised future payments will grow to after a given number of
periods at a specific compounded interest.

Discounting/Present Value Techniques

In the above section, we have discussed how compounding techniques can be
used to adjust the time value of money and helps in determining the future value
of an investment decision. The concept of present value is exactly opposite of
that of compound value (future value).
The present value of a future cash inflow or outflow is the amount of current
cash that is of equivalent value to the decision maker. The present value is
always less than or equal to the future value because money has interest-
earning potential.

Calculation of Present Value

Practical problem related to present value calculation can be categories as
follow
Present value of a single cash flow
We will first look at discounting a single cash flow or amount. The cash flow can
be discounted back to a present value by using a discount rate that accounts for
the factors mentioned above (present consumption preference, risk, and
inflation).
Conversely, cash flows in the present can be compounded to arrive at an
expected future cash flow.
The present value of a single cash flow can be written as follows:
PV = FVn / (1 + i)n
 Department of Management Studies, BSAITM

Where:
PV = the present value (or initial principal)
FVn =future value at the end of n periods
i = the interest rate paid each period
n = the number of periods

Present Value of a Series of Cash Flows

Till we have considered only the present value of a single receipt at some future
date. In many situations, especially in capital budgeting decision, we may be
interest in the present value of a series of receipts receiving by a firm at a
different time period.
For calculating present value of series of cash flow we need to determine the
present value of each future payment and then aggregates them to find the total
present value.

where,
PV = Present Value of a series of cash flow
C1, C2, C3, Cn = Cash flow in time records, 1,2,3 and n year.
i = rate of Interest for each year
t = number of year extending fram year 1 to n.
Present Value of an Annuity
As discussed earlier, an annuity is a series of equal payments or receipts that
occur at evenly spaced intervals. Lease and rental payments are examples. The
payments or receipts occur at the end of each period.
The present value (PV) of an annuity can be calculated by discounting each
periodic payment separately to the starting point and then adding up all the
discounted figures.
 Department of Management Studies, BSAITM

UNIT- 2
INVESTMENT DECISIONS
Investment decisions concerned with the allocation of funds into different
investment opportunities for the purpose of earning the highest possible return.
It simply assists firms in selecting the right type of assets for deploying their
funds. These decisions are taken by the investor or top-level managers who
properly analyses each opportunity before investing any fund into them.
Investment decisions are crucial decisions for every organization as it
determines its profitability. It should be ensured that a proper study is done
regarding the risk and return before committing any capital into available
investment avenues.
Investment decisions are of two types:
Long term and short-term investment decisions.
Long term investment decisions are concerned with the investment of funds in
long term assets and are termed as Capital budgeting.
Whereas, short term decisions relate to investment in short term assets which
is also called working capital management.

NATURE / IMPORTANCE OF INVESTMENT DECISIONS

1. Require Huge Funds: Investment decisions requires a large amount of funds
to be deployed by firm for earning profits. These decisions are very imperative
and requires due attentions as firms have limited funds but the demand for the
funds is excessive.
Every firm should necessarily plan its investment programmes and control its
expenditures.
2. High Degree of Risk: These decisions involve a high amount of risk as they are
taken on the basis of estimated return. Large funds are invested for earning
income in future which
is totally uncertain. This return fluctuates with the changes in fashion, taste,
research and technological advancement thereby leading to a greater risk.
3. Long Term Effect: Investment decisions have a long-lasting effect on future
profitability and growth of firm. These decisions decide the position of a firm in
future. Any wrong decision may have very adverse effects on return of an
organization and may even endanger its survival. Whereas, right decision taken
brings good returns for firm leading to better growth.
 Department of Management Studies, BSAITM

4. Irreversibility: Decisions related to investment are mostly irreversible in

nature. It is quite difficult to revert back from decisions once taken related to
the acquisition of permanent assets. Disposing off these high value assets will
cause heavy losses to firm.
5. Impacts Cost Structure: Investment decisions widely impacts the cost
structure of an organization. Firms by taking these decisions commit themselves
to various fixed cost such as interest, rent, insurance, supervision etc. for the
sake of earning profits. If these investments do not provide the anticipated
return, then firm overall cost will raise thereby causing losses.
6. Long term Commitment of Funds: Funds are deployed for a longer term by
organisations through these decisions. Firm deployed high amount of capital for
long period on permanent basis. Financial risk in investment decisions increases
due to long term commitment of funds. A firm should properly plan and monitor
all of its capital expenditures.
7. Complexity: Investment decision are most complex decisions as they are
based on future events which is totally uncertain. Future cash flows of an
investment cannot be estimated accurately as they are influenced by changes
in economic, social, political and technological factors. Therefore, uncertainty of
future conditions makes it difficult to accurately predict the future returns.

Scope of Investment Decisions

1. Selection of Right Assets: Investment decisions help in choosing right type of
investment plan for deploying the funds. Each of available opportunity is
properly analyzed by management while taking investment decisions. This way
every aspect of asset available for investment is taken into consideration which
leads to building up a strong portfolio.
2. Identify Degree of Risk: These decisions help in identifying the level of risk
associated with an investment opportunity. Decisions are taken on the basis of
expected return and risk required for earning such return. Managers properly
evaluate assets using various tools for finding out the risk while taking
investment decisions.
3. Determines firm Profitability: Decisions regarding investment plans
determines the future profit earning potential of a firm. A right decision may
bring large amount of funds to an organization leading to better growth.
 Department of Management Studies, BSAITM

Whereas, any wrong decision regarding deployment of funds may cause heavy
losses and even adversely affect the continuity of firm.
4. Enhance Financial Understanding: Investment decisions imparts large
amount of beneficial financial knowledge to individuals taking these decisions.
Investors while choosing the asset uses a variety of tools and techniques for
analysing its profitability. It provides a lot of information which enhances the
overall financial knowledge and enables investors in taking rational decisions
regarding investment.
5. National Importance: These decisions are of national importance for a nation
as it leads to overall development and growth. Investment decisions taken
determines the level of employment, economic growth and economic activities
in a country. More amount of investment creates better supply of funds in an
economy which increase the pace of overall economic development.

INVESTMENT CRITERIA
Investment criteria are the defined set of parameters used by financial and
strategic buyers to assess an acquisition target.
Within financial theory and practice, there are used five main criteria for
selecting investment projects: the net present value (NPV) criterion, the internal
rate of return (IRR) criterion, the return term (RT) criterion, the profitability ratio
(PR) criterion and the supplementary return (SR) criterion

CAPITAL BUDGETING
Capital Budgeting refers to the investment decisions in capital expenditure
incurred by which the benefits are received after one year. Capital expenditure
is the expenditure which is occurred in the present time but the benefits of this
expenditure or investment are received in future. Capital expenditure is incurred
on the fixed assets to acquire them or to improve them which gives benefits
over a period of time. Capital Budgeting involves the planning and controlling of
investment of funds which are to be invested in the capital assets as capital
expenditure. It is a process of deciding whether to invest or not in a long-term
investment whose returns are realized after five or ten years or more.

NATURE OF CAPITAL BUDGETING

 Department of Management Studies, BSAITM

Long Term Effect - Capital budgeting is a long-term process, the long-term

investment can give favourable returns or negative returns over a period of
time. Future of the company is based on the investment. the future of the
company depends on the return on the short-term investment, it can help in the
growth of the firm and the wrong decision can endanger the survival of the firm.

High Degree Of Risk - There is a high degree of risk in long-term investment as

the decision is based on the estimated returns in the future. In the modern era
fashion, taste and preference lead to high risk as the customers can switch from
the product in this long-term. The company has to think about the future needs
and wants of the customers to obtain gains.

Huge Funds - Huge funds are to be invested in the capital budgeting, long-term
assets are purchased for a longer period of time. Large amount of funds is
required and there is a high risk in taking decision that where the funds are to
be invested as mentioned above the capital budgeting can lead to growth of
company and can also become the reason of downfall of the company that’s
why the decision should be taken after proper analysis.

Irreversible Decision - The long-term decision making is irreversible in most of

the cases, it is a long-term process and the decision once taken has a huge
investment invested in it as capital expenditure.
The company can not reverse it back easily because of high investment of funds.
The sale of high-value assets is not easy, there is a problem in selling assets of
high value in the market.

Impact Competitive Strength - The future competitive strength of the firm is

also based on the future decisions. The future profit of the firm is determined
by the decision which has been taken in the present and the cost of the product
is also defined by the decisions. If the decision is in favour then the firm can sell
the product at a higher price than the competition in the market and vice-Versa.

Impact On Cost Structure - Cost structure is affected by the vital decisions, the
firm has to fix the costs of the supervision, insurance, interest etc. If the
investment does not generate returns then the profitability of the firm is
 Department of Management Studies, BSAITM

affected. Future profitability of the company totally depends on the cost

structure.

Scope of Capital Budgeting

Use Of Machinery - Due to advancements in technology Human are replaced by
the machinery in production. These types of machinery can produce products at
a cheaper rate. Capital budgeting helps in finding out the cost to acquire the
machinery.
Decision Making - Capital budgeting helps in deciding whether to buy or lease a
Machinery for production and Decision to replace old machinery with new.
Other decisions are also made with information through capital budgeting.
Increase Profits - Capital Budgeting directly influences the profitability of the
business. It Help in reducing the cost of operations to business by taking decision
for long term capital. It helps to provide proper information about current
expenditure and future benefit, that saves the unnecessary expenses.
Improves Performance - Capital Budgeting has an effective role in accelerating
the overall performance of business organizations. By providing the long term
assets by acquiring Plant and machinery that Improves the Performance of the
production department.
Selection Of Machinery - Various types of machines are available in the market
for production. The cost of the machine is different based on their capacity.
Capital Budgeting helps in deciding which one to buy for our organization.

Techniques of Capital Budgeting

Payback Period
Payback period is the most common and easiest technique of capital budgeting
process. This method measures how long will a project take to generate cash to
recover the initial investment value. It does not consider the time value of
money and cash flow are not discounted in this method.
Payback period method gives preference to the project having a shorter payback
period means the one which is able to recover the initial investment made in
short time. It pays to focus on cash flows, the investment made and economic
life of the project to find out the best earning capacity project. If the project
undertaken generates constant return, then the payback period can be simply
computed by dividing total cash outflow by annual cash inflow of project.
 Department of Management Studies, BSAITM

Payback period = Cash outlay (Investment)/Annual cash inflow Merits of Pay-

back Method:

The various merits of pay back methods are as follows:

i) Easy to Calculate: This method is easy to calculate and simple to understand.
ii) Cost less method: It is preferred by executives who like snap answers. Other
sophisticated techniques which require a lot of analysis time and the use of
computers.
iii) It stresses the liquidity objective: The management may like to use payback
method to emphasise those proposals which produce an early return of liquid
funds.
iv) It reduces the possibility of loss through obsolescence: This method does not
permit projection of annual cash inflows beyond a limited period. In this way, it
reduces the possibility loss through obsolescence.

Limitations of Payback Method

The payback method suffers from the following limitations:
i) Ignores the annual cash inflows: This system completely ignores the annual
cash inflows after the payback period.
ii) It considers only payback period: This system considers only the period of
pay back, does not consider the pattern of cash inflows i.e. the magnitude and
timing of cash inflows.
iii) Cost of Capital: Interest factor which is an important consideration in making
a sound investment decision, is overlooked by this method.
iv) It is delicate and rigid: A slight change in operation cost will affect the cash
inflows and such pay-back period shall also be affected.
v) Ignorance of profitability: Under this method the profitability of the project
is completely ignored.

Net Present Value Method

Net present value method of capital budgeting considers the time value of
money. It discounts all cash inflows and cash outflows of the project using the
cost of capital as the discounting factor. It compares the presented value of all
cash inflows and cash outflows of the project and where the difference is
maximum in the positive sense that the project is given preference. Higher the
 Department of Management Studies, BSAITM

present cash inflows from cash outflows higher will be NPV which means the
project is profitable. The difficult task in this method is understanding the
concept of a firm’s cost of capital used as a discounting factor. Net Present value
is simply calculated as –
Net present value = Present value of inflow – Present value of outflow

Merits of Net present value method

1) Net present value method recognises the time value of money.
2) It considers all cash flows over the entire life of the project in its calculations.
3) It consists of the objective of maximising the welfare of the owners.

Limitations of Net present value method Its limitations are as follows:

1) It is difficult to use.
2) It may not give satisfactory answer when the projects being compared involve
different amounts of investment.
3) It may mislead when dealing with alternative projects.

Accounting Rate of Return Method

Accounting rate of return method uses the information provided by financial
statements in judging the profitability of the investment proposal. It is simply a
financial ratio which evaluates the profit potential of a proposal.
It judges the profitability of the project by dividing the total net income of the
project with its average or initial investment. It does not consider the time value
of money nor does it focus on the length of life of the project. Accounting rate
of return is calculated by the following formula:
Accounting rate of return = Average income/ Average investment

Merits of the accounting rate of return method:

1) It is very simple to understand and use.
2) Rate of return may readily be calculated with the help of accounting data.
3) This method gives due weightage to profitability of the project if based on
average rate of return. Projects having a higher rate of return will be acceptable
and are comparable with the returns on similar investment desired by the other
firms.
 Department of Management Studies, BSAITM

4) It takes investment and the total earnings from the project during its lifetime
into consideration.

Demerits: The method suffers from the following weakness:

1) It uses accounting profits and not the cash inflows in appraising the projects.
2) It ignores the time value of money which is an important factor in capital
expenditure decisions. Profits accruing in different periods are valued equally.
3) It considers only the rate of return and not the length of project lives.
4) The method ignores the fact that profit can be reinvested, which in turn, will
affect the rate of return.
5) The method does not determine the fair rate of return on investment.
6) It is incompatible with the firm’s objective of maximising the market value of
shares, share value does not depend upon accounting rates.

Internal Rate of Return

Internal rate of return method is one of the most complex methods of capital
budgeting involving various computations. This method equates the discounted
cash inflow value with discounted cash outflow value of an investment. It aims
to arrive at a rate of interest at which the Net present value of the investment
is zero. It is termed as an internal rate because it does not depend on any rate
determined outside the investment but only with the outlay and proceeds
associated with the project.
Calculation of IRR involves the following step – Finding out positive net present
value, finding out the negative net present value and finding out the internal
rate of return .
Internal rate of return = [Lower rate + (Positive NPV / Diff. in positive & negative
NPV)] × DP
DP refers to the difference in the percentage of positive and negative NPV
Lower rate is the rate at which NPV is greater than Zero or NPV is positive

Merits of Internal Rate of Return (IRR) method Internal Rate of Return method
possesses the following merits:
1) Like the Net present value method, it considers the time value of money.
2) It considers cash flows over the entire life of the project.
 Department of Management Studies, BSAITM

3) The percentage figure calculated under this method is more meaningful and
acceptable, because it satisfies in terms of the rate of return on capital.
4) This method suggests the maximum rate of return and gives a fairly good idea
regarding the profitability of the project, even in the absence of the firm’s cost
of capital.
5) It is also compatible with the firm’s maximising owner’s welfare.

Limitations of Internal Rate of Return (IRR) method

1) It is difficult to understand and involves complicated computation problems.
2) It may not give a unique answer in all situations. It may yield a negative rate
or multiple rates under certain circumstances.
3) It may yield results inconsistent with the NPV method, if the project differs in
their expected lives or cash outlays, timing of cash flows.
4) It implies that the intermediate cash inflows generated by the project are
reinvested, at the internal rate of the project, whereas the NPV method implies
that cash inflows are reinvested at the firm’s cost of capital. The latter
assumption seems to be more appropriate.

Profitability Index
It is a method in which NPV is used as a basis of calculation and calculations are
expressed in percentage. Profitability index method is also known as a value
investment ratio or profit investment ratio. This method analyses the project by
evaluating the relationship between the costs associated with the project and
its future anticipated benefits.
It is simply the ratio between the present value of cash inflows and the present
value of cash outflows. If the profitability index is lower than 1.0 than it means
that the present value of cash inflows is lower than the initial investment cost.
Whereas if it is more than 1.0 than the project is considered as worthy and
acceptable.
Profitability Index = Present value of cash inflow / Initial Investment

Advantages or Importance of Capital budgeting

Evaluates Investment Plans - Capital budgeting is a key tool used by
management for the evaluation of investment projects. It assists in taking
decisions regarding long term investments by properly analyzing investment
 Department of Management Studies, BSAITM

opportunities. Using the capital budgeting techniques-risk, return and

investment amount of each project is examined.
Identify Risk - It enables in identifying the risk associated with investment plans.
Capital budgeting examines the project from different aspects to find out all
possible losses and risks. It studies how these risks affect the return and growth
of the business which are helpful in making an appropriate decision.
Chooses Investment Wisely - Capital budgeting plays an effective role in
selecting a profitable investment project for the business. It is the one that
decides whether a particular project is beneficial to take or not. This technique
considers cash flows of investment proposal during its entire life for finding out
its profitability. Companies are able to choose investment wisely by analyzing
different factors in a competitive market using capital budgeting techniques.
Avoid Over And Under Investment = Managers use capital budgeting
techniques to determine the appropriate investment amount for the business.
The right amount of investment is a must for every business for earning better
returns and avoiding losses. Capital budgeting analyses the firm capability and
objectives for determining the right investment accordingly.

Maximize Shareholder’s Wealth - Capital budgeting assists in maximizing the

overall value of shareholders. It is a tool that enables companies to deploy their
funds in the most effective way possible thereby earning huge profits.
Companies are able to select investments with higher returns and lower costs
which eventually raises the shareholder’s wealth.
Control Project Expenditure - Capital budgeting focuses on minimizing the
expenditure of investment projects. While examining the investment proposals,
it ensures that the project has an adequate amount of inflows for meeting out
its expenses and provide an anticipated return. The selection of effective
investment projects helps companies in controlling their expenditure and
earning better profits.

Disadvantages or limitations of Capital Budgeting

Irreversible Decisions - The major limitation with capital budgeting is that the
decisions taken through this process are long-term and irreversible in nature.
Decisions have an impact on the long term durability of the company and require
 Department of Management Studies, BSAITM

the utmost care while taking them. Any wrong capital budgeting decision would
have an adverse effect on profitability and continuity of business.
Rely On Assumptions - And Estimations Capital budgeting techniques rely on
different assumptions and estimations for analyzing investment projects.
Annual cash flow and life of project estimated is not always true and may
increase or decrease than the anticipated values. Decisions taken on the basis
of these untrue estimations may lead businesses to losses.
Higher Risk - Capital budgeting decisions are riskier in nature as it involves a
large amount of capital expenditure. These decisions require the utmost care as
it affects the success or failure of every business. Any wrong decisions regarding
allotment of funds may lead the business to substantial losses or eventually
cause a complete shutdown.
Uncertainty - This process is dependent upon futuristic data which is uncertain
for analyzing the investment proposals. Capital budgeting anticipates the future
cash inflows and outflows of the project for determining its profitability. The
future is always uncertain and data may prove untrue which leads to wrong
decisions.
Ignores Non-Financial Aspects - Capital budgeting technique considers only
financial aspects and ignores all non-financial aspects while analyzing the
investment plans. Non-financial factors have an efficient role in the success and
profitability of the project. The real profitability of the project cannot be
determined by ignoring these factors.

COST OF CAPITAL

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

According to the definition of John J. Hampton “ Cost of capital is the rate of

return the firm required from investment in order to increase the value of the
firm in the market place.
 Department of Management Studies, BSAITM

According to the definition of Solomon Ezra, “Cost of capital is the minimum

required rate of earnings or the cut-off rate of capital expenditure”

Common Components of Cost of Capital

Cost of capital is a composite cost of the individual sources of funds including
equity shares, preference shares, debt, and retained earnings. The individual
cost of each source of financing is called a component of the cost of capital. The
overall cost of capital depends on the cost of each source and the proportion of
each source used by the firm. The component of the cost of capital is also known
as the specific cost of capital which includes the individual cost of debt,
preference shares, ordinary shares, and retained earnings. Such components of
the cost of capital have been presented below:

(A) Cost of Debt – Debt may be issued at par, at premium or discount. It may be
perpetual or redeemable. A bond is a long-term debt instrument or security.
Bonds are issued by the Government and the public sector companies. Bonds
issued by the government do not have any risk of default, because it honors the
obligation of its bonds.
 Cost of perpetual or irredeemable debt
 Cost of non-perpetual or redeemable debt
 Cost of debt issued on redeemable condition
 Cost of callable debt.

(B) Cost of Preference Share – The cost of preference share capital is the
dividend expected by its holders. The computation of the cost of preference
capital however poses some conceptual problems. In the case of borrowings,
there is a legal obligation on the firm to pay interest at fixed rates while in the
case of preference shares, there is no such legal obligation. The payment of
preference dividend is not adjusted for taxes as they are paid after taxes and is
not deductible.
 Cost of perpetual preference Share
 Cost of redeemable preference Share
(C) Cost of ordinary/equity shares or common stock – The computation of the
cost of equity capital is a difficult task. Some people argue, as observed in the
 Department of Management Studies, BSAITM

case of preference shares, that the equity capital does not involve any cost. The
cost of equity share may be defined as the minimum rate of return that the
company must earn on that portion of the total capital employed which is
financed by equity capital so that the market price of the share of the company
remains unchanged.

(D) Cost of retained earning – According to this approach, it is the earning per
share which determines the market price of the shares. This is based on the
assumption that the shareholders capitalize on a stream of future earnings in
order to evaluate their shareholdings. A bond is a long-term debt instrument or
security. Bonds are issued by the Government and the public sector companies.
Bonds issued by the government do not have any risk of default, because it
honors the obligation of its bonds.

EXPLICIT COST
Explicit cost refers to all accounting costs which the business incurred in actual
in production and selling of its output and is deducted from total revenue to
derive the accounting profit. Thus the explicit cost is actual expenses directly
incurred by the business, easily identifiable, and are admissible by the business
as the cost of production following the accounting rules followed by it. it is also
known as out of pocket cost. The business incurs a lot of expenses to produce a
product or service. these costs can be broadly classified into the explicit cost (the
one which is incurred by the business) and implicit cost (opportunity cost etc).
Explicit costs are those costs that are easily identifiable, measurable, and can be
validated as well by the business as they are recorded in the books of accounts
of the business. Explicit cost doesn’t leave any room of confusion as these are
real cash outflows and impact business cash flows. Further explicit cost items
are analyzed to understand and take action where necessary to improve the
efficiency of the business.

EXPLICIT COST
Explicit cost refers to all accounting costs which the business incurred in actual
in production and selling of its output and is deducted from total revenue to
derive the accounting profit. Thus the explicit cost is actual expenses directly
incurred by the business, easily identifiable, and are admissible by the business
 Department of Management Studies, BSAITM

as the cost of production following the accounting rules followed by it. it is also
known as out of pocket cost.
The business incurs a lot of expenses to produce a product or service. these costs
can be broadly classified into the explicit cost (the one which is incurred by the
business) and implicit cost (opportunity cost etc).
Explicit costs are those costs that are easily identifiable, measurable, and can be
validated as well by the business as they are recorded in the books of accounts
of the business.
Explicit cost doesn’t leave any room of confusion as these are real cash outflows
and impact business cash flows. Further explicit cost items are analyzed to
understand and take action where necessary to improve the efficiency of the
business.
Examples of Explicit Cost All cost which is directly incurred by the business and
form parts of its book of account is explicit costs. The financial statements which
are analyzed by various stakeholders include all explicit costs incurred by the
business. Let’s understand the explicit cost with the help of an example:
Explicit cost is a tangible cost which is well documented and forms part of
business expenditure. It is a representative of the cost incurred and is tracked
by business to measure its efficiency and efficacy on various business
parameters. Explicit costs are closely tracked by analysts and stakeholders in
measuring business performance.

Uses of Explicit Cost

There are many uses of explicit Cost. Few are enumerated below:
 The first and foremost use of Explicit Cost is to measure the profitability of the
business as this cost is directly adjusted from Revenues to determine Profit.
 It helps in analyzing the long term trend for the business as different cost
trends can be analyzed over a period and projection can be undertaken easily.
 Explicit cost form part of the Income statement. An income statement is
incomplete without Explicit Cost.

Importance of Explicit
Cost Explicit cost is important and an indispensable part of the business. These
costs are accounted for and its importance is well understood. Explicit cost is
accounting costs that involve actual payments made by the business for
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different goods and services which are required in the regular running and
production activities of the business. It is important to note that for measuring
profitability only explicit cost is taken into consideration as the implicit cost is
used for measuring economic profit for the business.

Advantages of Explicit Cost Some of the advantages are:

 Explicit cost is a reliable source of determining business expenses which are
well accounted and included in Income Statement.
 Easily recognizable and can be ascertained in cash leaving no room for
ambiguity in ascertaining the cost.
 Explicit cost is required for computing both accounting profit as well as
economic profit. Even if a business wishes to include opportunity cost for
determining total return they will have to include explicit cost and if they just
want accounting return then also the explicit cost is a must.
 All reporting and recording of costs undertaken by businesses relate to explicit
costs. However, there are other non-cash expenses also which form part of
business expenditure which is not an explicit cost.

How Explicit Cost Differs From Implicit Cost?

Meaning – A. Explicit Cost refers to all direct cash expenses undertaken by the
business which forms part of the income statement. B. Implicit Cost refers to
those costs which cannot be ascertained directly and which are more of an
opportunity cost perspective.
Type of Profit - Explicit Cost is required to be included for computing both
accounting profit as well as economic profit. Implicit Cost is required to be
included for computing both economic profit only and doesn’t form part of
income statement.
Opportunity Cost - Explicit Cost doesn’t involve the concept of opportunity cost.
Implicit Cost is based on the premise of opportunity cost itself.
Rationale - The purpose of including explicit cost is based on the premise that
whatever cost incurred which can be determined and decimated only needs to
be accounted for. The purpose of implicit cost is to include all those expenses
which are not directly determinable; however, all those costs have directly
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contributed revenues for the business and true measure profit will be one which
includes these costs as well. for instance, time spent by promoter using their
expertise, usage of owner premises which otherwise would have been
utilized/rented elsewhere is some examples of implicit cost.

OPPORTUNITY COST
Opportunity cost is commonly defined as the next best alternative. Also, known
as the alternative cost, it is the loss of gain which could have been gained if
another alternative was chosen. It can also be explained as the loss of benefit
due to a change in choice.
Opportunity cost is an economic concept arising out of the realistic assumption
of the scarcity of resources. The limited amount of resources will also limit the
number of possibilities for production. As the number of possibilities of
production is limited, to produce a given combination of goods, the production
of another combination of goods would have to be forgotten. This can be
referred to as opportunity cost.
Opportunity cost is a concept that is widely used by promoters and business
analysts to conduct feasibility studies as well as to ascertain policy decisions to
be taken.

Opportunity Cost is Important Because

1. It's a measure of the cost of alternatives like sacrificing short-term profits
2. It is used to analyze the potential of an opportunity
3. And it can help you determine whether or not a particular course of action is
worth pursuing.
4. It can help you make better decisions
5. It helps to assess opportunity costs and benefits. 6. It encourages you to think
about the future
 Department of Management Studies, BSAITM

UNIT- 3
CAPITAL STRCTURE
Capital structure means the arrangement of capital from different sources so
that the funding needs of the business are satisfied. Different types of capital
impose different types of risks on a company and hence capital structure affects
the value of a company.
For example, if a company has raised funds in the form of equity shares and
bonds, we could say that company’s capital structure includes debt and equity.
Bank loans, retained earnings and working capital might also be part of the
company’s capital structure.

“Capital structure means the type of securities to be issued and proportionate

amounts that make up the capitalisation.” – C W Gerstenberg.

FEATURES OF CAPITAL STRCTURE

(i) Maximum Return: The financial structure of a company should be guided by
clear- cut objective. Its objective can be maximisation of the wealth of the
shareholders or maximisation of return to the shareholders.
(ii) Less Risky: The capital structure should represent a balance between
different types of ownership and debt securities. This is essential to reduce risk
on the use of debt capital.
(iii) Safety: A sound capital structure should ensure safety of investment. It
should be so determined that fluctuations in the earnings of the company do
not have heavy strain on its financial structure.
(iv) Flexibility: A sound capital structure should facilitate expansion and
contraction of funds. The company should be able to procure more capital in
times of need and should be able to pay all its debts when it does not require
funds.
(v) Economy: The capital structure should ensure the minimum costs of capital
which in turn would increase its ability to generate more wealth for the
company.
(vi) Capacity: The financial structure of a company should be d3mamic. It should
be revised periodically depending upon the changes in the business conditions.
If it has surplus funds, the company should have the capacity to repay its debt
and reduce interest obligations.
 Department of Management Studies, BSAITM

(vii) Control: The capital structure of a company should not dilute the control of
equity shareholders of the company. That is why, convertible debentures should
be issued with great caution.

Importance of Capital Structure

1. Increase in value of the firm: A sound capital structure of a company helps to
increase the market price of shares and securities which, in turn, lead to increase
in the value of the firm.
2. Utilisation of available funds: A good capital structure enables a business
enterprise to utilise the available funds fully. A properly designed capital
structure ensures the determination of the financial requirements of the firm
and raise the funds in such proportions from various sources for their best
possible utilisation. A sound capital structure protects the business enterprise
from over-capitalisation and under-capitalisation.
3. Maximisation of return: A sound capital structure enables management to
increase the profits of a company in the form of higher return to the equity
shareholders i.e., increase in earnings per share. This can be done by the
mechanism of trading on equity i.e., it refers to increase in the proportion of
debt capital in the capital structure which is the cheapest source of capital. If the
rate of return on capital employed (i.e., shareholders’ fund + longterm
borrowings) exceeds the fixed rate of interest paid to debt-holders, the
company is said to be trading on equity.
4. Minimisation of cost of capital: A sound capital structure of any business
enterprise maximises shareholders’ wealth through minimisation of the overall
cost of capital. This can also be done by incorporating long-term debt capital in
the capital structure as the cost of debt capital is lower than the cost of equity
or preference share capital since the interest on debt is tax deductible.
5. Solvency or liquidity position: A sound capital structure never allows a
business enterprise to go for too much raising of debt capital because, at the
time of poor earning, the solvency is disturbed for compulsory payment of
interest to .the debt-supplier.
6. Flexibility: A sound capital structure provides a room for expansion or
reduction of debt capital so that, according to changing conditions, adjustment
of capital can be made.
 Department of Management Studies, BSAITM

7. Undisturbed controlling: A good capital structure does not allow the equity
shareholders control on business to be diluted.
8. Minimisation of financial risk: If debt component increases in the capital
structure of a company, the financial risk (i.e., payment of fixed interest charges
and repayment of principal amount of debt in time) will also increase. A sound
capital structure protects a business enterprise from such financial risk through
a judicious mix of debt and equity in the capital structure.

Factors Affecting Capital Structure

Factor # 1. Promoters’ Control: The capital structure will be affected by the
degree of control the promoters wish to have over the company. They may not
issue equity shares beyond a certain number to prevent control by the
shareholders. Thus, they may opt for either a debenture issue or an issue of
preferential shares.
Factor # 2. Capital Market Conditions: The capital market has great influence
on the capital structure of a company. During economic prosperity investors will
readily take up shares. But during times of depressions the equity market may
be sluggish as investors may not be willing to invest in shares that may give them
more of a loss than return. They will instead prefer to invest in debentures and
preference shares which will carry fixed returns.
Factor # 3. Nature of Business: If a business firm deals in goods that are subject
to wide fluctuation in demand, its capital structure will weigh in favour of equity
capital. On the other hand, well established and entrenched companies will have
high gearing, i.e., high debt funds. The newly established companies may not
find investors willing to invest in their debentures and preference shares. They
may have to look elsewhere to satisfy their capital needs.
Factor # 4. Objective of Financing: The capital structure is affected by the
purpose of financing. Fixed investment requires equity financing but medium
term capital needs can be fulfilled by debentures and preference shares.
Factor # 5. Flexibility: Flexibility in capital structure is a great advantage to a
firm. A business organisation should be able to shed off its debt capital as and
when it feels the need. A company can pay off its debenture holders, and thus
get rid of its debts according to its needs. Of course it has to adhere to statutory
requirements; but then a debenture or preferential share is not a lifetime debt
or investment unlike equity shares.
 Department of Management Studies, BSAITM

Factor # 6. Legal Requirements: Countries have their rules and regulations

regarding fund raising by companies and these rules have to be adhered to.
There are rules and regulations regarding debt-equity ratio and ceilings in public
deposits. These have their impact on the capital structure of a company.
Factor # 7. Cost of Financing: The company has to take into consideration the
cost of capital financing. Prevailing rate of interest, return on investment
expected, issue costs, etc. have to be taken into account to arrive at the cost of
financing. The cost of alternative finance must be taken into account. If there is
a high rate of tax then debt financing can be considered.
Factor # 8. Cash Flow: A company has to consider its cash flow position before
deciding on the type of financing because in the case of debentures or long term
debt it will have to pay out interest along with instalments at fixed time intervals.
Factor # 9. Needs of Investors: The capital structure of a company is designed
keeping in mind the potential investors. Equity shares will attract investors that
prefer risks along with a say in the management. However, if investors choose
to avoid risks, the company will prefer preferential shares and debentures
instead.
Factor # 10. Objectives of Financing: This also influences the capital structure of
a company. For medium term finance to serve the purpose of modernisation or
expansion, companies prefer raising debentures and preference shares as these
do not give voting rights. But for permanent investment, companies always
prefer equity shares.

Determinants of Capital Structure

Determinant # 1. Nature of Business: The most important determinant of
capital structure of a company is the nature of the business itself. Businesses
having more risks and unstable income should prefer equity shares. But firms
engaged in public utility services or producing the commodity of basic necessity
may resort to debentures and preference shares.
Determinant # 2. Stability of Earnings: Analysis of determinants of capital
structure revolves principally around the adequacy and stability of earnings.
Sales stability and debt ratios are directly related. The volume, stability and
predictability of earnings determine whether the company can undertake the
fixed obligations of interest on debts and dividend on preference shares, etc.
 Department of Management Studies, BSAITM

With greater stability in sales and earnings, a firm can incur the fixed charges of
debt with less risk.
Determinant # 3. Age of the Company: Since a considerable amount of risk is
involved in starting a new business, its ideal capital structure is one in which
equity share is the only type of security issued. A new company of large size will
have to tap all possible sources of capital to secure requisite quantity of funds.
On the other hand well established companies with stable earnings records are
always in a better position to raise capital from whatever source they like.
Determinant # 4. Rapidity of Growth: The more rapid the expansion, the
greater the need to seek all possible sources of capital, ordinarily, rate of
expansion of business is the greatest at the beginning of the firm’s life, gradually
decreasing as the market’s saturation point is reached.
Determinant # 5. Nature of Investors: Investors are generally of different tastes
and of economic status. Modest investors like debentures or preference shares
while investors interested in speculation prefer equity shares. So, a firm will
have to use a variety of securities in order to appeal to various types of investors.
Determinant # 6. Desire to Retain Control: The desire to retain the voting
control of the company in the hands of a particular limited group may also
influence the pattern of capital structure. In a closely held company, efforts are
made to use debentures and non-voting shares to avoid the sharing of control
with others.
Determinant # 7. Assets Structure: Asset structure also influences the sources
of financing in several ways. Firms with long-lived fixed assets, especially when
demand for their output is relatively assured can use long-term debts. Firms
whose assets are mostly (current) receivables and inventory whose value is
dependent on the continued profitability of the individual firm can rely less or
long-term debt financing and more on short-term funds.
Determinant # 8. Advice Given by Financing Agencies: Such agencies are
specialized in tendering expert financial advice concerning the capital structure
of a firm, their advice should be given due weight in the financial plan of the
concern.
Determinant # 9. Taxation Policy: High corporate tax, high tax on dividend and
capital gain directly influence the capital structure decisions. High tax
discourages the issues of equity shares and encourages issuing more
debentures.
 Department of Management Studies, BSAITM

Determinant # 10. Statutory Requirements: The legal and statutory

requirements of the government also influence the capital structure. For
Example Banking companies are prohibited from issuing any type of security
except equity shares. Similarly, SEBI guidelines on investors’ protection
maintaining debt-equity ratio and current ratio as per norms, promoters’
contribution etc. have direct bearing on capital structure.

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity
financing that helps in maximising the value of a company in the market while
at the same time minimises its cost of capital.
Capital structure varies across industries. For a company involved in mining or
petroleum and oil extraction, a high debt ratio is not suitable, but some
industries like insurance or banking have a high amount of debt as part of their
capital structure.

CAPITAL STRUCTURE THEORIES

1. NET INCOME APPROACH
Durand suggested this approach, and he favored the financial leverage decision.
According to him, a change in financial leverage would lead to a change in the
cost of capital. In short, if the ratio of debt in the capital structure increases, the
weighted average cost of capital decreases, and hence the value of the firm
increases.

Net Income Approach suggests that the value of the firm can be increased by
decreasing the overall cost of capital (WACC) through a higher debt proportion.
There are various theories that propagate the ‘ideal’ capital mix/capital
structure for a firm. Capital structure is the proportion of debt and equity in
which a corporate finances it’s business. The capital structure of a company/firm
plays a very important role in determining the value of a firm.

Durand presented the Net Income Approach. The theory suggests increasing the
firm’s value by decreasing the overall cost of capital which is measured in terms
of the Weighted Average Cost of Capital. This can be done by having a higher
proportion of debt, which is a cheaper finance source than equity finance.
 Department of Management Studies, BSAITM

Weighted Average Cost of Capital (WACC) is the weighted average costs of

equity and debts, where the weights are the amount of capital raised from each
source.

WACC = Required Rate of Return x Amount of Equity + Cost of debt x Amount of

Debt
Or - Total Amount of Capital (Debt + Equity)

According to Net Income Approach, a change in the financial leverage of a firm

will lead to a corresponding change in the Weighted Average Cost of Capital
(WACC) and the company’s value. The Net Income Approach suggests that with
the increase in leverage (proportion of debt), the WACC decreases, and the
firm’s value increases. On the other hand, if there is a decrease in the leverage,
the WACC increases, thereby decreasing the firm’s value

For example, vis-à-vis the equity-debt mix of 50:50, if the equity-debt mix
changes to 20: 80, it would positively impact the value of the business and
increase the value per share.

Assumptions of Net Income Approach

the Net Income Approach makes certain assumptions which are as follows.
 The increase in debt will not affect the confidence levels of the investors.
 There are only two sources of finance; debt and equity. There are no sources
of finance like Preference Share Capital and Retained Earnings.
 All companies have a uniform dividend pay-out ratio; it is 1.
 There is no flotation cost, no transaction cost, and corporate dividend tax.
 Department of Management Studies, BSAITM

 The capital market is perfect; it means information about all companies is

available to all investors, and there are no chances of overpricing or under-
pricing of security. Further, it means that all investors are rational. So, all
investors want to maximize their return by minimizing risk.
 All sources of finance are for infinity. There are no redeemable sources of
finance.

Consider a fictitious company with the below figures—all figures

Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
Cost of Equity = 14%
Calculating the value of a company.

EBIT = 100,000
Less: Interest cost (10% of 300,000) = 30,000
Earnings (since tax is assumed to be absent) = 70,000
Shareholders’ Earnings = 70,000
Market value of Equity (70,000/14%) = 500,000
Market value of Debt = 300,000
Total Market value = 800,000
Overall cost of capital = EBIT/(Total value of the firm) = 100,000/800,000 = 12.5%

Now, assume that the proportion of debt increases from 300,000 to 400,000,
and everything else remains the same.
(EBIT) = 100,000
Less: Interest cost (10% of 400,000) = 40,000
Earnings (since tax is assumed to be absent) = 60,000
Shareholders’ Earnings = 60,000
Market value of Equity (60,000/14%) = 428,570 (approx)
Market value of Debt = 400,000
Total Market value = 828,570
Overall cost of capital = EBIT/(Total value of the firm) = 100,000/828,570 = 12%
(approx)
 Department of Management Studies, BSAITM

As observed, in the case of the Net Income Approach, with an increase in debt
proportion, the total market value of the company increases, and the cost of
capital decreases. The reason for this conclusion is the assumption of the NI
approach that irrespective of debt financing in capital structure, the cost of
equity will remain the same. Further, the cost of debt is always lower than the
cost of equity, so with the increase in debt finance, WACC reduces, and the
firm’s value increases.

2.NET OPERATING INCOME APPROACH

Net Operating Income Approach to capital structure believes that the value of a
firm is not affected by the change of debt component in the capital structure. It
assumes that the benefit that a firm derives by infusion of debt is negated by
the simultaneous increase in the required rate of return by the equity
shareholders. With an increase in debt, the risk associated with the firm, mainly
bankruptcy risk, also increases, and such a risk perception increases the
expectations of the equity shareholders.
A company’s capital structure is a mix/ratio of debt and equity in the company’s
mode of financing. This debt ratio in the capital structure is also known as
financial leverage. Some companies prefer more debt, while others prefer more
equity while financing their assets. The ultimate goal of a company is to
maximize its market value and its profits. In the end, the question that stands in
front is the relation between the capital structure and the value of a firm. This
approach was put forth by Durand and totally differs from the Net Income
Approach. Also famous as the traditional approach, Net Operating Income
Approach suggests that the change in debt of the firm/company or the change
in leverage fails to affect the total value of the firm/company.
As per this approach, the WACC and the total value of a company are
independent of the company’s capital structure decision or financial leverage.
As per this approach, the market value is dependent on the operating income
and the associated business risk of the firm. Both these factors cannot be
impacted by financial leverage. Financial leverage can only impact the share of
income earned by debt holders and equity holders but cannot impact the
operating incomes of the firm. Therefore, a change in the debt to equity ratio
cannot change the firm’s value.
 Department of Management Studies, BSAITM

It further says that with the increase in the debt component of a company, the
company is faced with higher risk. To compensate for that, the equity
shareholders expect more returns. Thus, with an increase in financial leverage,
the cost of equity increases.

Assumptions / Features of Net Operating Income Approach:

1. The overall capitalization rate remains constant irrespective of the degree of
leverage. At a given level of EBIT, the value of the firm would be “EBIT/Overall
capitalization rate.”
2. Value of equity is the difference between total firm value and less value of
debt, i.e., Value of Equity = Total Value of the Firm – Value of Debt.
3. WACC (Weightage Average Cost of Capital) remains constant, and with the
increase in debt, the cost of equity increases. An increase in debt in the capital
structure results in increased risk for shareholders. As compensation for
investing in the highly leveraged company, the shareholders expect higher
returns resulting in a higher cost of equity capital.

Example explaining Net Operating Income Approach to Capital Structure:

Consider a fictitious company with the below figures.
Earnings before Interest Tax (EBIT) = 100,000
Bonds (Debt part) = 300,000
Cost of Bonds issued (Debt) = 10%
WACC = 12.5%
Calculating the value of the company:
Department of Management Studies, BSAITM
 Department of Management Studies, BSAITM

As observed, in the case of the Net Operating Income approach, with the
increase in debt proportion, the total market value of the company remains
unchanged, but the cost of equity increases.

Modigliani and Miller Approach

The Modigliani and Miller approach to capital theory, devised in the 1950s,
advocates the capital structure irrelevancy theory. This suggests that the
valuation of a firm is irrelevant to a company’s capital structure. Whether a firm
is high on leverage or has a lower debt component has no bearing on its market
value. Instead, the market value of a firm is solely dependent on the operating
profits of the company.

A company’s capital structure is the way a company finances its assets. A

company can finance its operations by either equity or different combinations
of debt and equity. A company’s capital structure can have a majority of the debt
component. Or a majority of equity or an even mix of debt and equity. Each
approach has its own set of advantages and disadvantages. There are various
 Department of Management Studies, BSAITM

capital structure theories that attempt to establish a relationship between the

financial leverage of a company (the proportion of debt in the company’s capital
structure) with its market value. One such approach is the Modigliani and Miller
Approach. Modigliani and Miller’s Approach Modigliani and Miller devised this
approach during the 1950s. The fundamentals of the Modigliani and Miller
Approach resemble that of the Net Operating Income Approach. Modigliani and
Miller advocate capital structure irrelevancy theory, which suggests that the
valuation of a firm is irrelevant to a company’s capital structure. Whether a firm
is high on leverage or has a lower debt component in the financing mix has no
bearing on the value of a firm.

The Modigliani and Miller Approach further state that the operating income
affects the firm’s market value, apart from the risk involved in the investment.
The theory states that the firm’s value is not dependent on the choice of capital
structure or financing decisions of the firm.

Assumptions of Modigliani and Miller Approach

 There are no taxes.
 Transaction cost for buying and selling securities, as well as the bankruptcy
cost, is nil.
 There is a symmetry of information. This means that an investor will have
access to the same information that a corporation would, and investors will thus
behave rationally.
 The cost of borrowing is the same for investors and companies.
 There is no floatation cost, such as an underwriting commission, payment to
merchant bankers, advertisement expenses, etc.
 There is no corporate dividend tax.

The Modigliani and Miller Approach indicates that the value of a leveraged firm
(a firm that has a mix of debt and equity) is the same as the value of an
unleveraged firm (a firm wholly financed by equity). Suppose the operating
profits and future prospects are the same. If an investor purchases shares of a
leveraged firm, it would cost him the same as buying the shares of an
unleveraged firm.
 Department of Management Studies, BSAITM

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1 With the above assumptions of “no taxes,” the capital structure
does not influence the valuation of a firm. In other words, leveraging the
company does not increase the company’s market value. It also suggests that
debt holders in the company and equity shareholders have the same priority,
i.e., earnings are equally split amongst them.

Proposition 2 It says that financial leverage is directly proportional to the cost

of equity. With an increase in the debt component, the equity shareholders
perceive a higher risk to the company. Hence, in return, the shareholders expect
a higher return, thereby increasing the cost of equity. A key distinction here is
that Proposition 2 assumes that debt shareholders have the upper hand as far
as the claim on earnings is concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off

Theory of Leverage) The Modigliani and Miller Approach assumes that there are
no taxes, but in the real world, this is far from the truth. Most countries, if not
all, tax companies. This theory recognizes the tax benefits accrued by interest
payments. The interest paid on borrowed funds is tax-deductible. However, the
same is not the case with dividends paid on equity. In other words, the actual
cost of debt is less than the nominal cost of debt due to tax benefits. The trade-
off theory advocates that a company can capitalize on its requirements with
debts as long as the cost of distress, i.e., the cost of bankruptcy, exceeds the
value of the tax benefits. Thus, until a given threshold value, the increased debts
will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus
infers that a change in the debt-equity ratio affects the WACC (Weighted
Average Cost of Capital). This means that the higher the debt, the lower the
WACC. The Modigliani and Miller approach is one of the modern approaches of
Capital Structure Theory.

Capital Structure Theory – Traditional Approach

The traditional approach to capital structure suggests an optimal debt to equity
ratio where the overall cost of capital is the minimum and the firm’s market
 Department of Management Studies, BSAITM

value is the maximum. On either side of this point, changes in the financing mix
can bring positive change to the firm’s value. Before this point, the marginal cost
of debt is less than the cost of equity, and after this point, vice-versa.
Capital Structure Theories and their different approaches put forth the
relationship between the proportion of debt in the financing of a company’s
assets, the weighted average cost of capital (WACC), and the company’s market
value. While the Net Income Approach and Net Operating Income Approach are
the two extremes, the traditional approach, advocated by Ezta Solomon and
Fred Weston, is a midway approach, also known as the “intermediate
approach.” Traditional Approach to Capital Structure:

The traditional approach to capital structure advocates that there is a right

combination of equity and debt in the capital structure, at which the market
value of a firm is maximum. As per this approach, debt should exist in the capital
structure only up to a specific point, beyond which any increase in leverage
would result in a reduction in the value of the firm.
It means that there exists an optimum value of debt to equity ratio at which the
WACC is the lowest and the firm’s market value is the highest. Once the firm
crosses that optimum value of debt to equity ratio, the cost of equity rises to
give a detrimental effect on the WACC. Above the threshold, the WACC
increases, and the firm’s market value starts a downward movement.

Assumptions under Traditional Approach:

 Department of Management Studies, BSAITM

1. The interest rate on the debt remains constant for a certain period, and after
that, it increases with an increase in leverage.
2. The expected rate by equity shareholders remains constant or increases
gradually. After that, the equity shareholders start perceiving a financial risk,
and then from the optimal point, the expected rate increases speedily.
3. As a result of the activity of rate of interest and expected rate of return, the
WACC first decreases and then increases. The lowest point on the curve is
optimal capital structure.
4. Example Explaining Traditional Approach:
5. Consider a fictitious company with the following data.

From case 1 to case 3, the company increases its financial leverage, and as a
result, the debt increases from 10% to 50%, and equity decreases from 90% to
50%. The cost of debt and equity also rises, as stated in the table above, because
of the company’s higher exposure to risk. The new WACC is decreased from
16.3% to 15.5%.
As observed, with the increase in the company’s financial leverage, the overall
cost of capital reduces, despite the individual increases in the cost of debt and
equity, respectively. The reason is that debt is a cheaper source of finance.

LEVERAGE
Leverage is a practice that can help a business drive up its gains/losses. In
business language, if a firm has fixed expenses in the P/L account or debt in
 Department of Management Studies, BSAITM

Capital Structure, the firm is said to be levered. Nowadays, almost no business

is away from it, but very few have struck a balance.

In finance, leverage is very closely related to fixed expenses. We can safely state
that by introducing expenses that are fixed in nature, we are leveraging a firm.
By fixed expenses, we refer to the expenses, the amount of which remains
unchanged irrespective of the business’s activity. For example, an amount of
investment made in fixed assets or interest paid on loans does not change with
a normal change in the number of sales. Neither do they decrease with a
decrease in sales, nor do they increase with an increase in sales.

Advantages of Higher Leverage

Take OL, and the operating profits can see a sharp increase with a slight change
in sales as most parts of the expenses are stagnant and cannot further increase
with sales.

Likewise, if we consider FL, the earnings share of each shareholder will increase
significantly with an increase in operating profits. Here, the higher the degree of
leverage, the higher will be the percentage increase in operating profits and
earnings per share.

Disadvantages of Higher Leverage

It the risk of bankruptcy along with it. In the case of operating leverage, fixed
expenses extend the break-even point for a business. Break-even means the
minimum activity (sales) required for achieving a no loss / no-profit situation.
Financial leverage increases the minimum requirement of operating profits to
meet interest expenses. If the activity level is not attained, bankruptcy or cash
losses become certain.

TYPES OF LEVERAGE
There is a different basis for classifying business expenses. For our convenience,
let us classify fixed expenses into operating fixed expenses such as depreciation
on fixed expenses, salaries, etc. And fixed financial expenses such as interest and
dividends on preference shares. Like them, leverages are also of two types –
financial and operating.
 Department of Management Studies, BSAITM

FINANCIAL LEVERAGE (FL)

A Degree of Financial Leverage is created with the help of the debt component
in a company’s capital structure. The higher the debt, the higher would be the
FL because with higher debt comes a higher amount of interest that needs to be
paid. It can be good and bad for a business depending on the situation. If a firm
can generate a higher return on investment (ROI) than the interest rate it is
paying, leverage will have a positive effect on shareholder return. The darker
side is that if the said situation is the opposite, higher leverage can take a
business to the worst case, like bankruptcy.

Operating Leverage (OL) Just like the financial, it is a result of operating fixed
expenses. The higher the fixed expense, the higher is the Operating Leverage.
Like the FL had an impact on the shareholder’s return or, say, earnings per share,
OL directly impacts the operating profits (Profits before Interest and Taxes).
Under good economic conditions, an increase of 1% in sales will have more than
a 1% change in operating profits.

So, you need to be very careful in adding any leverages to your business. And
these are financial or operating, as it can also work as a double-edged sword.

Combined Leverage
Combined or Total Leverage is a combination of both operating and financial
leverage.

Advantages and Disadvantages of Leverage

In totality, it has its advantages under good economic situations, and at the same
time, it is not free from disadvantages.

Advantages of Higher Leverage

Take OL, and the operating profits can see a sharp increase with a slight change
in sales as most parts of the expenses are stagnant and cannot further increase
with sales.
 Department of Management Studies, BSAITM

Likewise, if we consider FL, the earnings share of each shareholder will increase
significantly with an increase in operating profits. Here, the higher the degree of
leverage, the higher will be the percentage increase in operating profits and
earnings per share

Disadvantages of Higher Leverage

It the risk of bankruptcy along with it. In the case of operating leverage, fixed
expenses extend the break-even point for a business. Break-even means the
minimum activity (sales) required for achieving a no loss / no-profit situation.
Financial leverage inc reases the minimum requirement of operating profits to
meet interest expenses. If the activity level is not attained, bankruptcy or cash
losses become certain.

FINANCIAL LEVERAGE
Financial Leverage – Meaning
Financial leverage means the presence of debt in the capital structure of a firm.
In other words, it is the existence of fixed-charge bearing capital, which may
include preference shares along with debentures, term loans, etc. The objective
of introducing leverage to the capital is to achieve the maximization of the
wealth of the shareholder.
Financial leverage deals with profit magnification in general. It is also well known
as gearing or ‘trading on equity.’ The concept of financial leverage is not just
relevant to businesses, but it is equally true for individuals. Debt is an integral
part of the financial planning of anybody, whether it is an individual, firm, or
company.

Financial Leverage (FL)

A Degree of Financial Leverage is created with the help of the debt component
in a company’s capital structure. The higher the debt, the higher would be the
FL because with higher debt comes a higher amount of interest that needs to be
paid. It can be good and bad for a business depending on the situation. If a firm
can generate a higher return on investment (ROI) than the interest rate it is
paying, leverage will have a positive effect on shareholder return. The darker
side is that if the said situation is the opposite, higher leverage can take a
business to the worst case, like bankruptcy.
 Department of Management Studies, BSAITM

Illustration of Financial Leverage The calculation below clearly shows the effect
of having debt in the capital. The table shows two options of financing, one by
equity only and another by debt and equity.

In the current example, the first situation, i.e. ROI > Interest Rate is true, and
that is why the results are favorable as we can see. If the ROI is less than the
interest rate, the ROE will decline, and on the other hand, if ROI is the same as
the interest rate, it will make no difference.
Leverage Effects
 Department of Management Studies, BSAITM

Going through the following points will help in understanding the effects of
leverage (both positive and negative):

Advantages of Leverage
 It helps boost liquidity as the company gets funds in the form of debt.
 Growing firms need more funds to grow their operations. Thus, taking on
leverage could help them to magnify their profit.
 Taking on more leverage is good for companies that are unwilling to dilute
their ownership.

Disadvantages of Leverage
 If a firm takes on too much leverage, it could result in financial issues.
 There are cases when a firm with too much leverage makes a decision that it
otherwise wouldn’t take. For example, if a firm has too much cash due to
leverage, then to use these it may invest in assets that aren’t needed.
 A company with more leverage means more debt. This, in turn, means an
obligation to pay interest in time, irrespective of the company’s financial
position. Such obligations could even lead to bankruptcy.

Effect on Cost of Capital Too much leverage can have an adverse impact on the
cost of capital as well. If the cost of debt is more than the total cost of capital,
then a rise in leverage would push up the cost of capital. And, if the cost of debt
is less than the total cost of capital, then taking on more debt reduces the cost
of capital.

OPERATING LEVERAGE
Operating leverage is the term used to denote the presence of fixed costs in the
operating cost structure of a firm. It is a measure of the magnification effect of
fixed costs on operating profits or PBIT. The term ‘degree of operating leverage’
is used synonymously, which is defined as the change in operating profits due to
a unit change in the level of revenues.

Operating leverage deals with the investment in fixed costs and their effect on
the operating profits. When a firm invests in fixed expenses, the increase in the
 Department of Management Studies, BSAITM

level of revenue does not increase the fixed expenses. Therefore the additional
increase in the revenue directly triggers an increase in the operating profits.

Pretty well, we can now see that the decision related to creating operating
leverage (OL) is a very important decision for a business as it directly impacts the
operating profit, which is the direct link to shareholders’ wealth maximization.
It is said that we cannot improve or implement anything till we do not measure
it.

A Measure of Operating Leverage / Degree of Operating Leverage:

Measurement of the effect of operating leverage is commonly known as the
degree of operating leverage (DOL). A percentage change in the operating
profits due to a 1 percent change in sales is called a DOL.

Let us get more clarification with the help of the above example. In the example,
the current situation suggests a fixed cost amounting to 1000, which will not
change under pessimistic and optimistic conditions. The impact of having that
 Department of Management Studies, BSAITM

operating leverage is explained by ‘% Change in EBIT.’ We can see that the

degree of OL is 2. When the sales are going down by 50%, the EBIT is going down
by 100%, and the same situation exists for the optimistic situation.

Type # 3. Combined Leverage: This leverage shows the relationship between a

change in sales and the corresponding variation in taxable income. If the
management feels that a certain percentage change in sales would result in
percentage change to taxable income they would like to know the level or
degree of change and hence they adopt this leverage. Thus, degree of leverage
is adopted to forecast the future study of sales levels and resultant
increase/decrease in taxable income. This degree establishes the relationship
between contribution and taxable income.

Example: A company, has a sales of Rs.2 lakh. The variable costs are 40 per cent
of the sales and fixed expenses are Rs.60,000. The interest on borrowed capital
is assumed to be Rs.20, 000. Compute the combined leverage and show the
impact on taxable income when sales increases by 10 per cent.
 Department of Management Studies, BSAITM

It should be observed that the leverage is ascertained from a particular sales

point. When different levels of sales are adopted, different degrees of
composite leverages are obtained. When the volume of sales increases, fixed
expenses remains same, the degree of leverage falls. This happens because of
existence of fixed charges in the cost structure.
 Department of Management Studies, BSAITM

UNIT- 4

WORKING CAPITAL MANAGEMENT

Working capital indicates the liquidity levels of businesses for managing day-to-
day expenses and covers inventory, cash, accounts payable, accounts receivable
and short-term debt. It is an indicator of the short-term financial position of an
organisation and is also a measure of its overall efficiency.
The working capital, also known as net worth capital is the money that a
company needs for managing it’s short term expenses. It is calculated as a
difference between an organisation’s current assets and its current liabilities.
Working capital is a measure of the operational efficiency, liquidity and short-
term financial health or solvency of the company.

Computation of Working Capital

Working Capital Formula: Working capital = Current Asset – Current Liabilities
Example of Working Capital
XYZ Company Current Assets:
 Fund in the bank: ₹1,00,000
 Pending accounts receivables: ₹4,00,000
 Inventory: ₹5,00,000
Total current assets = ₹10,00,000

XYZ Company Current Liabilities:

 Pending accounts payable: ₹3,00,000
 Temporary debt due payments for this year: ₹30,000
 A section of expended due debt for this year: ₹25,000
 Other accrued expenses for this year (e.g. rent, permanent salary, etc.):
₹4,00,000
Total current liabilities = ₹7,55,000

Working Capital of XYZ Company

= Current Assets – Current Liabilities
= ₹10,00,000 – ₹7,55,000
= ₹2,45,000
 Department of Management Studies, BSAITM

Need of working capital

1. Continuity in Business Operations: Working capital keeps the business
operations going. It is needed to purchase raw materials, to pay the workers and
staff and also to pay for recurring expenses like electricity and power bills, rent,
etc.
2. Dividend Payment: Working capital is needed to pay a dividend to the
shareholders. The payment of dividend takes place on a yearly or half-yearly
basis.
3. Repayment of Long-Term Loans: Working capital is also used to repay long-
term loans and debentures.
4. Increases Creditworthiness: A company that pays its creditors on time has a
positive reputation in the credit market. Such a goodwill helps a company to
obtain raw materials on credit. It can also get loans and advances from the
banks. The dealers will also be willing to give money to such companies. Hence,
working capital increases a company's creditworthiness.
5. Boosts Efficiency and Productivity: The company that faces no working
capital problems provides better working conditions and welfare facilities to its
workers. It also can maintain its machines in good condition. It can afford to
spend money for training and development of its workers. All such steps boost
the efficiency and productivity of the company.
6. Helps to Fight Competition: Working capital helps the company to fight its
competitors. It can be used to advertise and for sales promotion. The company
can also afford to give longer credit terms to the customers.
7. Helps to Withstand Seasonal Fluctuations: Working capital is required
throughout the year. But sales may be seasonal in nature. If the sales are low,
the money inflow is less. Therefore, liquid cash is required to pay wages to
workers and to meet other expenses. So, it helps the company withstand
seasonal fluctuations.
8. Increases Goodwill: The company that meets the needs of its working capital
without any difficulty earns a good reputation in the labour and capital markets.
This happens because the company pays wages and salaries to the employees
and the suppliers of raw materials, etc., on time. Thus, it also helps increase the
goodwill of the company.
 Department of Management Studies, BSAITM

Determinants of working capital

 Nature of Business is one of the factors. Usually in trading businesses the
working capital needs are higher as most of their investment is found
concentrated in stock. On the other hand, manufacturing/processing business
need a relatively lower compared to that of trading business/level of working
capital. The terms of ‘higher’ and ‘lower’ used above are relative and not
absolute. That is, of the total capital employed in the businesses a higher or
lower, as the case may be, portion is employed in current assets.
 Sales and Demand Conditions of a firm also affect its working capital position.
It is difficult to precisely determine the relationship between volume of sales
and working capital needs. Sales depend on the demand conditions. Most of the
firms experience seasonal and cyclical fluctuations in the demand of their
products and services. These business variations affect the working capital
requirement, particularly the temporary working capital requirement of the
firm. When there is an upward swing in the economy, the sales will increase and
untimely the firm’s investment in inventories and debtors will also increase. On
the other hand, when there is a decline in the economy, the sales will fall and
ultimately, the level of inventories and debtors will also fall. Under recessionary
conditions firms try to reduce their short-term borrowings.
 Manufacturing Policy: The manufacturing cycle of the firm also affects the
requirement of the working capital. The manufacturing cycle comprises the
purchase and use of raw material and production of finished goods. Longer the
manufacturing cycle, larger will be the firm’s working capital requirements and
vice versa. An extended manufacturing time span means a larger tie-up of funds
in inventories. Further, the requirement of working capital also depends on
whether the firm has adopted steady production policy or variable production
policy.
 Credit Policy: In the present day circumstances, almost all units have to sell
goods on credit. The nature of credit policy is an important consideration in
deciding the amount of working capital requirement. The larger the volume of
credit sales, the greater will be the requirement of working capital. Generally,
the credit policy of an individual firm depends on the norms of the industry to
which the firm belongs. Credit periods also influence the size and composition
of working capital. When longer credit period is allowed to customers as against
the one extended to the firm by its suppliers, more working capital is needed
 Department of Management Studies, BSAITM

and vice versa In the former case, there will be a relatively higher trade debtors
and in the latter there will be a higher trade creditors.
 Collection policy is another influencing factor. A stringent collection policy
might not only deter away some credit seeking customers, also force existing
customers to be prompt in settling dues resulting in lower level of working
capital. The opposite is true with a liberal collection policy. Collection
procedures do influence the level of working capital. A decentralized collection
of dues from customers and centralized payments to suppliers, shall reduce the
size of working capital. Centralized collections and centralized payments or
decentralized collections and decentralized payments would lead to a moderate
level of working capital. But with centralized collections and decentralized
payments, the working capital need will be the highest.
 The Availability of Credit from banks and financial institutions also influences
the working capital requirement of a firm. The availability of credit to a firm
depends upon the creditworthiness of the firm in the money market. If a firm
has good credit standing in the market, it can get credit easily on favorable terms
and hence it will require less working capital.
 The Operating Efficiency of the firm relates to the optimum utilization of
resources at minimum costs. If the firm is efficient in controlling its operating
costs and utilizing its current assets, than it helps in keeping the working capital
at a lower level. The use of working capital is improved and pace of cash
conversion cycle is accelerated with operating efficiency.
 The Price Level Changes also affect the level of working capital. Generally,
rising price levels will require a firm to maintain higher amount of working
capital. However, the effect of rising prices may be different for different
companies, as though the general price level increases, the individual prices may
move differently. Therefore some firms may require more working capital, while
other may require less working capital in case of price rise.
 Inflation has a bearing on level of working capital. Under inflationary
conditions generally working capital increases, since with rising prices demand
reduces resulting in stock pile-up and consequent increase in working capital.
 Level of trading is another factor. There are two levels of trading, viz. over
trading and under trading. Over trading means the business wants to maximize
turnover with inadequate stock level, hastened production cycle and swiftest
collection from debtors. Eventually the working capital will be lower. It is no
 Department of Management Studies, BSAITM

good, however, for the business is starved of its legitimate working capital
needs. Under trading is the opposite of over-trading. There is lethargy and overt
lags. There results a higher work-capital. This is no good either, since the working
capital is not effectively utilized. It is wastage of capital.
 The Growth and Expansion Plans to be undertaken by a firm also affect its
requirements of working capital. Hence the planning of the working capital
requirements and its procurements must go hand in hand with the planning of
the growth and expansion of the firm. Even the expansion of the sales also
increases the requirements of working capital.
 System of production process is another factor that has a bearing. If capital
intensive, high technology automated system is adopted for production, more
investment in fixed assets and less investment is current asses are involved.
Also, the conversion time is likely to be lower, resulting in further drop in the
level of working capital. On the other hand, if labor intensive technology is
adopted less investment in fixed assets and more investment in current assets
(especially work in-progress due to inclusion of an enhanced wage component
and prolonged processing) result.
 Dividend policy: A desire to maintain an established dividend policy may affect
working capital, often changes in working capital bring about an adjustment of
dividend policy. The relationship between dividend policy and working capital is
well established and very few companies declare a dividend without giving due
consideration to its effects on cash and their needs for cash. A shortage of
working capital often acts as a powerful reason for reducing or skipping a cash
dividend. On the other hand, a strong position may justify continuing dividend
payment.
 Finally, rapidity of turnover comes. There is a negative correlation between
rapidity of turnover and size of working capital. When sales are fast and swift,
lower is the investment in working capital. Actually stock of inventory is very
minimum. But, when sales are happening far and in-between, i.e. rather slow,
as in the case of jewellery, elaborate investment in working capital results. Thus
faster sales lead to lower working capital and vice versa.

Elementary Knowledge of Component of Working Capital

1) Current Assets: Current assets are the one side of working capital formula.
They can be defined as, type of assets which are easily convertible to cash in less
 Department of Management Studies, BSAITM

than one year are called current assets. Current assets are mainly utilized to
meet the requirements of daily operations of the business.
2) Cash and Cash Equivalents You will see the term cash under the current assets
in the balance sheet. This is the most liquid of funds and very essential for every
business to maintain the smooth operations of their business. Sufficient amount
of cash should be present with the company to fill any unexpected gaps in the
production and sales cycle.
3) Account Receivables: The account receivable is the amount of money
receivable from clients arises due to credit sales by the company in the normal
course of business. You will find account receivables on the company’s balance
sheet under the current assets. The important point is that they are classified as
assets but in real, they are not available for usage until realized in more liquid
form.
4) Inventory: Stock / Inventory are the goods, which purchased by company with
a view to resell in the market and earn profits. The turnover of inventory
determines how the successful the business is.
5) Accounts Payable: Accounts payable are the obligation upon company to pay
off its debt due from its creditors, and suppliers. Accounts come under the head
of current liabilities and one of the major components of working capital
management. Accounts payable can be managing through negotiations with
creditors to extend the payment period.

CASH MANAGEMENT
Cash management is the process of managing cash inflows and outflows. There
are many cash management considerations and solutions available in the
financial marketplace for both individuals and businesses. For businesses, the
cash flow statement is a central component of cash flow management.
Management of cash is one of the most important areas of overall working
capital management due to the fact that cash is the most liquid type of current
assets. As such it is the responsibility of the finance function to see that the
various functional areas of the business have sufficient cash whenever they
require the same.
At the same time, it has also to be ensured that the funds are not blocked in the
form of idle cash, as the cash remaining idle also involves cost in the form of
 Department of Management Studies, BSAITM

interest cost and opportunity cost. As such the management of cash has to find
a mean between these two extremes of shortage of cash as well as idle cash.

MOTIVES OF CASH
1.Transactions Motive – This motive refers to the holding of cash, to meet
routine cash requirements in the ordinary course of business. A firm enters into
a number of transactions which requires cash payment. For example, purchase
of materials, payment of wages, salaries, taxes, interest etc. Similarly, a firm
receives cash from cash sales, collections from debtors, return on investments
etc. But the cash inflows and cash outflows do not perfectly synchronize.
Sometimes, cash receipts are more than payments while at other times
payments exceed receipts. The firm must have to maintain sufficient (funds)
cash balance if the payments are more than receipts. Thus, the transactions
motive refers to the holding of cash to meet expected obligations whose timing
is not perfectly matched with cash receipts. Though, a large portion of cash held
for transactions motive is in the form of cash, apart of it may be invested in
marketable securities whose maturity conform to the timing of expected
payments such as dividends, taxes etc.

2.Precautionary Motive – Apart from the non-synchronisation of expected cash

receipts and payments in the ordinary course of business, a firm may be failed
to pay cash for unexpected contingencies. For example, strikes, sudden increase
in cost of raw materials etc. Cash held to meet these unforeseen situations is
known as precautionary cash balance and it provides a caution against them.
The amount of cash balance under precautionary motive is influenced by two
factors i.e. predictability of cash flows and the availability of short term credit.
The more unpredictable the cash flows, the greater the need for such cash
balances and vice versa. If the firm can borrow at short-notice, it will need a
relatively small balance to meet contingencies and vice versa. Usually
precautionary cash balances are invested in marketable securities so that they
contribute something to profitability.

3. Speculative Motive – Sometimes firms would like to hold cash in order to

exploit, the profitable opportunities as and when they arise. This motive is called
as speculative motive. For example, if the firm expects that the material prices
 Department of Management Studies, BSAITM

will fall, it can delay the purchases and make purchases in future when price
actually declines. Similarly, with the hope of buying securities when the interest
rate is expected to decline, the firm will hold cash. By and large, firms rarely hold
cash for speculative purposes.

4. Compensation Motive – This motive to hold cash balances is to compensate

banks and other financial institutes for providing certain services and loans.
Banks provide a variety of services to business firms like clearance of cheques,
drafts, transfer of funds etc. Banks charge a commission or fee for their services
to the customers as indirect compensation. Customers are required to maintain
a minimum cash balance at the bank. This balance cannot be used for
transaction purposes. Banks can utilize the balances to earn a return to
compensate their cost of services to the customers. Such balances are
compensating balances. These balances are also required by some loan
agreements between a bank and its customers. Banks require a chest to
maintain a minimum cash balance in his account to compensate the bank when
the supply of credit is restricted and interest rates are rising.

SIGNIFICANCE OF CASH MANAGEMENT

1.Cash planning – Cash is the most important as well as the least unproductive
of all current assets. Though, it is necessary to meet the firm’s obligations, yet
idle cash earns nothing. Therefore, it is essential to have a sound cash planning
neither excess nor inadequate.
2.Management of cash flows – This is another important aspect of cash
management. Synchronization between cash inflows and cash outflows rarely
happens. Sometimes, the cash inflows will be more than outflows because of
receipts from debtors, and cash sales in huge amounts. At other times, cash
outflows exceed inflows due to payment of taxes, interest and dividends etc.
Hence, the cash flows should be managed for better cash management.
3.Maintaining optimum cash balance – Every firm should maintain optimum
cash balance. The management should also consider the factors determining
and influencing the cash balances at various point of time. The cost of excess
cash and danger of inadequate cash should be matched to determine the
optimum level of cash balances.
 Department of Management Studies, BSAITM

4.Investment of excess cash – The firm has to invest the excess or idle funds in
short term securities or investments to earn profits as idle funds earn nothing.
This is one of the important aspects of management of cash. Thus, the aim of
cash management is to maintain adequate cash balances at one hand and to use
excess cash in some profitable way on the other hand.

OBJECTIVES OF CASH MANAGEMENT

There are two basic objectives of cash management:
1. Meeting cash disbursements: The first basic objective of cash management
is to meet the payments Schedule. In other words, the firm should have
sufficient cash to meet the various requirements of the firm at different periods
of times. The business has to make payment for purchase of raw materials,
wages, taxes, purchases of plant, etc. The business activity may come to a
grinding halt if the payment schedule is not maintained. Cash has, therefore,
been aptly described as the “oil to lubricate the ever turning wheels of the
business, without it the process grinds to a stop.”

2. Minimizing funds locked up as cash balances: The second basic objective of

cash management is to minimize the amount locked up as cash balances. In the
process of minimizing the cash balances, the finance manager is confronted with
two conflicting aspects. A higher cash balance ensures proper payment with all
its advantages. But this will result in a large balance of cash remaining idle. Low
level of cash balance may result in failure of the firm to meet the payment
schedule. The finance manager should, therefore, try to have an optimum
amount of cash balance keeping the above facts in view.

Principles of Cash Management

1. Determinable Variations of Cash Needs: A reasonable portion of funds, in the
form of cash is required to be kept aside to overcome the period anticipated as
the period of cash deficit. This period may either be short and temporary or last
for a longer duration of time. Normal and regular payment cf cash leads to small
reductions in the cash balance at periodic intervals. Making this payment to
different employees on different days of a week can equalize these reductions.
Another technique for balancing the level of cash is to schedule cash
 Department of Management Studies, BSAITM

disbursements to creditors during that period when accounts receivables

collected amounts to a large sum but without putting the goodwill at stake.

2. Contingency Cash Requirement: There may arise certain instances, which fall
beyond the forecast of the management. These constitute unforeseen
calamities, which are too difficult to be provided for in the normal course of the
business. Such contingencies always demand for special cash requirements that
was not estimated and provided for in the cash budget. Rejections of wholesale
product, large amount of bad debts, strikes, lockouts etc. are a few among these
contingencies. Only a prior experience and investigation of other similar
companies prove helpful as a customary practice. A practical procedure is to
protect the business from such calamities like bad-debt losses, fire etc. by way
of insurance coverage.

3. Availability of External Cash: Another factor that is of great importance to the

cash management is the availability of funds from outside sources. There
resources aid in providing credit facility to the firm, which materialized the firm’s
objectives of holding minimum cash balance. As such if a firm succeeds in
acquiring sufficient funds from external sources like banks or private financiers,
shareholders, government agencies etc., the need for maintaining cash reserves
diminishes.

4. Maximizing Cash Receipts: Every financial manager aims at making the best
possible use of cash receipts. Again, cash receipts if tackled prudently results in
minimizing cash requirements of a concern. For this purpose, the comparative
cost of granting cash discount to customer and the policy of charging interest
expense for borrowing must be evaluated on continuous basis to determine the
futility of either of the alternative or both of them during that particular period
for maximizing cash receipts. Yet, the under mentioned techniques proved
helpful in this context:

5. Concentration Banking: Under this system, a company establishes banking

centers for collection of cash in different areas. Thereby, the company instructs
its customers of adjoining areas to send their payments to those centers. The
collection amount is then deposited with the local bank by these centers as early
 Department of Management Studies, BSAITM

as possible. Whereby, the collected funds are transferred to the company’s

central bank accounts operated by the head office.

6. Local Box System: Under this system, a company rents out the local post
offices boxes of different cities and the customers are asked to\forward their
remittances to it. These remittances are picked by the authorized lock bank from
these boxes to be transferred to the company’s central bank operated by the
head office.

7. Reviewing Credit Procedures: It aids in determining the impact of slow payers

and debtors on cash. The accounts of slow paying customers should be reviewed
to determine the volume of cash tied up. Besides this, evaluation of credit policy
must also be conducted for introducing essential amendments. As a matter of
fact, too strict a credit policy involves rejections of sales. Thus, curtailing the cash
in flow. On the other hand, too lenient, a credit policy would increase the
number of slow payments and bad debts again decreasing the cash inflows.

8. Minimizing Credit Period: Shortening the terms allowed to the customers

would definitely accelerate the cash inflow side-by-side revising the discount
offered would prevent the customers from using the credit for financing their
own operations profitably.

9. Others: Introducing various procedures for special handling of large to very

large remittances or foreign remittances such as, persona! pick up of large sum
of cash using airmail, special delivery and similar techniques to accelerate such
collections.

10. Minimizing Cash Disbursements: The motive of minimizing cash payments is

the ultimate benefit derived from maximizing cash receipts. Cash disbursement
can be brought under control by preventing fraudulent practices, serving time
draft to creditors of large sum, making staggered payments to creditors and for
payrolls etc.

11. Maximizing Cash Utilization: Although a surplus of cash is a luxury, yet money
is costly. Moreover, proper and optimum utilization of cash always makes way
 Department of Management Studies, BSAITM

for achievement of the motive of maximizing cash receipts and minimizing cash
payments. At times, a concern finds itself with funds in excess of its requirement,
which lay idle without bringing any return to it. At the same time, the concern
finds it unwise to dispose it, as the concern shall soon need it. In such conditions,
efforts should be made in investing these funds in some interest bearing
securities.

Receivable Management
Receivable management is a process of managing the account receivables within
a business organisation. Account receivables simply mean credit extended by
the company to its customers and are treated as liquid assets. It involves taking
decisions regarding the investment to be made in trade debtors by organisation.
Deciding the proper amount be lent by the company to its customers in the form
of credit sales is quite important. It affects the overall cash availability for
undertaking various operations.
Receivable management business ensures that a sufficient amount of cash is
always maintained within the business so that operations can continue
uninterrupted. It helps in deciding the optimum proportion of credit sales. The
overall process of receivable management involves properly recording all credit
sales invoices, sending notices on due date to collection department, recording
all collections, calculation of outstanding interest on late payments etc.
Receivable management aims at raising the sales volumes and profit of the
business by managing and providing credit facilities to customers. A proper
receivable management process aims at monitoring and avoidance of
occurrence of any overdue payment and non-payment. It is an effective way of
improving the financial and liquidity position of the company. Credit facilities
are important for attracting and retaining customers and this makes
management of credit facilities by business crucial. Objectives of receivable
management are as follows:

Objectives or Features of Receivable

Management Monitor And Improve Cash Flow
Receivable management monitors and control all cash movements of
organisations. It maintains a systematic record of all sales transactions.
Receivable management helps business in deciding appropriate investment in
 Department of Management Studies, BSAITM

trade debtors. It aims that a sufficient amount of cash needed for day-to-day
activities is maintained at business. Credit facilities are extended by doing
proper analysis and planning to ensure optimum cash flow in a business
organisation.

Minimises Bad Debt Losses

Bad debts are harmful to organisations and may lead to heavy losses. Receivable
management takes all necessary steps to avoid bad debts in business
transactions. It designs and implement schedules for collection of outstanding
amount timely and informs the collection department on due dates. Customers
are notified for amount standing against them and charges interest on delay in
payments.

Avoids Invoice Disputes

Receivable management has an efficient role in avoiding any disputes arising in
business. Disputes adversely affect the relationship between customers and
business organisations. Complete and fair record of all transactions with
customers are maintained on a daily basis. There is no chance of confusion and
dispute arising as all sales transactions are accurately maintained. Automated
receivable management systems present full evidence in a short time in case of
dispute arising for resolving them.

Boost Up Sales Volume

Receivable management increase the sales and the profitability of the
organisation. By extending the credit facilities to their customers business are
able to boost up their sales volume. More and more customers are able to do
transactions with the business by purchasing products on a credit basis.
Receivable management helps business in managing and deciding their
investment in credit sales. This leads to increase in the number of sales and
profit level.

Improve Customer Satisfaction

Customer satisfaction and retention are key goals of every business. By lending
credit, it supports financially weaken customers who can’t purchase business
products fully on a cash basis. This strengthens the relationship between
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customer and organisation. Customers are happy with the services of their
business partners. Receivable management help in organising better credit
facilities for their customers.

Helps In Facing Competition

Receivable management helps in facing stiff competition in the market. Several
competitors existing in market offers different credit options to attract more
and more customers. Receivable management process analysis all information
about market and helps the business in farming its credit lending policies.
Customers are provided better services by extending credit at convenient rates.
Appropriate amount and rates of credit transactions can be easily decided
through receivable management process. All credit and payment terms are
decided for every customer as per their needs.

Nature of Receivable Management

Regulate Cash Flow
Receivable management regulates all cash flows in an organization. It controls
all inflow and outflow of funds and ensure that an efficient amount of cash is
always available. Proper management of receivables enables organizations in
efficient functioning at all the times.

Credit Analysis
It perform proper analysis of customer credentials for determining their credit
ratings. Monitoring and scanning of customers before provide them any credit
facility helps in minimizing the credit risk.

Decide Credit Policy

Receivable management decides the credit policy and standards as per which
credit facility should be extended to customers. A company may have a lenient
credit policy where customer credit-worthiness is not at all considered or a
stringent policy where credit-worthiness is considered for providing credit.

Credit Collection
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Receivable management focuses on efficient and timely collection of business

payments from its customers. It works towards reducing the time gap in
between the moments when bills are raised and payment is collected.

Maintain Up-To-Date Records

Receivable management maintains a systematic record of all business
transactions on a regular basis. All transactions are maintained fairly in the form
of proper billing and invoices which helps in avoiding any confusion or settling
of disputes arising later.

Importance and Function of Receivable Management

Evaluates Customer Credit Ratings

Receivable management evaluates its customers borrowing capacity and
repaying ability for determining their credit ratings. It approves any credit facility
to its customers after analyzing their information both qualitatively and
quantitatively. Proper investigation of client details helps in reducing the credit
risk.

Minimizes Investment
In Receivables It reduces investment in receivable by ensuring optimum funds
are available within organization at all the times. Receivable management
decides proper credit limit and credit period for avoiding any bankruptcy
situations. Attempts are made to collect account receivable as soon as they
become due for payment which reduces the overall investment in receivables.

Optimize Sales
Efficient receivable management assist business in raising their sales volume.
Business are able to attract more and more customers by providing them credit
facilities. They are able to properly decide and monitor credit facilities with the
help of a receivable management.

Reduce Risk of Bad Debts

It takes all steps to avoid any instances of bad debts. Receivable management
notify all customers for the payment as soon as the amount gets due. It charges
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interest on delay payments and aims at optimum collection of all payment

timely. Implementation of proper schedule and monitoring of collection process
results in minimizing the risk of bad debts.

Maintain Efficient Cash

Maintains of efficient cash is crucial for the survival of every organization.
Receivables management properly records all cash inflows and outflows of a
business. All credit facilities are extended after analyzing the capability of
organization and due payments are collected timely. This results in steady cash
flow within the organization.

Lower Cost of Credit

Receivable management helps business in lowering its cost of credit by limiting
the credit amount and credit period for its customers. It performs all processes
such as acquiring credit information of clients and collecting all due payments in
an efficient way which lower the overall cost associated with credit facilities.

Scope of Receivable Management

Formulation Of Credit Policy
Receivable management is the one which formulates and implements an
effective credit policy in an organization. Credit policies are decided as per the
capabilities of an organization. A company may either follow a liberal policy or
stringent credit policy for providing credit facilities to its customers.

Credit Evaluation
Credit evaluation involves examining the credit worthiness of customer before
approving any credit amount. Proper investigation of customer’s information
lowers the risk of bad debts. Receivable management acquire all credentials of
client for determining their borrowing capacity and repaying ability.

Credit Control
Receivable management implement a proper structure for monitoring all credit
functions of business. It records credit sales with proper documents on a daily
basis. Invoices are raised immediately after goods get dispatch and amount are
collected soon as they become due for payment.
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Maximize Profit
It plays an efficient role in maximizing the profit of organizations. Receivable
management helps in boosting the sales volume by providing credit facilities to
customers. More and more people are able to purchase goods on credit which
maximizes the overall profit level.

Better Competition
Efficient account receivable management helps business in facing the strong
competition in market. It enables in providing credit facilities to customers as
per their needs and capabilities. Receivable management analyses the credit
strategies adopted by competitors and according frame policy for an
organization. It attracts more and more customers by offering them credit
facilities at convenient rates.

INVENTORY MANAGEMENT
Definition: Inventory management is an approach for keeping track of the flow
of inventory. It starts right from the procurement of goods and its warehousing
and continues to the outflow of the raw material or stock to reach the
manufacturing units or to the market, respectively. The process can be carried
out manually or by using an automated system.

Inventory Management Objectives

 Preventing Dead Stock or Perishability: With an optimal inventory level, the
chances of wastage in the form of goods spoilage or dead stock.
 Optimizing Storage Cost: It reduces the chances of maintaining excessive
stock, even the requirements are pre-determined, which ultimately cuts done
the unnecessary warehousing costs.
 Maintaining Sufficient Stock: Now, the production department need not
worry about the shortage of raw material or goods because of its constant
supply.
 Enhancing Cash Flow: Inventory has a significant impact on the cash flow of
the company. With effective inventory management, the organization can
ensure sufficient liquid cash to enhance its operational efficiency.
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 Reducing the Inventories’ Cost Value: When there is a constant purchase of

goods or stock, the organization can ask for discounts and other benefits to
decrease the purchase price.

Types of Inventory Management

Bar-code Inventory Management The barcode system is its automated and
simplified version. The management can find out the stock remaining with just
one click on a computer device. The scanned barcodes enable the software to
maintain a track of all the purchases and the flow of inventory.

Continuous Inventory Management It links the barcode and radio frequency

identification with the accounting inventory system, inventory received, and
point of sales systems along with the production system, to trace the path of
inventory movement. It is mostly beneficial for accounting purpose. This is also
termed as perpetual inventory management.

Periodic Inventory Management It is a manual process, which is used for

determining the closing inventory value, for putting it up in the ledger at the end
of a financial year. Depending on the organizational need, it can also be analyzed
quarterly. However, it is a time-consuming way, since the inventory has to be
physically counted.

Inventory Management Process

Since it is a process of identifying and resolving inventory-related obstacles.
Given below is the step by step method of improving the organization’s
inventory management system:
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Step 1: Determining the Loopholes

The foremost step is to evaluate the inventory requirement and the actual stock
of the goods. Also, the reasons for this gap between the demand and inventory
should be ascertained.

Step 2: Analyzing Consumer Demand and Spending Patterns

The market demand forecasting holds equal importance. This is because it helps
the organization to estimate the production quantity, which ultimately leads to
the maintenance of adequate inventory. Step 3: Evaluating the Cost Involved Its
implementation involves different types of expenses such as warehousing,
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maintenance, transport, bulk discounts and supply chain costs. Each of these
should be well analyzed.

Step 4: Identifying the Extent of Process Automation

It is not possible for every organization to completely automate the inventory
management process. However, the management can recognize those
particular areas where there are possibilities of automation.

Step 5: Inspecting Supplier’s Practices and Performance

The next step is to find out the suppliers’ inventory management practices since
this strategy cannot be implemented solely. If the supplier is resistant to change
and tends to proceed with the traditional means, the organization needs to look
for alternative vendors.

Step 6: Classifying Inventories into Different Categories

The goods have to be segregated into various categories depending upon the
product type, customer class, maintenance cost or profit margin.

Step 7: Setting Objectives for Each Inventory Category

To efficiently manage and track the performance of the applied technique for
each category, it is essential to set individual goals. It not only provides a base
for benchmarking but also identifies the problems and issues faced in each of
these categories. Step 8: Prioritizing the Areas of Improvement Now, that we are
aware of the problems, the next step is about finding out the density of each
issue and its impact. The concerns which can be resolved immediately needs to
be addressed first. And then, the ones which are complex and requires
restoration should be considered.

Step 9: Taking Advice or Opinion from Experts

Designing an appropriate inventory management system is the task of the
personnel who specialize in the field. Thus, at this stage, the organization needs
to hire consultants or experts for advice and opinion on current technology and
problem fixation within the desired budget.

Step 10: Framing Suitable Inventory Management Policy

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The last step is to implement a satisfactory inventory management strategy for

the desired change. This improvement should be incorporated as an inventory
management policy to deal with the changes in demand and add value to
customer experience

Importance of Inventory Management

1.Enables Enterprise Resource Planning (ERP) The ERP software accommodates
and links the different business operations. These are inventory procurement,
warehousing, production, human resource, finance, marketing and sales to one
another. In this process, inventory management contributes its part of providing
the necessary data.
2.Proper Warehouse Management The barcode system, LIFO and FIFO
techniques provide a clear picture of the past and present inventory available
with the company to optimize the warehousing functions.
3.Efficient Inventory Valuation It provides for proper evaluation of the different
types of inventory, i.e., stock in hand, opening and closing stocks, raw material,
finished goods, etc. This data is also used to prepare the cost sheet.
4.Supports Supply Chain Management Being a segment of supply chain
management, it is responsible for streamlining all the warehousing operations
and flow of raw material or stock.
5.Manages Sales Operations Sales, as we know, is a continuous process which
depends upon the production of goods or services. If there is inefficient
inventory management in the organization, the chances of unavailability of raw
material for manufacturing may arise.

Challenges Faced in Inventory Management

 Lack of Knowledge: The personnel at the receiving and warehousing
departments may lack the required expertise and adequate knowledge of
segregating the regular and seasonal goods out of the whole stock.

 Expanding Product Portfolios: The customers’ demand and requirements for a

wide range of products have tremendously increased the inventory size, making
it difficult to manage, manually.
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 Supply Chain Complexity: The organization, at times, fail to track the stock or
goods during the supply chain process. Moreover, it is not necessary that the
business partners also maintain an inventory management system, creating
hurdles.

Techniques of inventory management

First-In, First-Out (FIFO)
First in, first out is the most prominent inventory valuation method for managing
the perishable goods. These include flowers, fruits, vegetables, fish and meat
products, dairy items, chemicals and pharmaceuticals. FIFO states that the
goods which were received first (old stock) needs to be consumed initially. Thus,
reducing the spoilage of those goods which have a short shelf life.
For this purpose, the store in-charge must ensure proper arrangement of stock.
It should be such that the newest batches should be placed in the last shelves,
whereas the oldest ones should be kept in front.
One of the ways of organizing the goods is through their batch numbers or expiry
dates.
In reselling businesses, this method also optimizes the inventory for non-
perishable items that have occupied the store space, since a long time.
When the same product is ready to be launched with new features look,
packaging or design; FIFO is used to avoid antiquity of the left out old stock.

Last-In, Last-Out (LIFO)

Last in last out is an inventory valuation technique used for the goods which are
non-perishable and homogeneous. Some of these are bricks, cement, stones,
sand, etc.
Since this type of stock is usually arranged in piles, the newest lot is on the top.
Therefore, the most recent goods have to be used first, followed by the oldest
stock, which is at the bottom.
Though, this technique shows a superior income statement; the balance sheet
is poorly valued with old stock.
Also, the International Financing Reporting Standards (IFRS) and the Accounting
Standards for Private Enterprises (ASPE) forbids the use of LIFO in accounting. In
the US, Generally Accepted Accounting Principles (GAAP) has not imposed any
such restrictions.
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Economic Order Quantity (EOQ)

EOQ is used as an inventory management method to estimate the optimum
quantity of material to be purchased. It is to fulfil the production requirement
such that the inventory maintenance cost is minimal.
Following are the two main objectives of EOQ:
Reducing the total inventory cost is the primary aim of this method. These costs
involve order cost, holding expense and shortage cost.
Next, is assuring that the right quantity of goods is ordered in each batch. It will
not only reduce the frequency of order placement; but will also keep a check
over the surplus inventory.

The formula of EOQ for inventory management is:

Where: Q is the optimum order units;
D is the periodic demand (in units);
S is the cost of each purchase order;
H is the per-unit annual holding cost.
Later on, Baumol’s EOQ model was developed as a cash management technique
for maintaining the optimum level of cash in the business.
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Dropshipping
Dropshipping is that form of business which ensures inventory control for
resellers. The organization does not maintain any inventory.
On receiving the order from a customer, the company forwards it to
manufacturer, supplier or wholesaler. Then, the vendor directly ships the
product to the customer.
Thus, cross-docking has the following advantages:
 Minimal inventory cost;
 Meagre startup investment;
 Scalability with low risk;
 Minimal order fulfilment expense

Contingency Planning
Contingency strategy can be seen as a backup plan. Thus, this type of inventory
management technique helps to deal with any of the following adverse business
circumstances:
 Shortage of space in warehouses;
 False inventory valuation or calculation;
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 Vendor runs out of stock and cannot meet the order deadlines;
 A sudden increase in demand leads to stock over-valuation;
 The manufacturer or vendor stops dealing in particular goods without any prior
information;  The company runs out of sufficient working capital to acquire
essential products.

In this method, the organization should foresee the inventory-related risk and
its impact. Accordingly, it should plan what actions are to be taken, if any of the
above problems arise. Along with this, a constant effort should be made to build
strong public relations for long-term existence. Therefore, contingency planning
is essential for effective inventory management.

Accurate Forecasting
In inventory management, market demand analysis and estimation of sales, play
a significant role. If the organization lacks proper information about a precise
number of future sales units, there are high chances of stock wastage or
shortage.
While accurate demand forecasting the organization must look into the
following factors:
 Economic conditions;
 Market trends;
 Planned advertisements and promotion;
 Marketing cost;
 Consumers’ growth rate;
 Seasonal impact on demand;
 Previous year’s sales record.

Set PAR Levels

Minimum safety stock or Periodic Automatic Replenishment (PAR) level refers
to establishing minimum stock criteria for each type of goods. If the inventory
goes down the set limit, it is an indication that the new minimum order needs
to be placed.
For such decision making, the store manager needs to analyze the frequency of
sales or production and procurement period. With the changing market
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demand, production capacity, warehousing capacity, maintenance cost and

various other factors; the PAR levels can be altered.
Therefore, the organization must review the PAR levels considering these
factors, from time to time. In the absence of the manager, safety stock levels
also aid the employees to take prompt inventory procurement decisions.

Inventory Kitting
Product bundling as we call it is a method of creating a bundle by grouping
different products, packaging and merchandising them together as a single unit.
In the inventory management, on selling a bundle, the system automatically
associates the pack’s sale to the sale of items included in it, separately.
Some of the benefits of this method are as follows:
 Spontaneous selling of different products helps to minimize inventory
obsoletion; along with clearance of the old stock.
 It reduces the overall warehousing, maintenance and shipping costs.
 It initiates inventory tracking and its minimum level maintenance.
 It improves the average order values and enhances sales revenue.

Just-In-Time (JIT)
Inventory Management Just-in-time is one of the Japanese inventory
management techniques, that emphasizes keeping a ‘zero inventory‘.
As the name suggests, it refers to maintaining only that much stock which is
required at present, for carrying out the production or merchandising process.
Some organizations first receive the order from the clients, and then they
proceed with the inventory procurement and manufacturing activities.
Following are the various advantages of JIT:
 JIT benefits through ordering the new stock only when the old one is about to
finish. Thus, it reduces obsoletion or expiry of the existing stock.
 It ensures a positive cash flow, with less working capital engaged in inventory.
 It also provides for optimizing the inventory cost by reducing the warehousing
and insurance expenses.
However, one of the most significant drawbacks of this technique is it may result
in stock-out. Since there is a possibility that the procurement team fails to order
the goods on time or the delivery of stock is delayed.
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Material Requirement Planning (MRP)

Commonly known as MRP method, it is an analytical approach. The manager
places the order with the vendors, for new stock only after finding out the
market demand and sales forecast, acquired from the different business areas.
For the manufacturers, merchandisers, wholesalers and stockists; it is a
beneficial technique since it provides for price risk optimization and also reduces
the overstock uncertainties.

Perpetual Inventory Management

It is a continuous inventory system that helps in regular tracking of the real-time
stock movements. In this method, the inventory is promptly updated in the
books of accounts, as soon as the purchase or sale of goods is made. Thus, this
is a superior technique to the periodic inventory system which initiates only an
occasional or random check of inventory through physical counting of goods.
Given below are the various plus points of perpetual inventory system:
 Efficient inventory forecasting;
 Immediate recording of the stock information;
 Competent in terms of time and cost;
 Error-free due to validated data.
Fast, Slow and Non-Moving (FSN)
Inventory The critical function of the FSN inventory technique is understanding
the frequency with which a specific product is consumed for production or
merchandising. Let us now go through its following three elements:

1. Fast-Moving Inventory: The goods which are readily saleable or consumed in

bulk, are termed as fast-moving inventory. The inventory turnover ratios of such
stock are quite high. 2. Slow-Moving Inventory: The stock which is not
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consumed that frequently resulting in low turnover ratio, is categorized under

slow-moving inventory.
3. Non-Moving Inventory: Some goods in the warehouse, goes out of demand
and therefore, becomes obsolete. Many times, such non-moving inventory leads
to dead stock.

The manager should take steps to use or eradicate the non-moving inventory
for creating space in the warehouse. Also, the slow-moving goods should be
stored in a limited quantity to avoid the chances of obsoletion.
On the other hand, the fast-moving stock should be maintained in a sufficient
quantity for uninterrupted production or supply of goods.

Batch Tracking
Throughout the supply chain management, goods are recorded and traced as
per their batch numbers, to facilitate lot tracking.
It is widely used to figure out where the inventory is, right from its receiving and
warehousing to production or sales. It even keeps track of the products’
expiration date (if available).

Given below are the benefits of batch tracking to the organizations:

 Batch tracking is a more efficient method of inventory management when
compared to the manual process.
 It improves vendor relationship through the identification and selection of
prominent suppliers.
 It helps to make out defective products in a batch, and thus, reduces the
chances of loss.
 A robust quality control system can be established through a lot tracking
system. Since the expiry date of each product or batch is known, the chances of
quality degradation reduce.

DIVIDEND POLICY
A dividend is the distribution of corporate profits to eligible shareholders.
Dividend payments and amounts are determined by a company's board of
directors. Dividends are payments made by publicly listed companies to reward
investors for putting their money into the venture.
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The dividend is one of the important ways in which the companies communicate
their financial health and shareholders’ value to the general public. Through the
distribution of their earnings, companies indicate a positive future and a strong
performance. The ability and the willingness of a company to pay stable
dividends constantly over a good period of time and even at an increasing pace
gives a good picture of the company’s fundamentals.

What is a Dividend Policy?

The dividend policy of a company is the decision about the distribution of
dividends to its shareholders. A dividend policy is a financial decision that
involves deciding on the dividend payout ratio, the frequency of dividends and
should they pay dividends at all or not. It is drafted by the company’s board of
directors and acts as a guideline for distributing dividends to the investors.

ADVANTAGES OF PAYING DIVIDENDS

Paying returns to investors has several advantages, both for the investors and
the company: Investor Preference
Investors are more interested in a company that pays stable dividends. This
assures them of a reliable source of earnings, even if the market price of the
share dips.
Bird-in-Hand Fallacy
Bird in hand theory states that the shareholders prefer the certainty of dividends
in comparison to the possibility of higher capital gains in the future.
Stability
Investors prefer companies with a track record of paying dividends as it
positively reflects their stability. This indicates predictable earnings to investors
and thus, makes the company a good investment.
Benefits without Selling
Investors invested in dividend-paying stocks do not have to sell their shares to
participate in the stock’s growth. They reap the monetary benefits without
selling the stock.
Temporary Excess Cash
A mature company may not have attractive avenues to reinvest the cash or may
have fewer expenses related to R&D and expansion. In such a scenario, investors
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prefer that a company distributes the excess cash so that they can reinvest the
money for higher returns somewhere else.
Information Signalling
When a company announces such returns, it gives a strong signal about the
future prospects of the company. Companies can also take advantage of the
additional publicity they get during this time.

Disadvantages of Paying Dividends Paying returns also has several

disadvantages:
Clientele Effect
Suppose a dividend-paying company is unable to pay returns to shareholders for
a certain period of time. In that case, it may result in the loss of old clientele who
preferred regular payments. These investors may sell off the stock in the short
term.
Decreased Retained Earnings
When a company makes such payments, it decreases its retained earnings. Debt
obligations and unexpected expenses can arise if the company does not have
enough cash.
Limits Company’s Growth
Paying dividends results in the reduction of usable cash, limiting the company’s
growth. The company will have less money to invest in business growth.
Logistics
The payment to shareholders requires a lot of record-keeping at the company’s
end. The company has to ensure that the right owner of the share receives its
payment.

Types/forms of dividends
 Cash dividends. The most common type of dividend. Companies generally pay
these in cash directly into the shareholder's brokerage account.
 Stock dividends. Instead of paying cash, companies can also pay investors with
additional shares of stock.
 Dividend reinvestment programs (DRIPs). Investors in DRIPs are able to
reinvest any dividends received back into the company's stock, often at a
discount.
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 Special dividends. These dividends pay out on all shares of a company’s

common stock, but don’t recur like regular dividends. A company often issues a
special dividend to distribute profits that have accumulated over several years
and for which it has no immediate need.
 Preferred dividends. Pay-outs issued to owners of preferred stock. Preferred
stock is a type of stock that functions less like a stock and more like a bond.
Dividends are usually paid quarterly, but unlike dividends on common stock,
dividends on preferred stock are generally fixed.

Factors affecting dividend policy

Factor # 1. Maintenance of Reserves: Various reserves for different purposes
are needed for efficient running of a company. Reserves for — depreciation,
working capital, bad debts, dividend equalization, expansion, taxation,
debenture redemption, and preference share redemption are very common for
a company to keep apart. The surplus is available for dividend. Factor # 2.
Existence of Earned Surplus: A company cannot pay dividends out of capital.
Dividend is payable out of current profits or accumulated profits of a company.
It can be paid after providing for depreciations as per Companies Act.

Factor # 3. Cash Needs of a Company: Cash position is a big criterion to pay

dividend. For a company, cash is needed for various contingencies. They cannot
be ignored for the survival of a company. So, dividend policy has to be made
after a serious consideration of the cash position of the company.

Factor # 4. Need for Growth and Expansion: A company, quite likely, is brought
into being not to remain static. It is to grow and expand. For this, cash flow must
exist. Every available amount cannot be spent for payment as dividend to
shareholders. That will restrict the scope for its growth and expansion. Many
companies follow orthodox dividend policy and provide for liberal ploughing
back of profits into the business and these retained earnings are utilized for
expansion and growth as a source of internal finance.

Factor # 5. Steady and Stable Dividend Policy: An ideal dividend policy rests on
the principle of stability and steadiness. Attractive dividend rate — after
providing for reasonable, regular and stable income — should be aimed at.
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Regularity of dividend depends upon stability of earnings, dividend equalization

reserve and adequate free reserves.

Factor # 6. Government Taxation Policy: In these days corporate taxation is a

very important factor to take into consideration. Government levies huge
amount of taxes on companies to augment its revenue needs. This means the
management is put into difficulty in maintaining stable or high rate of dividend.
So, this has to be considered while formulating dividend policy.

Factor # 7. Legal Restrictions: There may be ceiling on the rate of dividend

imposed by the Government. Here the management is helpless. Similarly, for
closely held companies there may be restrictions on ploughing back of profits
because members are interested in reducing their income tax on their dividends.

Factor # 8. Dividend Restrictions by Creditors: Lenders to companies, while

granting long term credit, may restrict the rate of dividend payment. This
dictation by the lenders restricts the management in declaring dividend as they
intend to do.

Factor # 9. Fixed Asset Replacement Provision:

While the price is on rise, i.e., in an inflationary economy management has to
give serious thought on replacement of fixed assets. It would require huge
amount which must be provided to keep the company running. Hence, a
company is compelled to provide for liberal depreciation. Depreciation on
historical cost is absolutely inadequate during inflation.

MODELS OF DIVIDEND POLICY

A. IRRELEVANCE THEORY OF DIVIDEND
The advocates of this school of thought argue that the dividends have no impact
on the share price or market value of the firm. The argue that the shareholders
do not differentiate between the present dividend and the future capital gains
and are basically interested in higher returns either earned by the firm by
investing the profits in future profitable investments.
They believe that the profits are distributed as dividends only if no adequate
investment opportunities for investments for the business.
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The various theories supporting this thought are as follows:

1. Residuals Theory of Dividends
2. Modigliani and Millers Approach

RESIDUALS THEORY OF DIVIDENDS

The theory is based upon the assumptions that since the external financing has
excessive costs and may not be available to the firm. The firm finances its
investment by retained earnings or by retaining earnings. The retaining earnings
are that portion of profits that is not distributed to the investors.
The residual theory of dividend policy is that the firm will only pay dividends
from residual earnings, that is, from earnings left over after all suitable (positive
NPV) investment opportunities have been financed. With the residual dividend
policy, the primary focus of the firm’s management is indeed on investment, not
dividends.

Thus the firm’s decision to pay the dividends is influenced by:

 The investment opportunities available to the business
 The availability of the internal funds. If the internal funds are excessive and all
the investments are financing the residual is paid as dividends.
Thus, the divided policy is totally passive in nature and has no influence on the
market price of the firm.

MODIGLIANI AND MILLER (MM) APPROACH

This theory was proposed by Franco Modigliani and Merton Miller in 1961 who
argued that the value of the firm is determined by the basic earning power, the
firm’s risk and not by the distribution of earnings. The value of the firm therefore
depends on the investment decisions and not the dividend decision. However,
their argument was based on some assumptions.

Assumptions of MM hypothesis
 The capital markets are perfect and all the investors behave rationally.
 There are no taxes and flotation costs and if the taxes are there then there is
no difference between the dividends tax and capital gains tax.
 No transaction costs associated with share floatation.
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 The firm’s investment policy is independent of the dividend policy. The effect
of this assumption is that the new investments out of retained earnings will not
change and there will not change in the required rate of return of the firm.
 There is perfect certainty by every investor as to future investments and profits
of the firm. Thus investors are able to forecast earnings and dividends with
certainty.

The MM hypothesis is based upon the arbitrage theory. The arbitrage process
involves switching and balancing the operations. Arbitrage leads to entering into
two transactions which exactly balance or completely offset the effect of each
other.

The two transactions are paying of dividends and raising external capital. Since
the firm uses retained earnings to finance new investments, the paying of
dividends will require the firm to raise the capital externally. The arbitrage
theory suggests that the dividend effect will be exactly offset by the effect of
raising additional share capital.

When the dividends are paid to the shareholders, the market price of share
decreases (because of external financing). Thus what is gained by the
shareholders as a result of dividends is completely neutralized by the reduction
in the market value of the shares.

According to MM, the investors will thus be indifferent between dividends and
retained earnings. The market value of the shares will depend entirely on the
expected future earnings of the firm.
Valuation Formula and its Denotations

MM theory on dividend policy is based on the assumption of the same discount

rate/rate of return applicable to all the stocks.
P1 = P0 * (1 + ke) – D1
Where,
P1 = market price of the share at the end of a period
P0 = market price of the share at the beginning of a period
ke = cost of capital
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D1 = dividends received at the end of a period

Criticism of Modigliani Miller’s Model

MM theory on dividend policy suffers from the following limitations:
 Perfect capital markets do not exist. Taxes are present in the capital markets.
 According to this theory, there is no difference between internal and external
financing. However, on considering the flotation costs of new issues, it is false.
 This theory believes that the dividends do not affect the shareholder’s wealth.
However, there are transaction costs associated with the selling of shares to
make cash inflows. This makes the investors prefer dividends.
 The assumption of no uncertainty is unrealistic. The dividends are relevant
under certain conditions as well.

B. RELEVANCE THEORY OF DIVIDEND

The relevance theory of dividend argues that dividend decision affects the
market value of the firm and therefore dividend matters. This theory suggests
that investors are generally risk averse and would rather have dividends today
(“bird-in-the-hand”) than possible share appreciation and dividends tomorrow.
The relevance theory of dividend proposes that dividend policy affect the share
price.
Therefore, according to this theory, optimal dividend policy should be
determined which will ensure maximization of the wealth of the shareholders.
Relevance theory can discussed with following models:
1.Walter Approach
2.Gorden Approach

WALTER APPROACH
The Walter approach was given by James E Walter and is based on a simple
argument that where the reinvestment rate, that is, rate of return that the
company may earn on retained earnings, is higher than cost of equity (rate of
return of the shareholders), then it would be in the interest of the firm to retain
the earnings.
If the company’s reinvestment rate on retained earnings is the less than
shareholders’ rate of return, the company should not retain earnings. If the two
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rates are the same, then the company should be indifferent between retaining
and distributing.

The Walter’s model is based on the following assumptions:

The firm finances its entire investments by means of retained earnings only.
 Internal rate of return (r) and cost of capital (KE) of the firm remains constant.
The firms’ earnings are either distributed as dividends or reinvested internally.
The earnings and dividends of the firm will never change.
The firm has a very long or infinite life.
Hence, the basis of Walter formula is:
Walter’s Model Valuation Formula and its Denotations
Walter’s formula to calculate the market price per share (P) is:
P = D/k + {r*(E-D)/k}/k,
Where
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return of the firm
k = cost of capital of the firm
Explanation: The mathematical equation indicates that the market price of the
company’s share is the total of the present values of:
 An infinite flow of dividends, and
 An infinite flow of gains on investments from retained earnings.

Criticism of Walter’s Model

Walter’s theory is critiqued for the following unrealistic assumptions in the
model:
No External Financing
Walter’s assumption of complete internal financing by the firm through retained
earnings is difficult to follow in the real world. The firms do require external
financing for new investments.

Constant r and k
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It is very rare to find the internal rate of return and the cost of capital to be
constant. The business risks will definitely change with more investments that
are not reflected in this assumption.

According to the theory, the optimum dividend policy depends on the

relationship between the firm’s internal rate of return and cost of capital. If R>K,
the firm should retain the entire earnings, whereas it should distribute the
earnings to the shareholders in case the RK is that the firm is able to produce
more return than the shareholders from the retained earnings.

Walter’s view on optimum dividend payout ratio can be summarised as below:

Department of Management Studies, BSAITM
Department of Management Studies, BSAITM