Sikkim Manipal University Financial Management textbook overview

SIKKIMMANIPALUNIVERSITY
238
References:
FinancialManagementbyKhanJain
FinancialManagementby I.M.Pandey
FinancialManagementby PrasannaChandra
FinancialManagementby ShashiGuptaandNeetiGupta
FinancialManagementby Rustogi
FinancialManagement
Subjectcode:MB0029
Contents
Unit1
FinancialManagement 1
Unit2
FinancialPlanning 15
Unit3
TimeValueofMoney 34
Unit4
ValuationofBondsandshares 50
Unit5
CostofCapital 72
Unit6
Leverage 88
Unit7
CapitalStructure 101
Unit8
CapitalBudgeting 113
Edition:Fall2008
Contents
Unit9
RiskAnalysisinCapitalBudgeting 147
Unit10
CapitalRationing 167
Unit11
WorkingCapitalmanagement 174
Unit12
CashManagement 190
Unit13
InventoryManagement 204
Unit14
ReceivablesManagement 218
Unit15
DividendDecision 231
Edition:Fall2008
BKIDB0671
Dr.K.Jayakumar
ViceChancellor
SikkimManipalUniversityofHealth,Medical,andTechnologicalstudies
Prof.NandagopalV.B.
DirectorandDean
SikkimManipalUniversityofHealth,Medical,and Technologicalstudies.
BoardofStudies
Dr.T.V.NarasimhaRao
Professor.ManipalUniversalLearning
Prof.K.V.Varambally
Director,ManipalInstituteofManagement,Manipal
Ms.VimalaParthasarathy
Asst.Professor.SikkimManipalUniversityofHealth,
MedicalandTechnologicalstudies.
Mr.ShankarJagannathan
FormerGroupTreasurer
WiproTechnologiesLimited,Bangalore
Ms.SadhanaDash
SenorManagerHR
MicrosoftIndiacorporation( Pvt)limited
Mr.AbrahamMathews
Chief FinancialOfficer
InfosysBPO,Bangalore
Mr.PankajKhanna
Director,HR,FidelityMutualFund
ContentPreparationTeam ContentReviewedand Editedby
1.ProfV.Narayanan Dr.T.V.NarasimhaRao
Dean,M.S.RamaiahInstituteofManagement,Bangalore Professor.ManipalUniversalLearning
2. Smt.AshaNadig
AdarshInstituteofManagement,Bangalore
Edition:Fall2008
Thisbookisadistanceeducationmodulecomprisingofcollectionoflearningmaterialforourstudents.
Allrightsreserved.Nopartofthisworkmaybereproducedinanyformbyanymeanswithoutpermission
in writing from Sikkim Manipal University of Health, Medical and Technological Sciences, Gangtok,
Sikkim.
Printed and Published on behalf of Sikkim Manipal University of Health, Medical and Technological
Sciences, Gangtok, Sikkim by Mr. Rajkumar Mascreen, GM, Manipal Universal Learning Pvt. Ltd.,
Manipal 576104.PrintedatManipalPressLimited,Manipal.
INTRODUCTION
Financial Management deals with the management of financial resource of a business firm. It
discusses the goal of financial management and emphasizes on shareholder value
maximization.Financialmanagementmainlycomprisesofallmanagerialactionsrelatingtothe
three major decision areas such as Investment, Financing and Dividends and working capital
management.Thiscoursewarecomprises15units:
Unit1: FinancialManagement
Explains the meaning and scope of financial management. It examines the goal of
corporatefinancialmanagement.
Unit2: FinancialPlanning
Givesabriefaccountofthemeaningandneedforfinancialplanning.
Unit3: TimeValueofMoney
Thisunitintroducestheconceptsoftimevalueofmoney,compoundingand
Discountingofcashflows.
Unit4: ValuationofBondsandShares
Explainstheprinciplesbehindthevaluationsofbondsandequalityshares
Unit5: CostofCapital
This unit describes the concept of cost of capital and the computation of the
weightedaveragecostofcapital.
Unit6: Leverage
Describestheconceptsofoperating,financialandcombinedleverageandgivesthe
procedureforcomputingthedifferenttypesofleverage.
Unit7: CapitalStructure
This unit introduces the concept of capital structure and the importance thereof. It
alsodiscussesthevarioustheoriesofcapitalofstructure.
Unit8: CapitalBudgeting
Explains the meaning and significance of capital budgeting decisions. It gives a
detailedaccountofvariousinvestmentappraisaltechniques.
Unit9: RiskAnalysisinCapitalBudgeting
Givesthemeaningofrisktypesandsourcesofriskincapitalbudgetingdecisions.It
also analysis the various approaches for handling the risk factor in investment
decisions
Unit10: CapitalRationing
This unit explains the meaning of capital rationing. It also examines the steps
involvedincapitalrationingprocess.
Unit11: WorkingCapitalManagement
Gives the meaning of various concepts of working capital. It gives a detailed
accountofthefactorsthatinfluencetheworkingcapitalrequirementsofafirm.
Unit12: CashManagement
Cash is an important component of working capital. It needs to be managed
efficiently so as to avoid either excess cash balances or cash shortages. This unit
looksatdifferentcashmanagementtools.
Unit13: InventoryManagement
This unit describes briefly the various forms of inventory that a firm keeps. A brief
descriptionand pricing of inventory along with the determination of stock levels are
alsoexplained.
Unit14: ReceivablesManagement
Gives the meaning of receivables management. Costs of maintaining receivables,
formulation of credit policy and determinations of an optimal credit period are
discussed.
Unit15: DividendDecision
Dividendsarepaymentsmadebyfirmtoitsshareholders.Dividendsformapartof
thereturnsexpectedbytheshareholders.Thisunitexplainsthedividendpolicy
mattersofabusinessfirmandthedifferenttypesofdividends.
FinancialManagement Unit1
SikkimManipalUniversity
1
Unit1 FinancialManagement
Structure
1.1 Introduction
1.2 MeaningAndDefinitions
1.3 GoalsOfFinancialManagement
1.3.1 ProfitMaximization
1.3.2 WealthMaximization
1.4FinanceFunctions
1.4.1 InvestmentDecisions:
1.4.2 FinancingDecisions:
1.4.3 DividendDecisions
1.4.4 LiquidityDecision
1.5OrganizationOfFinanceFunction
1.5.1 InterfaceBetweenFinanceAndOtherBusinessFunctions
1.5.2 FinanceAndAccounting
1.5.3 FinanceAndMarketing
1.5.4 FinanceAndProduction(Operations)
1.5.5 FinanceAndHR
1.6 Summary
TerminalQuestions
AnswerstoSAQsandTQs
1.1 Introduction
Toestablishanybusiness,apersonmustfindanswerstothefollowingquestions:
a) Capital investments are required to be made. Capital investments are made to acquire the
realassets,requiredforestablishingandrunningthebusinesssmoothly.Realassetsareland
andbuildings,plantandequipmentsetc.
b) Decisiontobetakenonthesourcesfromwhichthefundsrequiredforthecapitalinvestments
mentionedabovecouldbeobtained,tobetaken.
c) Therefore, there are two sources offunds viz. debt andequity. In what proportion thefunds
aretobeobtainedfromthesesourcesistobedecidedforformulatingthefinancingplan.
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d) Decisionontheroutineaspectsofdaytodaymanagementofcollectingmoneyduefromthe
firmscustomersandmakingpaymentstothesuppliersofvariousresourcestothefirm.
Thesearethecoreelementsoffinancialmanagementofafirm.
FinancialManagementofafirmisconcernedwith procurementandeffectiveutilizationoffunds
for the benefit of its stakeholders. The most admired Indian companies are Reliance, Infosys.
Theyhavebeenratedwellbythefinancialanalystonmanycrucialaspectsthatenabledthemto
create value for its share holders. They employ the best technology, produce quality goods or
renderservicesattheleastcostandcontinuouslycontributetotheshareholderswealth.
Allcorporatedecisionshavefinancialimplications.Therefore,financialmanagementembracesall
thosemanagerialactivitiesthatarerequiredtoprocurefundsattheleastcostandtheireffective
deployment.Financeisthelifebloodofallorganizations.Itoccupiesapivotalroleincorporate
management. Any business which ignores the role of finance in its functioning cannot grow
competitively in todays complex business world. Value maximization is the cardinal rule of
efficientfinancialmanagerstoday.
LearningObjectives:
Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.
1. ThemeaningofBusinessFinance.
2. TheobjectivesofFinancialManagement.
3. Thevarious interfacesbetweenfinanceandothermanagerial functions ofafirm.
1.2MeaningAndDefinitions
The branch of knowledge that deals with the art and science of managing money is called
financial management. With liberalization and globalization of Indian economy, regulatory and
economicenvironmentshaveundergonedrasticchanges.ThishaschangedtheprofileofIndian
financemanagerstoday.Indianfinancialmanagershavetransformedthemselvesfromlicensed
raj managers to well informed dynamic proactive managers capable of taking decisions of
complexnatureinthepresentglobalscenario.
Traditionally, financial management was considered a branch of knowledge with focus on the
procurementoffunds.Instrumentsoffinancing,formation,merger&restructuringoffirms,legal
andinstitutionalframeworkinvolvedthereinoccupiedtheprimeplaceinthistraditionalapproach.
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Themodernapproachtransformedthefieldofstudyfromthetraditionalnarrowapproachto the
mostanalyticalnature.Thecoreofmodernapproachevolvedaround,procurementoftheleast
costfundsanditseffectiveutilizationformaximizationofshareholderswealth.Globalizationof
business and impact of information technology on financial management have added new
dimensionstothescopeoffinancialmanagement.
SelfAssessmentQuestion1
1. FinancialManagementdealswithprocurementoffundsattheleastcostand______funds.
1.3GoalsOfFinancialManagement
Goals mean financial objective of a firm. Experts in financial management have endorsed the
view thatthe goalof Financial Management of afirmis maximization of economic welfareofits
shareholders. Maximization of economic welfare means maximization of wealth of its
shareholders. Shareholders wealth maximization is reflected in the market value of the firms
shares. Afirms contribution tothe society is maximized when it maximizes itsvalue. There are
twoversionsofthegoalsoffinancialmanagementofthefirm:
1.3.1 ProfitMaximization:
Inacompetitiveeconomy,profitmaximizationhasbeenconsideredasthelegitimateobjectiveof
a firm because profit maximization is based on the cardinal rule of efficiency. Under perfect
competition allocation of resources shall be based on the goal of profit maximization. A firms
performance is evaluated in terms of profitability. Investors perception of companys
performancecanbetracedtothegoalofprofitmaximization.But,thegoalofprofitmaximization
hasbeencriticizedonmanyaccounts:
1. Theconceptofprofitlacksclarity.Whatdoestheprofitmean?
a) Isitprofitaftertaxorbeforetax?
b) Isitoperatingprofitornetprofitavailabletoshareholders?
Differences in interpretation on the concept of profit expose the weakness of the goal of profit
maximization
2. Profit maximization ignores time value of money because it does not differentiate between
profitsofcurrentyearwiththeprofittobeearnedinlateryears.
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3. The concept of profit maximization fails to consider thefluctuationinthe profits earnedfrom
yeartoyear.Fluctuationsmaybeattributabletothebusiness riskofthefirmbuttheconcept
failstothrowlightonthisaspect.
4. Profit maximization does not make clear the concept of profit as to whether itisaccounting
profitoreconomicnormalprofitoreconomicsupernormalprofits.
5.Becauseofthesedeficiencies,profitmaximizationfailstomeetthestandardsstipulatedinan
operationallyfeasiblecriterionformaximizingshareholderswealth.
1.3.2 WealthMaximization
Wealth Maximization has, been accepted by the finance managers, because it overcomes the
limitationsof profit maximisation. Wealth maximisation means maximizing thenet wealthofthe
Companys share holders. Wealth maximisation is possible only when the company pursues
policiesthatwouldincreasethemarketvalueofsharesofthecompany.
Following arguments are in support of the superiority of wealth maximisation over profit
maximisation:
1. Wealthmaximisationisbasedontheconceptofcashflows.Cashflowsarearealityandnot
based on any subjective interpretation. On the other hand there are many subjective
elementsintheconceptofprofitmaximisation.
2. It considers time value of money. Time value of money translates cash flows occurring at
differentperiodsintoacomparablevalueat zeroperiod.In thisprocess,thequalityofcash
flowsisconsideredcriticallyinalldecisionsasitincorporatestheriskassociatedwiththecash
flowstream.Itfinallycrystallizesintotherateofreturnthatwillmotivateinvestorstopartwith
theirhardearnedsavings.Itiscalledrequiredrateofreturnorhurdleratewhichisemployed
in evaluating all capital projects undertaken by the firm. Maximizing the wealth of
shareholders means positive net present value of the decisions implemented. Positive net
presentvalue canbedefinedastheexcessofpresentvalueofcashinflowsof anydecision
implemented over the present value of cash out flows associated with the process of
implementationofthedecisions taken.Tocomputenetpresentvalueweemploytimevalue
factor. Timevaluefactoris known as time preference ratei.e. the sumof riskfree rateand
riskpremium.Riskfreerateistheratethataninvestorcanearnonanygovernmentsecurity
forthedurationunderconsideration.Riskpremiumistheconsiderationfortheriskperceived
bytheinvestorininvestinginthatassetorsecurity.
X Ltd is a listed company engaged in the business of FMCG (Fast Moving Consumer goods).
Listedmeansthecompanyssharesareallowedtobetradedofficiallyontheportalsofthestock
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exchange.TheBoardofDirectorsofXLtdtookadecisioninoneofitsBoardmeeting,toenter
into the business of power generation. When the company informs the stock exchange at the
conclusion of the meeting of the decision taken, the stock market reacts unfavourably with the
resultthatthenextdaysclosingofquotationwas30%lessthanthatofthepreviousday.
The question now is, why the market reacted in this manner. Investors in this FMCG Company
might have thought that the risk profile of thenew business (power) that the company wants to
takeupishighercomparedtotheriskprofileoftheexistingFMCGbusinessoftheXLtd.When
theywantahigherreturn,marketvalueofcompanyssharedeclines.Thereforetheriskprofileof
the company gets translated into a time value factor. The time value factor so translated
becomestherequiredrateofreturn. Requiredrateofreturnisthereturnthattheinvestorswant
formakinginvestmentinthatsector.
Anyprojectwhichgeneratespositivenetpresentvaluecreateswealthtothe company.Whena
companycreateswealthfromacourseofactionithasinitiatedtheshareholdersbenefitbecause
suchacourseofactionwillincreasethemarketvalueofthecompanysshares.
SuperiorityofWealthMaximisationoverProfitMaximisation
1. Itisbasedoncashflow,notbasedonaccountingprofit.
2. Through the process of discounting it takes care of the quality of cash flows. Distant cash
flowsareuncertain.Convertingdistantuncertaincashflowsintocomparablevaluesatbase
period facilitates better comparison of projects. There are various ways of dealing with risk
associated withcashflows. These risks are adequately considered when presentvaluesof
cashflowsaretakentoarriveatthenetpresentvalueofanyproject.
3. In todays competitive business scenario corporates play a key role. In company form of
organization,shareholdersownthecompanybutthemanagementofthecompanyrestswith
the board of directors. Directors are elected by shareholders and hence agents of the
shareholders. Company management procuresfundsfor expansion and diversificationfrom
Capital Markets. In the liberalized set up, the society expects corporates to tap the capital
markets effectively for their capital requirements. Therefore to keep the investors happy
throughtheperformanceofvalueofsharesinthemarket,managementofthecompanymust
meetthewealthmaximisationcriterion.
4. When a firm follows wealth maximisation goal, it achieves maximization of market value of
share.Whenafirmpracticeswealthmaximisationgoal,itispossibleonly whenitproduces
qualitygoodsatlowcost.Onthisaccountsocietygainsbecauseofthesocietalwelfare.
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5. Maximizationofwealthdemandsonthepartofcorporatestodevelopnewproductsorrender
new servicesin the mosteffectiveandefficientmanner. This helps the consumers as it will
bringtothemarkettheproductsandservicesthatconsumersneed.
6. Another notable features of the firms committed to the maximisation of wealth is that to
achievethis goalthey areforced to render efficient service totheir customers with courtesy.
Thisenhancesconsumerwelfareandhencethebenefittothesociety.
7. From the point of evaluation ofperformance oflistedfirms, the most remarkable measureis
that of performance of the company in the share market. Every corporate action finds its
reflection on the market value of shares of the company. Therefore, shareholders wealth
maximizationcouldbeconsideredasuperiorgoalcomparedtoprofitmaximisation.
8. Sincelistingensures liquidity tothe sharesheldby the investors, shareholders can reap the
benefits arising from the performance of company only when they sell their shares.
Therefore,itisclearthatmaximizationofmarketvalueofshares willleadtomaximisationof
thenetwealthofshareholders.
Therefore,wecanconcludethatmaximizationofwealthistheappropriateofgoaloffinancial
managementintodayscontext.
SelfAssessmentQuestions2
1.Underperfectcompetition,allocationofresourcesshallbebasedonthegoalof_______.
2._____________isbasedoncashflows.
3.__________________considertimevalueofmoney.
1.4 FinanceFunctions
Financefunctionsarecloselyrelatedtofinancialdecisions.Thefunctionsperformedbyafinance
manager are known as finance functions. In the course of performing these functions finance
managertakesthefollowingdecisions:
1.Financingdecision 2.InvestmentDecision 3.Dividenddecision 4.Liquiditydecision.
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1.4.1 InvestmentDecisions:
To survive and grow, all organizations must be innovative. Innovation demands managerial
proactiveactions.Proactiveorganizationscontinuouslysearchforinnovativewaysofperforming
the activities of the organization. Innovation is wider in nature. It could be expansion through
entering into new markets, adding new products to its product mix, performing value added
activitiestoenhancethecustomersatisfaction,oradoptingnewtechnologythatwoulddrastically
reduce the cost of production or rendering services or mass production at low cost or
restructuring the organization to improve productivity. All these will change the profile of an
organization.Thesedecisionsarestrategicbecause,theyareriskybutif executedsuccessfully
withaclearplanofaction,theygeneratesupernormalgrowthtotheorganization.
If themanagementerrsinanyphaseoftakingthesedecisionsandexecutingthem,thefirmmay
become bankrupt. Therefore, such decisions will have to be taken after taking into account all
factsaffectingthedecisionsandtheirexecution.
Twocriticalissuestobeconsideredinthesedecisionsare:
1. Evaluationofexpectedprofitabilityofthenewinvestments.
2. Rateofreturnrequiredontheproject.
The rate of return required by investor is normally known by hurdle rate or cutoff rate or
opportunitycostofcapital.
Afterafirmtakesadecisiontoenterintoanybusinessorexpanditsexistingbusiness,plansto
investinbuildings,machineriesetc.areconceivedandexecuted.Theprocessinvolvediscalled
CapitalBudgeting.CapitalBudgetingdecisionsdemandconsiderabletime,attentionand energy
of the management. They are strategicinnature as the success orfailure of an organization is
directlyattributabletotheexecutionofcapitalbudgetingdecisionstaken.
Investment decisions are also known as Capital Budgeting Decisions. Capital Budgeting
decisionsleadtoinvestmentinrealassets
Dividendsarepayoutstoshareholders.Dividendsarepaidtokeeptheshareholdershappy.
Dividendpolicyformulationrequiresthedecisionofthemanagementastohowmuchofthe
profitsearnedwillbepaidasdividend.Agrowingfirmmayretainalargeportionofprofitsas
retainedearningstomeetitsneedsoffinancingcapitalprojects.Here,thefinancemanagerhas
tostrikeabalancebetweentheexpectationofshareholdersondividendpaymentandtheneedto
provideforfundsoutoftheprofitstomeettheorganizationsgrowth.
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1.4.2 FinancingDecisions:
Financing decisions relate to the acquisition of funds at the least cost. Here cost has two
dimensionsvizexplicitcostandimplicitcost.
Explicitcostreferstothecostintheformofcouponrate,costoffloatingandissuingthesecurities
etc.
Implicit costis not avisible costbutit may seriously affect the companys operations especially
when itisexposedtobusinessandfinancialrisk.Forexample,implicitcostisthefailureofthe
organizationtopaytoitslendersordebentureholdersloaninstallments onduedateonaccount
of fluctuations in cash flow attributable to the firms business risk. In India if the company is
unabletopay its debts, creditors of the company may use legal meansto sue thecompanyfor
windingup.Thisriskisnormallyknownasriskofinsolvency.Acompanywhichemploysdebtas
ameansoffinancingnormallyfacesthisriskespecially whenitsoperationsareexposed tohigh
degreeofbusinessrisk.
In all financing decisions a firm has to determine the proportion of equity and debt. The
compositionofdebtandequityiscalledthecapitalstructureofthefirm.
Debtis cheapbecause interestpayable on loan is allowed as deductions in computingtaxable
income on which the company is liable to pay income tax to the Government of India. For
example,if the interest rateon loan taken is 12%, tax rate applicableto the company is 50 %,
thenwhenthecompanypaysRs.12asinteresttothelender,taxableincomeofthecompanywill
bereducedbyRs.12.
Inotherwordswhenactualcostis12%withthetaxrateof50%theeffectivecostbecomes6%
therefore, debt is cheap. But, every installment of debt brings along with it corresponding
insolvencyrisk.
Anotherthingnotableinthisconnectionisthatthefirmcannotavoiditsobligationtopayinterest
andloaninstallmentstoitslendersanddebentures.
Onthe otherhand,acompanydoesnothaveanyobligationtopaydividendtoitsshareholders.
A company enjoys absolute freedom not to declare dividend even if its profitability and cash
positionsare comfortable. However, shareholders areone ofthe stakeholdersof the company.
Theyareinrealitytheownersofthecompany.Thereforewellmanagedcompaniescannotignore
the claim of shareholders for dividend. Dividend yield is an important determinant for stock
prices.Dividendyieldreferstodividendpaidwithreferencetothemarketpriceofthe sharesof
thecompany.Aninvestorincompanysshareshastwoobjectivesforinvesting:
1. IncomefromCapitalappreciation(i.e.Capitalgainsonsaleofsharesatmarketprice)
2. Incomefromdividends.
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Itistheabilityofthecompanytogiveboththeseincomestoitsshareholdersthatdeterminesthe
marketpriceofthecompanysshares.
The most important goal of financial management is maximisation of net wealth of the
shareholders. Therefore, management of every company should strive hard to ensure that its
shareholdersenjoybothdividendincomeandcapitalgainsaspertheexpectationofthemarket.
But,dividendisdeclaredoutoftheprofitearnedbythecompanyafterpayingincometaxtothe
GovtofIndia.
Forexample,letusassumethefollowingfacts:
Dividend=12%onpaidupvalue
Taxrateapplicabletothecompany=30%
Dividendtax=10%
When a Company pays Rs.12 on paid up Capital of Rs.100 as dividend, the profit that the
companymustearnbeforetaxis:
Since payment of dividend by an Indian Company attracts dividend tax, the company when it
paysRs.12toshareholders,mustpaytotheGovtofIndia
10%ofRs.12=Rs.1.2asdividendtax.Thereforedividendanddividendtaxsumupto12+1.2
=Rs.13.2
Sincethisispaidoutoftheposttaxprofit,inthis question,thecompanymustearn:
Posttaxdividendpaid
1Taxrateapplicabletothecompany=pretaxprofitrequiredtodeclareandpaythedividend
13.2 13.2
10.3 0.7
Therefore, to declare a dividendof12 %Company hastoearn a pre tax profitof19 %. On the
other hand, to pay an interest of 12 % Company has to earn only 8.4 %. This leads to the
conclusionthatforeveryRs.100procuredthroughdebt,itcosts8.4%whereasthesameamount
procuredintheformofequity(sharecapital)costs
19 %. This confirms the established theory that equity is costly but debt is a cheap but risky
sourceoffundstothecorporates.
The challenge before the finance manager is to arrive at a combination of debt and equity for
financingdecisionswhichwouldattainanoptimalstructureofcapital.Anoptimalstructureisone
thatarrivesattheleastcoststructure,keepinginmindthefinancialriskinvolvedandtheabilityof
thecompanytomanagethebusinessrisk.Besides,financingdecisioninvolvestheconsideration
ofmanagerialcontrol,flexibilityandlegalaspects.Assuchitinvolves quitealotofregulatoryand
managerialelementsinfinancingdecisions.
=
= = Rs19approximate
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1.4.3 DividendDecisions
Dividendyieldisanimportantdeterminantofaninvestorsattitudetowardsthesecurity(stock)in
his portfolio management decisions. But dividend yield is the result of dividend decision.
Dividend decision is a major decision made by a finance manager. It is the decision on
formulationofdividendpolicy.Sincethegoaloffinancialmanagementismaximisationofwealth
of shareholders, dividend policy formulation demands the managerial attention on theimpact of
its policy on dividend on the market value of the shares. Optimum dividend policy requires
decisionondividend payment rates soasto maximizethe marketvalue of shares. Thepayout
ratio means what portionofearningsper share is given tothe shareholdersintheform of cash
dividend. In the formulation of dividend policy, management of a company must consider the
relevanceofitspolicyonbonusshares.
Dividend policy influences the dividend yield on shares. Since companys ratingsinthe Capital
market have a major impact on its ability to procure funds by issuing securities in the capital
markets,dividendpolicy,adeterminantofdividendyieldhastobeformulatedhavingregardtoall
the crucial elements in building up the corporate image. The following need adequate
considerationindecidingondividendpolicy:
1. PreferencesofshareholdersDotheywantcashdividendorCapitalgains?
2. Currentfinancialrequirementsofthecompany
3. Legalconstraintsonpayingdividends.
4. Striking an optimum balance between desires of share holders and the companys funds
requirements.
1.4.4 LiquidityDecision
Liquidity decisions are concerned with Working Capital Management. It is concerned with the
daytodayfinancialoperationsthatinvolvecurrentassetsandcurrentliabilities.
Theimportantelementofliquiditydecisionsare:
1) Formulationofinventorypolicy
2) Policiesonreceivablemanagement.
3) Formulationofcashmanagementstrategies
4) Policiesonutilizationofspontaneousfinanceeffectively.
1.4.5 OrganizationOfFinanceFunction
Financialdecisionsarestrategicincharacterandtherefore,anefficientorganizationalstructure
isrequiredtoadministerthesame.Financeislikebloodthatflowsthroughouttheorganization.
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InallorganizationsCFOsplayanimportantroleinensuringproperreportingbasedon
substancetothestakeholdersofthecompany.Becauseofthecrucialrolethesefunctionsplay,
financefunctionsareorganizeddirectlyunderthecontrolofBoardofDirectors.Forthesurvival
ofthefirm,thereisaneedtoensurebothlongtermandshorttermfinancialsolvency. Failureto
achievethiswillhaveitsimpactonallotheractivitiesofthefirm.
Weakfunctionalperformancebyfinancialdepartmentwillweakenproduction,marketingandHR
activitiesofthecompany.Theresultwouldbetheorganizationbecominganemic.Once
anemic,unlesscrucialandeffectiveremedialmeasuresaretakenupitwillpavewayfor
corporatebankruptcy.
CFOreportstotheBoardofDirectors. UnderCFO,normallytwoseniorofficersmanagethe
treasurerandcontrollerfunctions.
ATreasurerperformsthefollowingfunction:
1. Obtainingfinance.
2. Liasoningwithtermlendingandotherfinancialinstitutions.
3. Managingworkingcapital.
4. Managinginvestmentinrealassets.
AControllerperforms:
1. AccountingandAuditing
2. Managementcontrolsystems
3. Taxationandinsurance
4. Budgetingandperformanceevaluation
5. Maintaining assets intact to ensure higher productivity of operating capital employed in the
organization.
In India CFOs have a legal obligation under various regulatory provisions to certify the
correctnessofvariousfinancialstatementsinformationreportedtothestakeholdersintheannual
reports. Listing norms, regulations on corporate governance and other notifications of Govt of
IndiahaveadequatelyrecognizedtheroleoffinancefunctioninthecorporatesetupinIndia.
1.____________leadtoinvestmentinrealassets.
2._______________relatetotheacquisitionoffundsattheleastcost.
3.Formulationofinventorypolicyisanimportantelementof___________.
4.Obtainingfinanceisanimportantfunctionof_________.
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1.5 InterfaceBetweenFinanceAndOtherBusinessFunctions
1.5.1 FinanceAndAccounting
Lookingatthehierarchyofthefinancefunctionofanorganization,thecontrollerreportstoCFO.
Accountingisoneofthefunctionsthatacontrollerdischarges.Accountingandfinanceareclosely
related. For computation of Return on Investment, earnings per share and of various ratios for
financial analysis the data base will be accounting information. Without a proper accounting
system, an organization cannot administer effectively function of financial management. The
purposeofaccountingistoreportthefinancialperformanceofthebusinessfortheperiodunder
consideration. It is historical in character. But financial management uses the historical
accounting information for decision making. All the financial decisions are futuristic based on
cash flow analysis. All the financial decisions consider quality of cash flows as an important
elementofdecisions.Sincefinancialdecisionsarefuturistic,itistakenandputintoeffectunder
conditionsofuncertainty.
Assumingthedegreeofuncertaintyandincorporatingtheireffectondecisionmakinginvolveuse
ofvariousstatisticalmodels.Intheselectionofthesemodels,elementofsubjectivitycreepsin.
1.5.2 FinanceAndMarketing
Many marketing decisions have financial implications. Selections of channels of distribution,
decidingonadvertisementpolicy,remuneratingthesalesmenetchavefinancialimplications.In
fact,therecentbehaviourofrupeeagainstus$(appreciationofrupeeagainstUSdollar),affected
thecashflowpositionsofexportorientedtextileunitsandBPOsandothersoftwarecompanies.
Itisgenerallybelievedthatthecurrencyinwhichmarketingmanagerinvoicestheexportsdecides
thecashflowconsequencesoftheorganizationifthecompanyismainlydependentonexports.
Marketing cost analysis, a function of finance managers is the best example of application of
principlesoffinanceontheperformanceofmarketingfunctionsbyabusinessunit. Formulation
ofpolicyoncreditmanagementcannotbedoneunlesstheintegrationofmarketingwithfinanceis
achieved.Decidingoncredittermstoachieveaparticularlevelofsaleshasfinancialimplication
becausesanctioningliberalcreditmayresultinhugebaddebt,ontheotherhandaconservative
credittermsmaydepressthesales.Credittermsalsoaffecttheinvestmentinreceivable,anarea
of working capital management. There is a close relation between inventory and sales. Co
ordination of stores administration with that of marketing management is required to ensure
customersatisfactionandgoodwill.Butinvestmentininventoryrequiresthefinancialclearance
becausefundsarelockedinandthefundssoblockedhaveopportunitycostofcapital.
13
1.5.3FinanceAndProductions(Operations)
Financeandoperationsmanagementarecloselyrelated.Decisionsonplantlayout,technology
selection, productions / operations, process plant size, removing imbalance in the flow of input
material in the production / operation process and batch size are all operations management
decisionsbuttheirformulationandexecutioncannotbedoneunlessevaluatedfromthefinancial
angle. The capital budgeting decisions are closely related to production and operations
management.Thesedecisionsmakeormarabusinessunit.Wehaveexamplestosubstantiate
this. Failure to understand the implications of the latest technological trend on capacity
expansionshascostevenbluechipcompanies.ManytextileunitsinIndiabecamesickbecause
they did not provide sufficient finance for modernization of plant and machinery. Inventory
management is crucial to successful operation management. But management of inventory
involvesquitealotoffinancialvariables.
1.5.4 FinanceAndHR
Attractingandretainingthe bestmanpowerintheindustry cannotbedoneunlesstheyarepaid
salaryatcompetitiverates. Ifanorganizationformulates&implementsapolicyforattractingthe
competent man power it has to pay the most competitive salary packages to them. But it
improvesorganizationalcapitalandproductivity.Infosysdoesnothavephysicalassetssimilarto
that ofIndianRailways.Butifboth weretocometocapitalmarketwithapublicissueofequity,
Infosys wouldcommandbetterinvestorsacceptancethantheIndianRailways.Thisisbecause
thevalueofhumanresourcesplaysanimportantroleinvaluingafirm.Thebetterthequalityof
man power in an organization, the higher the value of the human capital and consequently the
highertheproductivityoftheorganization.
IndianSoftwareandITenabledserviceshavebeengloballyacclaimedonlybecauseoftheman
powertheypossess.Butithasacostfactori.e.thebestremunerationtothestaff.
1.6Summary
Financial Management is concerned with the procurement of the least cost funds and its
effective utilizationfor maximization of the net wealth of thefirm. Thereexistsa close relation
betweenthemaximizationofnetwealthofshareholdersandthemaximizationofthenetwealth
of the company. The broad areas of decision are capital budgeting, financing, dividend and
working capital. Dividend decision demands the managerial attention to strike a balance
betweentheinvestorsexpectationandtheorganizationsgrowth.
14
TerminalQuestions
1. Whataretheobjectivesoffinancialmanagement?
2. Howdoesafinancemanagerarriveatanoptimalcapitalstructure?
3. Examinetherelationshipoffinancialmanagementwithotherfunctionalareasofafirm.
AnswersToSelfAssessmentQuestionss
SelfAssessmentQuestions1:
1. Effectiveutilization
1. Profitmaximisation.
2. Wealth maximisation
3. Wealthmaximisation
1. Investmentdecisions.
2. Financingdecisions
3. Liquidity
4. Treasures
AnswerforTerminalQuestions
1. Refer1.3
2. Refer1.4.1
3. Refer1.5
15
Unit2FinancialPlanning
Structure
2.1. Introduction
2.2. Stepsinfinancialplanning
2.3. Factorsaffectingfinancialplan
2.4. Estimationoffinancialrequirementsofafirm.
2.5. Capitalizations
2.1.1 CostTheory
2.1.2 Earningstheory:
2.1.3 Overcapitalization
2.1.4 Undercapitalization
2.6 Summary
TerminalQuestions
AnswertoSAQsandTQs
2.1 Introduction
LiberalizationandglobalizationpoliciesinitiatedbytheGovernmenthavechangedthedimension
of business environment. It has changed the dimension of competition that a firm faces today.
Thereforeforsurvivalandgrowthafirmhastoexecuteplannedstrategysystematically.
Toexecuteanystrategicplan,resourcesarerequired.Resourcesmaybemanpower,plantand
machinery,building,technologyoranyintangibleasset.
To acquire all these assets financial resources are essentially required. Therefore, finance
managerofacompanymusthavebothlongrangeandshortrangefinancialplans.Integrationof
boththeseplansisrequiredfortheeffectiveutilizationofalltheresourcesofthefirm.
Thelongrangeplanmustconsider(1)Fundsrequiredtoexecutetheplannedcourseofaction.
(2) Funds available at the disposal of the company. (3) Determination of funds to be procured
fromoutsidesources.
16
LearningObjectives:
Afterstudyingthisunityoushould
1. Explainthestepsinvolvedinfinancialplanning.
2. Explainthefactorsaffectingthefinancialplanning.
3. Listoutthecausesofovercapitation
4. Explaintheeffectsofundercapitation.
ObjectivesofFinancialPlanning
FinancialPlanningisaprocessby whichfundsrequiredforeachcourseofactionisdecided.It
must consider expected business Scenario and develop appropriate courses of action. A
financial plan has to consider Capital Structure, Capital expenditure and cash flow. In this
connectiondecisionsonthecompositionofdebtandequitymustbetaken.
Financialplanninggeneratesfinancialplan.Financialplanindicates:
1. Thequantumoffundsrequiredtoexecutebusinessplans.
2. Compositionofdebtandequity,keepinginviewtheriskprofileoftheexistingbusiness,new
businesstobetakenupandthedynamicsofcapitalmarketconditions.
3. Formulationofpoliciesforgivingeffecttothefinancialplansunderconsideration.
Afinancialplanisatthecoreofvaluecreationprocess. Asuccessfulvaluecreationprocesscan
effectivelymeetthebenchmarksofinvestorsexpectations.
Benefitsthataccruetoafirmoutofthefinancialplanning
1. Effectiveutilizationoffunds:Shortageismanagedbyaplanthatensuresflowofcashatthe
least cost. Surplus is deployed through well planned treasury management. Ultimately the
productivityofassetsisenhanced.
2. Flexibilityincapitalstructureisgivenadequateconsideration.Hereflexibilitymeansthefirms
ability to change the composition of funds that constitute its capital structure in accordance
withthechangingconditionsofcapitalmarket.Flexibilityreferstotheabilityofafirmtoobtain
funds at the right time, in the right quantity and at the least cost as per requirements to
financeemergingopportunities.
3. Formulation of policies and instituting procedures for elimination of all types of wastages in
theprocessofexecutionofstrategicplans.
4. Maintainingtheoperatingcapabilityofthefirmthroughtheevolutionofscientificreplacement
schemesforplantandmachineryandotherfixedassets.Thiswillhelpthefirminreducingits
17
operatingcapital.Operatingcapitalreferstotheratioofcapitalemployedtosalesgenerated.
A perusal of annual reports of Dell computers will throw light on how Dell strategically
minimized the operating capital required to support sales. Such companies are admired by
investingcommunity.
5. Integrationoflongrangeplanswiththeshortageplans.
Guidelinesforfinancialplanning
1. Neverignorethecoordinalprinciplethatfixedassetrequirementsbemetfromthelongterm
sources.
2. Make maximum use of spontaneous source of finance to achieve highest productivity of
resources.
3. Maintain the operating capital intact by providing adequately out of the current periods
earnings.Dueattentiontobegiventophysicalcapitalmaintenanceoroperatingcapability.
4. Neverignoretheneedforfinancialcapitalmaintenanceinunitsofconstantpurchasingpower.
5. Employcurrentcostprinciplewhereverrequired.
6. Givedueweightagetocostandriskinusingdebtandequity.
7. Keeping the need for finance for expansion of business, formulate plough back policy of
earnings.
8. Exercisethoroughcontroloveroverheads.
9. Seasonalpeakrequirementstobemetfromshorttermborrowingsfrombanks.
2.2 StepsInFinancialPlanning
1. Establish Corporate Objectives: Corporate objectives could be grouped into qualitative and
quantitative. For example, a companys mission statement may specify create economic
valueadded.Butthisqualitativestatementhastobestatedinquantitativetermssuchasa
25%ROEora12%earningsgrowthrates.Sincebusinessenterprisesoperateinadynamic
environment,thereisaneedtoformulatebothshortrunandlongrunobjectives.
2. Next stage is formulation of strategies for attaining the objectives set. In this connection
corporatesdevelopoperatingplans.Operatingplansareframedwithatimehorizon.Itcould
beafiveyearplanoratenyearplan.
3. Once the plans are formulated, responsibility for achieving sales target, operating targets,
costmanagementbenchmarks,profittargetsetcisfixedonrespectiveexecutives.
4. Forecastthevariousfinancialvariablessuchassales,assetsrequired,flowoffunds,costto
be incurred and then translate the same into financial statements. Suchforecasts help the
18
finance manager to monitor the deviations of actual from the forecasts and take effective
remedialmeasurestoensurethattargetssetareachievedwithoutanytimeoverrunandcost
overrun.
5. Develop a detailed plan for funds required for the plan period under various heads of
expenditure.
6. Fromthefundsrequiredplan,developaforecastoffundsthatcanbeobtainedfrominternal
as well as external sources during the time horizon for which plans are developed. In this
connectionlegalconstrainsinobtainingfundsonthebasisofcovenantsofborrowingsshould
begivendueweightage.Thereisalsoaneedtocollaboratethefirmsbusinessriskwithrisk
implicationsofaparticularsourceoffunds.
7. Developacontrolmechanismforallocationoffundsandtheireffectiveuse.
8. Atthetimeofformulatingtheplanscertainassumptionsneedtobemadeabouttheeconomic
environment. But when plans are implemented economic environment may change. To
manage such situations, there is a need to incorporate an inbuilt mechanism which would
scaleuporscaledowntheoperationsaccordingly.
ForecastofIncomeStatementandBalanceSheet
Therearethreemethodsofpreparingincomestatement:
1. Percentofsalesmethodorconstantratiomethod
2. Expensemethod
3. Combinationofboththesetwo
PercentofSalesmethod:Thisapproachisbasedontheassumptionsthateachelementofcost
bearssomeconstantrelationshipwiththesalesrevenue.
Forexample,Rawmaterialcostis40%ofsalesrevenueoftheyearended31.03.2007.Butthis
methodassumesthattheratioofrawmaterialcosttosaleswillcontinuetobethesamein2008
also. Such an assumption may not hold good in most of the situations. For example, Raw
materialcostincreasesby10%in2008butsellingpriceoffinishedgoodsincreasesonlyby5%.
Inthiscaserawmaterialcostwillbe44/105ofthesalesrevenuein2008.Thiscanbesolvedto
someextentbytakingaverageforsamerepresentativeyears.However,inflation,changeinGovt
policies,wageagreements,technologicalinnovationtotallyinvalidatethisapproachonalongrun
basis.
19
2. BudgetedExpense Method: Expensesfor the planning period arebudgeted on the basisof
anticipated behaviour of various items of cost and revenue. This demands effective data
baseforreasonablebudgetingofexpenses.
3. Combinationofboththesemethodsisusedbecausesomeexpensescanbebudgetedbythe
management taking into account the expected business environment and some other
expensescouldbebasedontheirrelationshipwiththesalesrevenueexpectedtobeearned.
ForecastofBalanceSheet
1. Itemsofcertainassetsandliabilities which havea close relationship with the sales revenue
could be computed based on the forecast of sales and the historical data base of their
relationshipwiththesales.
2. Determine the equity and debt mix on the basis of funds requirements and the companys
policyonCapitalstructure.
Example:ThefollowingdetailshavebeenextractedfromthebooksofXLtd
IncomeStatement(Rs.Inmillions)
2006 2007
Saleslessreturns 1000 1300
GrossProfit 300 520
SellingExpenses 100 120
Administration 40 45
Deprecation 60 75
OperatingProfit 100 280
Nonoperatingincome 20 40
EBIT(Earningsbeforeinterest&Tax 120 320
Interest 15 18
Profitbeforetax 105 302
Tax 30 100
Profitaftertax 75 202
Dividend 38 100
Retainedearnings 37 102
BalanceSheet (Rs.Inmillion)
20
Liabilities 2006 2007 Assets 2006 2007
Shareholdersfund FixedAssets 400 510
ShareCapital Less:Depreciation 100 120
Equity 120 120 300 390
Preference 50 50 Investments 50 50
Reserves&Surplus 122 224
SecuredLoans 100 120
CurrentAssets,loans
&Advances
Unsecuredloans 50 60 CashatBank 10 12
Receivables 80 128
CurrentLiabilities Inventories 200 300
TradeCrs 210 250 Loans&Advances 50 80
Provisions
Miscellaneous
expenditure
10 24
Tax 10 60
ProposedDividend 38 100
760 984 700 984
Forecast the income statement and balance sheet for the year 2008 based on the following
assumptions.
1. Salesfortheyear2008willincreaseby30%overthesalesvaluefor2007.
2. Use percent of sales method to forecast the values for various items of income statement
usingthepercentagefortheyear2007.
3. Depreciationistochargedat25%offixedassets.
4. FixedassetswillincreasebyRs.100million.
5. InvestmentswillincreasebyRs.100million.
6. CurrentassetsandCurrentliabilitiesaretobedecidedbasedontheirrelationshiptosalesin
theyear2007.
7. MiscellaneousexpenditurewillincreasebyRs.19million.
8. Securedloansin2008willbebasedonitsrelationshiptosalesintheyear2007.
9. Additionalfundsrequired,ifany,willbemetbybankborrowings.
10. Taxrateswillbe30%.
21
11. Dividendswillbe50%ofprofitaftertax.
12. Nonoperatingincomewillincreaseby10%.
13. Therewillbenochangeinthetotalamountofadministrationexpensestobespentintheyear
2008
14. Thereisnochangeinequityandpreferencecapitalin2008.
15. Interestfor2008willmaintainthesameratioasithasin2007withthesalesof2007.
IncomeStatementfortheYear2008 (Rs.Inmillion)
(Forecast)
Particulars Basis Working Amount(Rs.)
a.Sales Increaseby30% 1300x1.3 1690
b.CostofSales Increaseby30% 780x1.3 1014
c.Grossprofit SalesCostofsales 16901014 676
d.Sellingexpenses 30%increase 120x1.3 156
e.Administration Nochange 45
f.Depreciation %given 390+100
4
123(Roundedoff)
g.OperatingProfit C(D+E+F) 352
h.NonoperatingIncome Increaseby10% 1.1x40 44
i.EarningsBefore
Interest&Taxes(EBIT)
396
j.Interest 18ofsales
1300
18x1690
1300
23(Decimalignored)
k.Profitbeforetax 373
l.Tax 112
m.Profitaftertax 261
n.Dividends 130
o.Retainedearnings 131
BalanceSheetfortheyear2008(Rs.Inmillion)
(Forecast)
22
Particulars Basis Working Amount(Rs.)
Assets
FixedAssets Given 510
Add:Addition 100
610
Depreciation 120+123 243
1.Netfixedassets 367
2.Investments 150
3.CurrentAssets&Loans
&advances
Cashatbank 12
1300
12x1690
1300
16(Roundedoff)
Receivables 128
1300
128x1690
1300
166
Inventories 300
1300
300x1690
1300
390
Loans&Advances 80
1300
80x1690
1300
104
4.Miscellaneous
Expenditure
Given 24+19 43
Total 1236
Liabilities
1. ShareCapital
Equity 120
Preference 50
2.Reserves&Surplus Increasebycurrent
yearsretained
earnings
355
3.SecuredLoan 60
1300
60x1690
1300
78
Bankborrowings 40(Difference
Balancingfigure)
23
4. UnsecuredLoan 60 60
5. CurrentLiabilities&
Provision
Tradecreditors 250
1300
250x1690
1300
325
Provisionfortax 60
1300
60x1690
1300
78
ProposedDividend Currentyeargiven 130
TotalLiabilities 1236
ComputerisedFinancialPlanningSystems
AllcorporateforecastsuseComputerisedforecastingmodels.
Additional funds required to finance the increase in sales could be ascertained using a
mathematicalrelationshipbasedonthefollowing:
Additionalfunds =Requiredincrease Spontaneous Increasein
Required inassets increasein retained
liabilities earnings
(This formula has been recommended by Engene.F.Brighaom and Michael C Ehrharte in their
bookfinancialmanagementTheoryandPractice,10
th
edition.
Prof.PrasannaChandra,inhisbookFinancialManagement,hasgivenacomprehensiveformula
forascertainingtheexternalfinancingrequirements:
EFR=A(Ds)L(Ds)ms(1d)(D1m+SR)
S S
Here
A =Expectedincreaseinassets,bothfixedandcurrentrequiredforthe
Sexpectedincreaseinsalesinthenextyear.
L=ExpectedSpontaneousfinancingavailablefortheexpectedincreasein
Ssales
MS
1
(1d)=Itistheproductof
ProfitmarginxExpectedsalesforthenextyearxRetentionRatio
X Ds
X Ds
24
Here, retention ratio is 1 payout ratio. Payout ratio refers to the ratio of dividend paid to
earningspershare
D1m=Expectedchangeinthelevelofinvestmentsandmiscellaneousexpenditure
SR=Itisthefirmsrepaymentliabilityontermloansanddebentureforthenextyear.
Thisformulahascertainfeatures:
1. Ratiosofassetsandspontaneousliabilitiestosalesremainconstantovertheplanningperiod.
2. Dividendpayoutandprofitmarginforthenextyearcanbereasonablyplannedinadvance.
3. Since external funds requirements involve borrowings from financial institution, the formula
rightlyincorporatesthemanagementsliabilityonrepayments.
Example
ALtdhasgiventhefollowingforecasts:
Salesin2008willincreasetoRs.2000fromRs.1000in2007
ThebalancesheetofthecompanyasonDecember31,2007givesthefollowingdetails:
Liabilities Rs Assets Rs
ShareCapital NetFixedAssets 500
Equity(SharesofRs.10each) 100 Inventories 200
Reserves&Surplus 250 Cash 100
Longtermloan 400 BillsReceivable 200
Crsforexpensesoutstanding 50
Tradecreditors 50
BillsPayable 150
1000 1000
Ascertain the external funds requirements for the year 2008, taking into account the following
information:
1. TheCompanysutilizationoffixedassetsin2007was50%ofcapacitybutitscurrentassets
wereattheirproperlevels.
2. Currentassetsincreaseatthesamerateassales.
3. Companysaftertaxprofitmarginisexpectedtobe5%,anditspayoutratiowillbe60%.
4. Creditorsforexpensesarecloselyrelatedtosales(AdaptedfromIGNOUMBA)
Answers
Preliminaryworkings
A=Currentassets=Cash+BillsReceivables+Inventories
25
=100+200+200=500
A=500=Rs.500
S1000
L=Tradecreditors+Billspayable+Expensesoutstanding
=50+150+50=Rs.250
L =250=Rs.250
S 1000
M(ProfitMargin)=5/100=0.05
S
1
=Rs.200
1d=10.6=0.4or40%
D1m=NIL
SR=NIL
Therefore:
) 1 ( ) 1 (
) (
1
SR m d mS S x
S
L
S
s A
EFR + D - - - D -
D
=
=500250(0.05x200x0.4)(0+0)
=50025040(0+0)
=Rs.210
Therefore, external funds requirements (additional funds required) for 2008 will be Rs.210.
This additional funds requirements will be procured by the firm based on its policy on capital
structure.
1. Corporateobjectivescouldbegroupinto________and________.
2. Controlmechanismisdevelopedfor_____________andtheireffectiveuse.
3. Seasonalpeakrequirementstobemetfrom___________________frombanks.
4. Exercisethrough_________overoverheads.
2.3FactorsAffectingFinancialPlan
1. Nature of the industry: Here, we must consider whether it is a capital intensive or labour
intensiveindustry.Thiswillhaveamajorimpactonthetotalassetsthatthefirmowns.
2. Size of the Company: The size of the company greatly influences the availability of funds
from different sources. A small company normally finds it difficult to raise funds from long
X Ds
X1000
X Ds X1000
26
term sourcesatcompetitive terms. Onthe other hand,large companies like Relianceenjoy
theprivilegeofobtainingfundsbothshorttermandlongtermatattractiverates.
3. Status of the company in the industry: A well established company enjoying a good
market share, for its products normally commands investors confidence. Such a company
cantapthecapitalmarketforraisingfundsincompetitivetermsforimplementingnewprojects
toexploitthenewopportunitiesemergingfromchangingbusinessenvironment.
4. Sources of finance available: Sources of finance could be grouped into debt and equity.
Debt is cheap but risky whereas equity is costly. A firm should aim at optimum capital
structure that would achieve the least cost capital structure. A large firm with a diversified
product mix may manage higher quantum of debt because the firm may manage higher
financialriskwithalowerbusinessrisk.Selectionofsourcesoffinanceiscloselylinkedtothe
firmscapacitytomanagetheriskexposure.
5. The Capital structure of a company is influenced by the desire of the existing management
(promoters)ofthecompanytoretaincontrolovertheaffairsofthecompany.Thepromoters
whodo notlike tolosetheirgripovertheaffairsofthecompanynormallyobtainextrafunds
forgrowthbyissuingpreferencesharesanddebenturestooutsiders.
6. Matching the sources with utilization: The prudent policy of any good financial plan is to
match the term of the source with the term of investment. To finance fluctuating working
capitalneedsthefirmresortstoshorttermsfinance.Allfixedassetsfinancedinvestmentsare
tobefinancialbylongtermsources.Itisacardinalprincipleoffinancialplanning.
7. Flexibility:Thefinancialplanofacompanyshouldpossessflexibilitysoastoeffectchanges
in the composition of capital structure when ever need arises. If the capital structure of a
companyisflexible,itwillnotfaceanydifficultyinchangingthesourcesoffunds.Thisfactor
hasbecomeasignificantonetodaybecauseoftheglobalizationofcapitalmarket.
8. GovernmentPolicy:SEBIguidelines,financeministrycirculars,variousclausesofStandard
Listing Agreement and regulatory mechanism imposed by FEMA and Department of
corporate affairs (Govt of India) influence the financial plans of corporates today.
ManagementofpublicissuesofsharesdemandsthecomplianceswithmanystatuesinIndia.
Theyaretobecompliedwithatimeconstraint.
SelfAssessmentQuestions2:
1. ___________hasamajorimpactonthetotalassetsthatthefirmowns.
2. Sourcesoffinancecouldbegroupedinto__and_______________.
27
3. ___________ofanygoodfinancialplanis tomatchthetermofthesourcewiththetermof
thesourcewiththetermoftheinvestment.
4. ________________referstheabilityto______________________wheneverneedarises.
2.4 EstimationOfFinancialRequirementsOfaFirm.
Theestimationofcapitalrequirementsofafirminvolvesacomplexprocess.Evenwithexpertise,
managementsofsuccessfulfirmscouldnotarriveattheoptimumcapitalcompositionintermsof
thequantumandthesources.Capitalrequirementsofafirmcouldbegroupedintofixedcapital
and workingcapital.Thelongtermrequirementssuchasinvestmentinfixedassetswillhaveto
be met out of funds obtained on long term basis. Variable working capital requirements which
fluctuate from season to season will have to be financed only by short term sources. Any
departurefromthiswellacceptednormcausesnegativeimpactsonfirmsfinances.
SelfAssessmentQuestion3:
1.Capitalrequirementofafirmcouldbegroupedinto________and__________.
2.Variableworkingcapitalwillhavetobefinancedonlyby_______________.
2.5Capitalizations
Meaning: Capitalization ofafirm refers the composition ofits longterm funds. It refers to the
capitalstructureofthefirm.Ithastwocomponentsvizdebtandequity.
Afterestimatingthefinancialrequirementsofafirm,thenthenextdecisionthatthemanagement
hastotakeistoarriveatthevalueatwhichthecompanyhastobecapitalized.
TherearetwotheoriesofCapitalizationfornewcompanies:
1.Costtheoryand 2.Earningstheory
2.5.1CostTheory:
Under this approach, the total amount of capitalization for a new company is the sum of the
following:
1. Costoffixedassets.
2. Costofestablishingthebusiness.
3. Amountofworkingcapitalrequired
28
Meritsofcostapproach:
1. It helps promoters to estimate the amount of capital required for incorporation of company
conducting market surveys, preparing detailed project report, procuring funds, procuring
assetsbothfixedandcurrent,trialproductionrunandsuccessfullyproducing,positioningand
marketingofitsproductsorrenderingofservices.
2. Ifdonesystematicallyitwilllayfoundationforsuccessfulinitiationoftheworkingofthefirm.
Demerits
1. Ifthefirmestablishesitsproductionfacilitiesatinflated prices,productivityofthefirm willbe
lessthanthatoftheindustry.
2. Networthofacompanyisdecidedbytheinvestorsbytheearningsofacompany.Earnings
capacitybasednetworthhelpsafirmtoarriveatthetotalcapitalintermsofindustryspecified
yardstick ( i,e, operating capital based on bench marks in that industry) cost theory fails in
thisrespect.
2.5.2 EarningsTheory:
Earningsareforecastandcapitalizedatarateofreturnwhichisrepresentativeoftheindustry.It
involvestwosteps.
1. Estimationoftheaverageannualfutureearnings.
2. Normalearningrateoftheindustrytowhichthecompanybelongs.
Merits
1. It is superior to cost theory because there are, the least chances of neither under not over
capitalization.
2. Comparisonofearningsapproachwiththatofcostapproachwillmakethemanagementtobe
cautious in negotiating the technology and cost of procuring and establishing the new
business.
Demerits
1. The major challenge that a new firm faces is in deciding on capitalization and its division
thereofintovariousprocurementsources.
2. Arrivingatcapitalizationrateisequallyaformidabletaskbecausetheinvestorsperceptionof
established companies cannot be really representative of what investors perceive of the
earningpowerofnewcompany.
29
Because of the problem, most of the new companies are forced to adopt the cost theory of
capitalization.
Ideallyeverycompanyshouldhavenormalcapitalization.Butitisanutopianwayofthinking.
Changing business environment, role of international forces and dynamics of capital market
conditionsforceustothinkintermsofwhatisoptimaltodayneednotbesotomorrow.Evenwith
these constraints, management of every firm should continuously monitor the firms capital
structuretoensuretoavoidthebadconsequencesofoverandundercapitalization.
2.5.3 Overcapitalization
Acompanyissaidtobeovercapitalized,whenitstotalcapital(bothequityanddebt)exceedsthe
truevalue ofits assets. Itis wrong toidentify overcapitalization with excess of capitalbecause
most of the overcapitalized firms suffer from the problems of liquidity. The correct indicator of
overcapitalizationistheearningscapacityofthefirm.Iftheearningsofthefirmarelessthenthat
of the market expectation,it willnot be in a position to pay dividends toits shareholders as per
theirexpectations.Itisasignofovercapitalization.Itisalsopossiblethatacompanyhasmore
fundsthanitsrequirementsbasedoncurrentoperationlevels,andyethavelowearnings.
Overcapitalizationmaybeonaccountofanyofthefollowing:
1. Acquiringassetsatinflatedrates
2. Acquiringunproductiveassets.
3. Highinitialcostofestablishingthefirm
4. Companieswhichestablishtheirnewbusinessduringboomconditionareforcedtopaymore
for acquiring assets, causing a situation of overcapitalization once the boom conditions
subside.
5. Totalfundsrequirementshavebeenoverestimated.
6. Unpredictablecircumstances(likechangeinimportexportpolicy,changeinmarketratesof
interest,changesininternationaleconomicandpoliticalenvironment)reducesubstantiallythe
earningcapacityofthefirm.Forexample,rupeeappreciationagainstU.S.dollarhasaffected
earningcapacityoffirmsengagedmainlyinexportbusinessbecausetheyinvoicetheirsales
inUSdollar.
7. Inadequate provision for depreciation adversely affects the earning capacity of a company ,
leadingtoovercapitalizationofthefirm.
8. Existenceofidlefunds.
30
Effectsofovercapitalization
1. Declineintheearningsofthecompany.
2. Fallindividendrates.
3. Marketvalueofcompanyssharefalls,andcompanylosesinvestorsconfidence.
4. Company may collapseatany time becauseofanemicfinancial conditions it willaffectits
employees, society, consumers and its shareholders. Employees will lose jobs. If the
companyisengagedintheproductionandmarketingofcertainessentialgoodsandservices
tothesociety,thecollapseofthecompanywillcausesocialdamage.
RemediesforOvercapitalization:
Restructuringthefirmistobeexecutedtoavoidthesituationofcompanybecomingsick.
Itinvolves
1. Reductionofdebtburden.
2. Negotiationwithtermlendinginstitutionsforreductionininterestobligation.
3. Redemptionofpreferencesharesthroughaschemeofcapitalreduction.
4. Reducingthefacevalueandpaidupvalueofequityshares.
5. Initiating merger with well managed profit making companies interested in taking over ailing
company.
2.5.4 Undercapitalization
Undercapitalization is just the reverse of overcapitalization. A company is considered to be
undercapitalizedwhenitsactualcapitalizationislowerthanitspropercapitalizationaswarranted
byitsearningcapacity.
Symptomsofundercapitalization
1. Actualcapitalizationislessthanthatwarrantedbyitsearningcapacity.
2. Its rate of earnings is exceptionally high in relation to the return enjoyed by similar situated
companiesinthesameindustry.
Causesofundercapitalization
1. Underestimationoffutureearningsatthetimeofpromotionofthecompany.
2. Abnormalincreaseinearningsfromneweconomicandbusinessenvironment.
3. Underestimationoftotalfundsrequirements.
31
4. Maintainingveryhighefficiencythroughimprovedmeansofproductionofgoodsorrendering
ofservices.
5. Companies which are set up during recession start making higher earning capacity as soon
astherecessionisover.
6. Useoflowcapitalizationrate.
7. Companieswhichfollowconservativedividendpolicywillachieveaprocessofgraduallyrising
profits.
8. Purchaseofassetsatexceptionallylow pricesduringrecession.
Effectsofundercapitalization
1. Encouragement to competition: undercapitalization encourages competition by creating a
feelingthatthelineofbusinessislucrative.
2. Itencouragesthemanagementofthecompanytomanipulatethecompanysshareprices.
3. Highprofitswillattracthigheramountoftaxes.
4. High profits will make the workers demand higher wages. Such a feeling on the part of
employeesleadstolabourunrest.
5. High margin of profit may create among consumers an impression that the company is
charginghighpricesforitsproducts.
6. High margin of profits and the consequent dissatisfaction among its employees and
consumer,mayinvitegovernmentalenquiryintothepricingmechanismofthecompany.
Remedies
1. SplittingupofthesharesThiswillreducethedividendpershare.
2. Issueofbonusshares:Thiswillreduceboththedividendpershareandearningspershare.
Bothovercapitalizationandundercapitalizationaredetrimentaltotheinterestsofthesociety.
1.______________ofafirmreferstothecompositionofitslongtermfunds.
2.Twotheoriesofcapitalizationfornewcompaniesare________andearningstheory.
3.Acompanyissaidtobe___________,whenitstotalcapitalexceedsthetruevalueofits
assets.
4.Acompanyisconsideredtobe________________whenitsactualcapitalizationislowerthan
itspropercapitalizationaswarrantedbyitsearningcapacity.
32
2.6 Summary
Financial planning deals with the planning, execution and monitoring of the procurement and
utilizationoffunds.Financialplanningprocessgivesbirthtofinancialplan.Itcouldbethoughtof
ablueprintexplainingtheproposedstrategyanditsexecution.Therearemanyfinancialplanning
models. All these models forecast the future operations and then translate them into income
statementsandbalancesheets.Itwillalsohelpthefinancemanagerstoascertainthefundsto
be procured from outside sources. The essence of all these is to achieve a least cost capital
structurewhichwouldmatchwiththeriskexposureofthecompany. Failuretofollowtheprinciple
of financial planning may lead a new firm to over or undercapitalization when the economic
environmentundergoesachange. Ideallyeveryfirmshouldaimatoptimumcapitalization.Other
wiseitmayfaceasituationofoverorundercapitalization.Botharedetrimentaltotheinterestsof
thesociety.Therearetwotheoriesofcapitalizationvizcosttheoryandearningstheory.
TerminalQuestions
1. ExplainthestepsinvolvedinFinancialPlanning.
2. ExplainthefactorsaffectingFinancialPlan
3. ListoutthecausesofOverCapitalization.
4. ExplaintheeffectsofUnderCapitalization.
AnswersToSelfAssessmentQuestions
1. Qualitative,Quantitative.
2. Allocationoffunds
3. Shorttermborrowings
1. Natureoftheindustry
2. Debt,Equity
3. Theproductpolicy
4. Flexibilityincapitalstructure,effectchangesinthecompositesofcapitalstructure
33
1. Fixedcapital,workingcapital.
2. Shorttermsources
1. Capitalization
2. Costtheory
3. OverCapitalized
4. Undercapitalized
AnswertoTerminalQuestions
1. Refertounit2.2
2. Refertounit 2.3
3. Refertounit 2.5.3
4. Refer tounit 2.5.4
34
Unit3 TimeValueofMoney
Structure
3.1 Introduction
3.2 TimePreferenceRateandRequiredRateofReturn
3.2.1 CompoundingTechnique
3.2.2 DiscountingTechnique
3.2.3 FutureValueofaSingleFlow(Lumpsum):
3.2.4 FutureValueofSeriesofCashFlows
3.2.5 FutureValueofanAnnuity
3.2.5.1SinkingFund
3.3 PresentValue
3.3.1 DiscountingorPresentValueofaSingleFlow
3.3.2 PresentValueofaSeriesofCashFlows
3.3.2.1 PresentValueofPerpetuity
3.3.2.2 CapitalRecoveryFactor
3.4 Summary
SolvedProblems
TerminalQuestions
AnswertoSAQsandTQs
3.1 Introduction
Themainobjectiveofthisunitistoenableyoutolearnthetimevalueofmoney.Inthepreviousunit,
wehavelearntthatwealthmaximizationistheprimaryobjectiveoffinancialmanagementandthatis
more important than profit maximization for its superiority in the sense that it is futureoriented. A
decisiontakentodaywillhavefarfetchingimplications.Forexample,afirminvestinginfixedassets
willreapthebenefitsofsuchinvestmentforanumberofyears.Ifsuchassetsareprocuredthrough
bankborrowingsor term loansfromfinancial institutions, these involve an obligation topay interest
and return of principal. Decisions are made by comparing the cash inflows (benefits/returns) and
cashoutflows(outlays).Sincethesetwocomponentsoccuratdifferenttimeperiods,thereshouldbe
35
acomparison.Inordertohavealogicalandmeaningfulcomparisonbetweencashflowsthataccrue
overdifferentintervalsoftime,itisnecessarytoconverttheamountstoacommonpointoftime.This
unitisdevotedforadiscussionofthetechniquesofdoingso.
LearningObjectives:
1. Explainthetimevalueofmoney.
2. Understandthevaluationconcepts.
3. Calculatethepresentandfuturevaluesoflumpsumandannuityflows.
Rationale: Time Value of Money is the value of a unit of money at different time intervals. The
value of money received today is more than its value received at a later date. In other words, the
valueofmoneychangesoveraperiodoftime.Sincearupeereceivedtodayhasmorevalue,rational
investors would prefer current receipts to future receipts. That is why this phenomenon is also
referredtoasTimePreferenceofMoney.Someimportantfactorscontributingtothisare:
Investmentopportunities:
Preferenceforconsumption
Risk
ThesefactorsremindusofthefamousEnglishsayingAbirdinhandisworthtwointhebush.
Whyshouldmoneyhavetimevalue?
Someofthereasonsare:
Moneycanbeemployedproductivelytogeneraterealreturns.Forexample,ifwespendRs.500on
materialsandRs.300onlabourandRs.200onotherexpensesandthefinishedproductissoldfor
Rs.1100,wecansaythattheinvestmentofRs.1000hasfetchedusareturnof10%.
Secondly,duringperiodsofinflation,arupeehasahigherpurchasingpowerthanarupeeinfuture.
Thirdly, we all live under conditions of risk and uncertainty. As future is characterized by
uncertainty, individuals prefer current consumption to future consumption. Most people have
36
subjective preference for present consumption either because of their current preferences or
becauseofinflationarypressures.
3.2 FutureValue:
TimePreferenceRateandRequiredRateofReturn
Thetime preferencefor money isgenerally expressed by an interest rate. This rate will bepositive
even in the absence of any risk. It is called the riskfree rate. For example, if an individuals time
preferenceis8%,itimpliesthatheiswillingtoforegoRs.100todaytoreceiveRs.108afteraperiod
ofoneyear.ThusheconsidersRs.100andRs.108areequivalentinvalue.Butinrealitythisisnot
the only factor he considers. There is an amount of risk involved in such investment. He therefore
requiresanotherrateforcompensatinghimwiththiswhichiscalledtheriskpremium.
Requiredrateofreturn=Riskfreerate+RiskPremium
There are two methods by which time value of money can be calculated compounding and
discounting.
3.2.1CompoundingTechnique:Underthismethodofcompounding,thefuturevaluesofallcash
inflowsattheendofthetimehorizonataparticularrateofinterestarefound.Interestiscompounded
when the amount earned on an initial deposit becomes part of the principal at the end of the first
compoundingperiod.IfMr.AinvestsRs.1000inabankwhichoffershim5%interestcompounded
annually, he has Rs. 1050 in his account at the end of the first year. The total of the interest and
principal Rs. 1050 constitutes the principal for the next year. He thus earns Rs. 1102.50 for the
secondyear.Thisbecomestheprincipalforthethirdyear.Thiscompoundingprocedurewillcontinue
for an indefinite number of years. The compounding of interest can be calculated by the following
equation:
A=P(1+i)
n
WhereA=Amountattheendoftheperiod
P=Principalattheendoftheperiod
i=rateofinterest
n=numberofyears
The amount of money in the account at the end of various years is calculated as under, using the
equation:
37
Amountattheendofyear1=Rs.1000(1+0.05)==Rs.1050
Amountattheendofyear2=Rs.1050(1+0.05)==Rs.1102.50
Amountattheendofyear3=Rs.1102.50(1+0.05)==Rs.1157.63
Year 1 2 3
Beginningamount Rs.1000 Rs.1050 Rs.1102.50
Interestrate 5% 5% 5%
Amountofinterest 50 52.50 55.13
Beginning
principal
1000 Rs.1050 Rs.1102.50
Endingprincipal Rs.1050 Rs.1102.50 Rs.1157.63
Theamountattheendofyear2canbeascertainedbysubstitutingRs.1000(1+0.05)forR.
1050,thatis,Rs.1000(1+0.05)(1+0.05)=Rs.1102.50.
Similarly, theamount at the end of year3canbe ascertainedby substituting Rs. Rs. 1000(1+0.05)
(1+0.05)(1+0.05)=Rs.1157.63.
ThusbysubstitutingtheactualfiguresfortheinvestmentorRs.1000intheformulaA=P(1+i)
n
,we
arriveattheresultshownaboveinTable.
3.2.2DiscountingTechnique:Underthemethodofdiscounting,wefindthetimevalueofmoney
now,thatis,attime0onthetimeline.Itisconcernedwithdeterminingthepresentvalueofafuture
amount. This is in contrast to the compounding approach where we convert present amounts into
futureamountsindiscountingapproachweconvertthefuturevaluetopresentsums.Forexample,if
Mr.ArequirestohaveRs.1050attheendofyear1,giventherateofinterestas5%,hewouldlike
toknowhowmuchheshouldinvesttodaytoearnthisamount.IfPistheunknownamountandusing
theequationwegetP(1+0.5)=1050.Solvingtheequation,wegetP=Rs.1050/1.05=Rs.1000.
ThusRs.1000wouldbetherequiredprincipalinvestmenttohaveRs.1050attheendofyear1at
5%interestrate.Inotherwords,thepresentvalueofRs.1050receivedoneyearfromnow,rateof
interest 5%, is Rs. 1000. The present value of money is the reciprocal of the compounding value.
Mathematically, we have P=A {1/(1+i)
n
} in which P is the present value for the future sum to be
received,Aisthesumtobereceivedinfuture,iistheinterestrateandnisthenumberofyears.
38
3.2.3 Future Value of a Single Flow (lump sum): The process of calculating future value will
becomeverycumbersomeiftheyhavetobecalculatedoverlongmaturityperiodsof10or20years.
Ageneralizedprocedureforcalculatingthefuturevalueofasinglecashflowcompoundedannually
isasfollows:
FV
n
=PV(1+i)
n
WhereFV
n
=Futurevalueoftheinitialflowinnyearshence
PV=Initialcashflow
I=Annualrateofinterest
N=Lifeofinvestment
The expression (1+i)
n
represents the future value of the initial investment of Re. 1 at the end of n
numberofyearsattheinterestratei,referredtoastheFutureValueInterestFactor(FVIF).Tohelp
ease in calculations, the various combinations of I and n can be referred to in the table. To
calculate the future value of any investment, the corresponding value of (1+i)
n
from the table is
multipliedwiththeinitialinvestment.
Example:Thefixeddepositschemeofabankoffersthefollowinginterestrates:
Periodofdeposit Rateperannum
<45days 9%
46daysto179days 10%
180daysto365days 10.5%
365daysandabove 11%
HowmuchdoesaninvestmentofR.10000investedtodaygrowtoin3years?
Solution:FVn=PV(1+i)
n
orPV*FVIF(11%,3y)
=10000*1.368(fromthetables)
=Rs.13680
Doublingperiod:Averycommonquestionarisinginthemindsofaninvestorishowlongwillittake
for the amount invested to doublefor a given rate of interest. There are 2 ways of answering this
question.Oneiscalledruleof72.Thisrulestatesthattheperiodwithinwhichtheamountdoubles
isobtainedbydividing72bytherateofinterest.Forinstance,ifthegivenrateofinterestis10%,the
doublingperiodis72/10,thatis,7.2years.
39
A much accurate way of calculating doubling period is the rule of 69, which is expressed as
0.35+69/interestrate.Goingbythesameexamplegivenabove,wegetthenumberofyearsas7.25
years{0.35+69/10(0.35+6.9)}.
Increasedfrequencyofcompounding
It has been assumed that the compounding is done annually. If a scheme is offered where
compounding is done more frequently, let us see its effect on interest earned. For example, if we
have deposited Rs. 10000 in a bank which offers 10% interest per annum compounded semi
annually,theinterestearnedwillbeasfollows:
Amountinvested Rs. 10000
Interestearnedforfirst6months
10000*10%*1/2(for6months) Rs. 500
Amountattheendof6months Rs. 10500
Interestearnedforsecond6months
10500*10%*1/2 Rs. 525
Amountattheendoftheyear Rs. 11025
If in theabove case compounding isdoneonlyoncea year the interest earned will be10000*10%
whichisequaltoRs.1000andwewillhaveRs.11000attheendoffirstyear.Wefindthatweget
moreinterestifcompoundingisdoneonamorefrequentbasis.Thegeneralizedformulaforshorter
compoundingperiodsis:
FV
n
=PV(1+i/m)
m*n
Where,FV
n
=Futurevalueafternyears
PV=Cashflowtoday
i=Nominalinterestrateperannum
m=No.oftimescompoundingisdoneduringayear
n=No.ofyearsforwhichcompoundingisdone.
Example: Under the Andhra Banks Cash Multiplier Scheme, deposits can be made for periods
ranging from 3 months to 5 years. Every quarter, interest is added to the principal. The applicable
rate of interest is 9%for deposits less than 23 months and10%for periods more than24 months.
WhatwilltheamountofRs.1000todaybeafter2years?
40
Solution:
FV
n
=PV(1+i/m)
m*n
1000(1+0.10/4)
4*2
1000(1+0.10/4)
8
Rs.1218
Effective vs. nominal rate of interest: We have just learnt that interest accumulation by frequent
compoundingismuchmorethantheannualcompounding.Thismeansthattherateofinterestgiven
to us, that is, 10% is the nominal rate of interest per annum. If the compounding is done more
frequently,saysemiannually,theprincipalamountgrowsat10.25%perannum.0.25%isknownas
theEffectiveRateofInterest.Thegeneralrelationshipbetweentheeffectiveandnominalratesof
interestisasfollows:
r={(1+i/m)
m
}1
Where,
r=Effectiverateofinterest
i=Nominalrateofinterest
m=Frequencyofcompoundingperyear.
Example:Calculatetheeffectiverateofinterestifthenominalrateofinterestis12%andinterestis
compoundedquarterly.
Solution:
r={(1+i/m)
m
}1
r={(1+0.12/4)
4
}1
r=0.126or12.6%p.a.
3.2.4 FutureValueOfSeriesOfCashFlows
Wehaveconsideredonlysinglepaymentmadeonceanditsaccumulationeffect.Aninvestormaybe
interestedininvestingmoneyininstallmentsandwishtoknowthevalueofhissavingsafternyears.
Forexample,Mr.MadaninvestsRs.500,Rs.1000,Rs.1500,Rs.2000andRs.2500attheendof
eachyearfor5years.Calculatethevalueattheendof5yearscompoundedannuallyiftherateof
interestis5%p.a.
41
Solution:
Endof
year
Amount
invested
Numberof
years
compounded
Compounded
interestfactor
fromtables
FVin
Rs.
1 Rs.500 4 1.216 608
2 Rs.
1000
3 1.158 1158
3 Rs.
1500
2 1.103 1654
4 Rs.2000 1 1.050 2100
5 Rs.
2500
0 1.000 2500
Amountattheendof5
th
Year Rs.
8020
3.2.5 FutureValueOfAnAnnuity
Annuityreferstotheperiodicflowsofequalamounts.Theseflowscanbeeithertermedasreceipts
or payments. For example, if you have subscribed to the Recurring Deposit Scheme of a bank
requiring you to pay Rs. 5000 annually for 10 years, this stream of payouts can be called
Annuities. Annuities require calculations based on regular periodic contribution of a fixed sum of
money.
Thefuturevalueofaregularannuityforaperiodofnyearsatirateofinterestcanbesummedupas
under:
FVA
n
=A{(1+i)
n
1}/i
WhereFVA
n
=Accumulationattheendofnyears
i=Rateofinterest
n=Timehorizonorno.ofyears
A=Amountdeposit/investedattheendofeveryyearfornyears.
The expression {(1+i)
n
1}/ i is called the Future Value Interest Factor for Annuity (FVIFA). This
representstheaccumulationofRe.1investedattheendofeveryyearfornnumberofyearsatirate
ofinterest.Thetablesattheendofthisbookgiveusthecalculationsfordifferentcombinationsofi
and n. We just have to multiply the relevant value with A and get the accumulation in the formula
givenabove.
42
Example:M.RamKumardepositsRs.3000attheendofeveryyearfor5yearsintohisaccountfor
5years,interestbeing5%compoundedannually.Determinetheamountofmoneyhewillhaveatthe
endofthe5
th
year.
Endof
year
Amount
invested
Numberof
years
compounded
Compounded
interest
factorfrom
tables
FVinRs.
1 Rs.
2000
4 1.216 2432
2 Rs.
2000
3 1.158 2316
3 Rs.
2000
2 1.103 2206
4 Rs.2000 1 1.050 2100
5 Rs.
2000
0 1.000 2000
Amountattheendof5
th
Year Rs.11054
ORUsingformulaandthetableswecanfindthat:
=2000FVIFA(5%,5y)
=2000*5.526
=Rs.11052
Wenoticethatwecangettheaccumulationsattheendofnperiodusingthetables.Calculationsfor
alongtimehorizonareeasilydonewiththehelpofreferencetables.Annuitytablesarewidelyused
inthefieldofinvestmentbankingasreadyreckoners.
Example: Calculate the value of an annuity flow of Rs. 5000 done on a yearly basis for 5 years,
yieldinganinterestof8%p.a.
Solution:
=5000FVIFA(8%,5y)
=5000*5.867
=Rs.29335
43
3.2.5.1SinkingFund
Sinkingfundisafundwhichiscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuture
sumafteraspecifiedperiod.Thesinkingfundfactorisusefulindeterminingtheannualamounttobe
putinafundtorepaybondsordebenturesortopurchaseafixedassetorapropertyattheendofa
specifiedperiod.
A=FVA*i/{(1+i)
n
1}
i/{(1+i)
n
1}iscalledtheSinkingFundFactor.
1. Theimportantfactorscontributingtotimevalueofmoneyare__________,________________
and_______.
2. Duringperiodsofinflation,arupeehasa___________thanarupeeinfuture.
3. As future is characterized by uncertainty, individuals prefer _________consumption to
__________consumption.
4. There are two methods by which time value of money can be calculated by _________ and
_________techniques.
3.3 PresentValue
Wehave sofar seen howthe compoundingtechnique can beused. They can beusedto compare
thecashflowsseparatedbymorethanonetimeperiod,giventheinterestrate.Withthistechnique,
theamount of present cash can be converted into an amountof cashofequivalent value infuture.
Likewise, we may be interested in converting the future cash flows into their present values. The
Present Value PV of a future cash flow is the amount of the current cash that is equivalent to the
investor. The process of determining present value of a future payment or a series of future
paymentsisknownasdiscounting.
44
3.3.1DiscountingorPresentValueofaSingleFlow:
WecandeterminethePVofafuturecashfloworastreamoffuturecashflowsusingtheformula:
PV=FV
n
/(1+i)
n
WherePV=PresentValue
FV
n
=Amount
i=Interestrate
n=Numberofyears
Example: If Ms. Sapna expects to haveanamountof Rs.1000after one year what should be the
amountshehastoinvesttodayifthebankisoffering10%interestrate?
Solution:
PV=FV
n
/(1+i)
n
=1000/(1+0.10)1
=Rs.909.09
Thesamecanbecalculatedwiththehelpoftables.
=1000*PVIF(10%,1y)
=1000*0.909
=Rs.909
Example:AninvestorwantstofindoutthevalueofanamountofRs.100000tobereceivedafter15
years.Theinterestofferedbybankis9%.CalculatethePVofthisamount.
Solution:
PV=FV
n
/(1+i)
n
or100000PVIF(9%,15y)
=100000*0.275
=Rs.27500
3.3.2PresentValueofaSeriesofCashFlows
Inabusinessscenario,thebusinessmanwillreceiveperiodicamounts(annuity)foracertainnumber
ofyears.Aninvestmentdonetodaywillfetchhimreturnsspreadoveraperiodoftime.Hewouldlike
to know if it is worthwhile to invest a certain sum now in anticipation of returns he expects over a
certainnumberofyears.Heshouldthereforeequatetheanticipatedfuturereturnstothepresentsum
heiswillingtoforego.ThePVofaseriesofcashflowscanberepresentedbythefollowingformula:
45
PV=Ct/(1=i)
1
+Ct/(1=i)
2
+Ct/(1=i)
3
Ct/(1=i)
4
+..+Ct/(1=i)
n
Whichreducesto:
PVA
n
=A{1+i)
n
1/i(1+i)
n
}
The expression {1+i)
n
1 / i(1+i)
n
} is known as Present Value Interest Factor Annuity (PVIFA). It
representsthePVIFAofRe.1forthegivenvaluesofiandn.ThevaluesofPVIFA(I,n)canbefound
outusingthetablesattheendofthebook.Itshouldbenotedthatthesevaluesaretrueonlyifthe
cashflowsareequalandtheflowsoccurattheendofeveryyear.
Example:
Calculate the PV of an annuity of Rs. 500 received annually for 4 year, when discounting factor is
10%.
Endofyear Cash
inflows
PVfactor PVin
Rs.
1 Rs.500 0.909 454
2 Rs.500 0.827 413
3 Rs.500 0.751 375
4 Rs.500 0.683 341
PresentValueofanannuityRs.1585.
ORbydirectlylookingatthetablewecancalculate:
=500*PVIFA(10%,4y)
=500*3.170
=Rs.1585
Example: Find out the present value of an annuity of Rs. 10000 over 3 years when discounted at
5%.
Solution:
=10000*PVIFA(5%,3y)
=10000*2.773
=Rs.27730
46
3.3.2.1PresentValueofPerpetuity
Anannuityforaninfinitetimeperiodisperpetuity.Itoccursindefinitely.Apersonmayliketofindout
the present value of his investment assuming he will receivea constant returnyear after year. The
PVofperpetuityiscalculatedasP=A/i
Example: If the principal of a college wants to institute a scholarship of Rs. 5000 to a meritorious
studentinfinanceeveryyear,findoutthePVofinvestmentwhichwouldyieldRs.5000inperpetuity,
discountedat10%.
Solution:
P=A/i
=5000/0.10
=Rs.50000
ThismeansheshouldinvestRs.50000togetanannualreturnofRs.5000.
Presentvalueofanunevenperiodicsum:Insomeinvestmentdecisionsofafirm,thereturnsmay
notbeconstant.Insuchcases,thePViscalculatedasfollows:
P=A
1
/(1+i)+A
2
/(1+i)
2
+A
3
/(1+i)
3
+A
4
/(1+i)
4
++A
n
/(1+i)
n
OR
PV=A
1
PVIF(i,1)+A
2
PVIF(i,2)+A
3
PVIF(i,3)+A
4
PVIF(i,4)+.+A
n
PVIF(i,n)
Example: An investor will receive Rs. 10000, Rs. 15000, Rs. 8000, Rs. 11000 and R. 4000
respectivelyattheendofeachof5years.Findoutthepresentvalueofthisstreamofunevencash
flows,iftheinvestorsinterestrateis8%.
PV=10000/(1+0.08)+15000/(1+0.08)
2
+8000/(1+0.08)
3
+11000/(1+0.08)
4
+4000/(1+0.08)
5
=Rs.39276
Or
PV=10000PVIF(8,1)+15000PVIF(8,2)+8000PVIF(8,3)+11000PVIF(8,4)+
4000PVIF(8,5)
=10000*0.926+15000*0.857+8000*0.794+11000*0.735+4000*0.681
=Rs.39276
47
3.3.2.2CapitalRecoveryFactor
Capital recovery is theannuity ofan investmentfor a specified time ata given rateof interest. The
reciprocalofthepresentvalueannuityfactoriscalledCapitalRecoveryFactor.
A=PVA
n
{i(1+i)
n
}/(1+i)
n
1}
{i(1+i)
n
}/(1+i)
n
1}isknownastheCapitalRecoveryFactor.
Example: A loanof Rs. 100000 is to be repaid in 5equalannual installments. Ifthe loan carriesa
rateof14%p.a,whatistheamountofeachinstallment?
Solution:
Installment*PVIFA(14%,5)=100000
Installment=100000/3.433=Rs.29129
1. _________________iscreatedoutoffixedpaymentseachperiodtoaccumulatetoafuturesum
afteraspecifiedperiod.
2. The________________ofafuturecashflowistheamountofthecurrentcashthatisequivalent
totheinvestor.
3. Anannuityforaninfinitetimeperiodiscalled______________.
4. Thereciprocalofthepresentvalueannuityfactoriscalled_____________.
3.4 Summary
Money has time preference. A rupee in hand today is more valuable than a rupee a year later.
Individualspreferpossessionofcashnowratherthanatafuturepointoftime.Thereforecashflows
occurring at different points in time cannot be compared. Interest rate gives money its value and
facilitates comparison of cash flows occurring at different periods of time. Compounding and
discountingaretwomethodsusedtocalculatethetimevalueofmoney.
SolvedProblemsTimeValueofMoney
1. WhatisthefuturevalueofaregularannuityofRe.1.00earningarateof12%interestp.a.for5
years?
Solution:1*FVIFA(12%,5y)=1*6.353=Rs.6.353
48
2. IfaborrowerpromisestopayRs.20000eightyearsfromnowinreturnforaloanofRs.12550
today,whatistheannualinterestbeingoffered?
Solution:20000*PVIF(k%,8y)=Rs.12550Kisapproximately6%.
3. AloanofRs.500000istoberepaidin10equalinstallments.Iftheloancarries12%interestp.a.
whatisthevalueofoneinstallment?
Solution:A*PVIFA(12%,10y)=500000SoA=500000/5.650=Rs.88492
4. ApersondepositsRs.25000inabankthatpays6%interesthalfyearly.Calculatetheamountat
theendof3years.
Solution:25000*(1+0.06)3*2=25000*1.194=Rs.29850
5. FindthepresentvalueofRs.100000receivableafter10yearsif10%isthetimepreferencefor
money.
Solution:100000*(0.386)=Rs.38600
TerminalQuestions
1. If you deposit Rs. 10000 today in a bank that offers 8% interest, in how many years will this
amountdouble?
2. AnemployeeofabankdepositsRs.30000intohisPFA/cattheendofeachyearfor20years.
What is the amount he will accumulate in his PF at the end of 20 years, if the rate of interest
givenbyPFauthoritiesis9%?
3. Apersoncansave_____________annuallytoaccumulateRs.400000bytheendof10years,
ifthesavingearns12%.
4. Mr. Vinod has to receive Rs. 20000 per year for 5 years. Calculate the present value of the
annuityassuminghecanearninterestonhisinvestmentat10%p.a.
5. AparnainvestsRs.5000attheendofeachyearat10%interestp.a.Whatistheamountshe
willreceiveafter4years?
AnswerstoSelfAssessmentQuestions
1. Investmentopportunities,preferenceforconsumption,risk.
2. Higherpurchasingpower
3. Currentandfuture
49
4. Compoundinganddiscounting
1. Sinkingfund
2. PresentValuePV
3. Perpetuity
4. CapitalRecoveryFactor.
AnswerstoTerminalQuestions
1. (Hint:Useruleof72and69)
2. 30000*FVIFA(9%,20Y)=30000*51.160=Rs.1534800
3. A*FVIFA(12%,10y)=400000whichis400000/17.549=Rs.22795
4. 20000*PVIFA(105,5y)=20000*3.791=Rs.75820
5. 5000*FVIFA(10%,5y)=5000*6.105=Rs.23205
50
Unit4 ValuationOfBondsAndShares
4.1 Introduction
4.2 ValuationofBonds
TypesofBonds
4.2.1 IrredeemableorPerpetualBonds
4.2.2 RedeemableorBondswithMaturityPeriod
4.2.3 ZeroCouponBond
BondyieldMeasures
4.2.1 HoldingPeriodRateofReturn
4.2.2 CurrentYield
4.2.3 YieldtoMaturity(YTM)
4.2.4 BondValueTheorems
4.3 ValuationofShares
4.3.1 ValuationofPreferenceShares
4.3.2 ValuationofOrdinaryShares
4.4 Summary
SolvedProblems
TerminalQuestions
AnswerstoSAQsandTQs
4.1 Introduction
Valuationistheprocessoflinkingriskwithreturnstodeterminetheworthofanasset.Assetscanbe
real orfinancialsecuritiesare calledfinancial assets,physicalassets are realassets. The ultimate
goal of any individual investor is maximization of profits. Investment management is a continuous
processrequiringconstantmonitoring.Thevalueofanassetdependsonthecashflowitisexpected
to provide over the holding period. The fact that as on date there is no method by which prices of
shares and bonds can be accurately predicted should be kept in mind by an investor before he
decides to take an investment decision. The present chapter will help us to know why some
51
securities are priced higher than others. We can design our investment structure by exploiting the
variablestomaximizeourreturns.
Ordinarysharesareriskierthanbondsordebenturesandsomesharesaremoreriskythanothers.
Theinvestorwouldthereforecommitfundsonashareonlyifheisconvincedabouttherateofreturn
beingcommensuratewithrisk.
LearningObjectives:
1. KnowthemeaningofvalueasusedinFinanceTheory.
2. UnderstandthemechanicsofBondvaluation,and
3. Understandthemechanicsofvaluationofequityshares.
Concept of Intrinsic value: A security can be evaluated by the series of dividends or interest
paymentsreceivableoveraperiodoftime.Inotherwords,asecuritycanbedefinedasthepresent
valueofthefuturecashstreamstheintrinsicvalueofanassetisequaltothepresentvalueofthe
benefits associated with it. The expected returns (cash inflows) are discounted using the required
returncommensuratewiththerisk.Mathematically,itcanberepresentedby:
V
0
=C
1
/(1+i)
1
+C
2
/(1+i)
2
+C
3
/(1+i)
3
+C
n
/(1+i)
n
=C
n
/(1+i)
n
WhereV
0
=Valueoftheassetattimezero(t=0)
P
0
=Presentvalueoftheasset
C
n
=Expectedcashflowattheendofperiodn
i=Discountrateorrequiredrateofreturnonthecashflows
n=Expectedlifeofanasset.
Example:
Assuming a discount rate of 10% and the cash flows associated with 2 projects A and B over a 3
yearperiod,determinethevalueoftheassets.
52
Year Cashflows
ofA(Rs.)
Cashflows
ofB(Rs)
1 20000 10000
2 20000 20000
3 20000 30000
Solution:
ValueofassetA=20000PVIFA(10%,3y)
=20000*2.487
=Rs.49470
ValueofassetB=10000PVIF(10%,1)+20000PVIF(10%,2)+30000PVIF(10%,3)
=10000*0.909+20000*0.826+30000*0.751
=9090+16520+22530
=Rs.48140
Example:
CalculatethevalueofanassetiftheannualcashinflowisRs.5000peryearforthenext6yearsand
thediscountrateis16%.
Solution:
Valueoftheasset=C
n
/(1+i)
n
=5000/(1+0.16)
6
Or =5000PVIFA(16%,6y)
=5000*3.685
=Rs.18425
4.1.1ConceptsofValue
Bookvalue:Bookvalueisanaccountingconcept.Valueiswhatanassetisworthtodayintermsof
theirpotentialbenefits.Assetsarerecordedathistoricalcostandthesearedepreciatedoveryears.
Bookvaluemayincludeintangibleassetsatacquisitioncostminusamortizedvalue.Thebookvalue
ofadebtisstatedattheoutstandingamount.Thedifferencebetweenthebookvalueofassetsand
liabilities is equal to the shareholders net worth. (Net worth is the sum total of paidup capital and
reservesandsurplus).Bookvalueofashareiscalculatedbydividingthenetworthbythenumberof
sharesoutstanding.
53
Replacement value is the amount a company is required to spend if it were to replace itsexisting
assetsinthepresentcondition.Itisdifficulttofindcostofassetspresentlyusedbythecompany.
Liquidationvalueistheamountacompanycanrealizeifitsoldtheassetsafterthewindingupofits
business. It will not include the valueof intangibles as theoperations of the company will cease to
exist. Liquidation value is generally the minimum value the company might accept if it sold its
business.
Going concern value is the amount a company can realize if it sells its business as an operating
one.Thisvalueishigherthantheliquidationvalue.
Marketvalueisthecurrentpriceatwhichtheassetorsecurityisbeingsoldorboughtinthemarket.
Marketvaluepershareisgenerallyhigherthanthebookvaluepershareforprofitableandgrowing
firms.
4.2 ValuationofBonds
Bonds are long term debt instruments issued by government agencies or big corporate houses to
raiselargesumsofmoney.Bondsissuedbygovernmentagenciesaresecuredandthoseissuedby
private sector companies may be secured orunsecured. The rateof interestonbonds isfixedand
theyareredeemableafteraspecificperiod.Someimportanttermsinbondvaluation:
Facevalue:Alsoknownasparvalue,thisisthevaluestatedonthefaceofthebond.Itrepresents
theamountthattheunitborrowswhichistoberepaidatthetimeofmaturity,afteracertainperiodof
time.AbondisgenerallyissuedatvaluessuchasRs.100orRs.1000.
Couponrateisthespecifiedrateofinterestinthebond.Theinterestpayableatregularintervalsis
theproductoftheparvalueandthecouponratebrokendowntotherelevanttimehorizon.
Maturity period refers to the number of years after which the par value becomes payable to the
bondholder.Generally,corporatebondshaveamaturityperiodof710yearsandgovernmentbonds
2025years.
Redemptionvalueistheamountthebondholdergetsonmaturity.Abondmayberedeemedatpar,
atapremium(bondholdergetsmorethantheparvalueofthebond)oratadiscount(bondholder
getslessthantheparvalueofthebond).
54
Marketvalueisthepriceatwhichthebondistradedinthestockexchange.Marketpriceistheprice
at which the bonds can be bought and sold and this price may be different from par value and
redemptionvalue.
TypesofBonds
Bondsareofthreetypes:(a)IrredeemableBonds(alsocalledperpetualbonds)(b)Redeemable
Bonds(i.e.,Bondswith finitematurityperiod)and(c)ZeroCouponBonds.
4.2.1 IrredeemableBondsorPerpetualBonds
Bonds which will never mature are known as irredeemable or perpetual bonds. Indian Companies
Actsrestrictstheissueofsuchbondsandthereforetheseareveryrarelyissuedbycorporatesthese
days.Incaseofthesebondstheterminalvalueormaturityvaluedoesnotexistbecausetheyarenot
redeemable.Thefacevalueisknowntheinterestreceivedonsuchbondsisconstantandreceived
at regular intervals and hence the interest receipts resemble a perpetuity. The present value (the
intrinsicvalue)iscalculatedas:
V
0
=I/id
IfacompanyofferstopayRs.70asinterestonabondofRs.1000parvalue,andthecurrentyieldis
8%,thevalueofthebondis70/0.08whichisequalto Rs.875
4.2.2 RedeemableBonds:
There are two types viz.,bonds with annual interest payments and bonds with semiannual interest
payments.
Bondswithannualinterestpayments
BasicBondValuationModel:
The holder of a bond receives a fixed annual interest for a specified number of years and a fixed
principal repaymentat the timeof maturity. The intrinsic valueor thepresent valueofbondcan be
expressedas:
V
0
orP
0
=
n
t=1
I/(I+k
d
)
n
+F/(I+k
d
)
n
Whichcanalsobestatedasfolloows
V
0
=I*PVIFA(kd,n)+F*PVIF(kd,n)
WhereV
0
=Intrinsicvalueofthebond
55
P
0
=PresentValueofthebond
I=AnnualInterestpayableonthebond
F=Principalamount(parvalue)repayableatthematuritytime
n=Maturityperiodofthebond
K
d
=Requiredrateofreturn
Example:AbondwhosefacevalueisRs.100hasacouponrateof12%andamaturityof5years.
Therequiredrateofinterestis10%.Whatisthevalueofthebond?
Solution:
Interestpayable=100*12%=Rs.12
PrincipalrepaymentisRs.100
Requiredrateofreturnis10%
V
0
=I*PVIFA(kd,n)+F*PVIF(kd,n)
Valueofthebond=12*PVIFA(10%,5y)+100*PVIF(10%,5y)
=12*3.791+100*0.621
=45.49+62.1
=Rs.107.59
Example: Mr. Anant purchases a bond whose face value is Rs. 1000, maturity period 5 years
coupledwithanominalinterestrateof8%.Therequiredrateofreturnis10%.Whatisthepricehe
shouldbewillingtopaynowtopurchasethebond?
Solution:
Interestpayable=1000*8%=Rs.80
PrincipalrepaymentisRs.1000
Requiredrateofreturnis10%
V0=I*PVIFA(kd,n)+F*PVIF(kd,n)
Valueofthebond=80*PVIFA(10%,5y)+1000*PVIF(10%,5y)
=80*3.791+1000*0.621
=303.28+621
=Rs.924.28
56
ThisimpliesthatthecompanyisofferingthebondatRs.1000butisworthRs.924.28attherequired
rate of return of 10%. The investor may not be willing to pay more than Rs. 924.28 for the bond
today.
BondValueswithSemiAnnualInterestpayment:
Inreality,itisquitecommontopayinterestonbondssemiannually.Withtheeffectofcompounding,
the value of bonds with semiannual interest is much more than the ones with annual interest
payments.Hence,thebondvaluationequationcanbemodifiedas:
V
0
orP
0
=
n
t=1
I/2/(I+i
d
/2)
n
+F/(I+i
d
/2)
2n
WhereV
0
=Intrinsicvalueofthebond
P
0
=PresentValueofthebond
I/2=SemiannualInterestpayableonthebond
F=Principalamount(parvalue)repayableatthematuritytime
2n=Maturityperiodofthebondexpressedinhalfyearlyperiods
k
d
/2=Requiredrateofreturnsemiannually.
Example:AbondofRs.1000valuecarriesacouponrateof10%,maturityperiodof6years.Interest
ispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthebond.
Solution:
V
0
orP
0
=
n
t=1
(I/2)/(I+k
d
/2)
n
+F/(I+k
d
/2)
2n
=(100/2)/(1+0.12/2)
6
+1000/(1+0.12/2)
6
=50*PVIFA(6%,12y)+1000*PVIF(6%,12y)
=50*8.384+1000*0.497
=419.2+497
=Rs.916.20
Itistobekeptinmindthattherequiredrateofreturnishalved(12%/2)andtheperioddoubled(6y*2)
astheinterestispaidsemiannually.
4.2.3 ValuationofZeroCouponBonds.
InIndiaZerocouponbondsarealternativelyknownasDeepDiscountBonds. Forclosetoa
decade,thesebondsbecameverypopularinIndiabecauseofissuanceofsuchbondsatregular
intervalsbyIDBIandICICI. Zerocouponbondshavenocouponrate,i.e.thereisnointeresttobe
57
paidout.Instead,thesebondsareissuedatadiscounttotheirfacevalue,andthefacevalueisthe
amountpayabletotheholderoftheinstrumentonmaturity.Thedifferencebetweenthediscounted
issuepriceandfacevalueiseffectiveinterestearnedbytheinvestor.Theyarecalleddeepdiscount
bondsbecausethesebondsarelongtermbondswhosematurity
sometimeextendsupto25to30years.
Example:
RiverValleyAuthorityissuedDeepDiscountBondofthefacevalueofRs.1,00,000payable25years
later,atanissuepriceofRs.14,600.Whatistheeffectiveinterestrateearnedbyaninvestorfrom
thisbond?
Solution:
The bond in question is a zero coupon or deepdiscount bond. It doesnot carry any coupon rate.
Therefore,theimpliedinterestratecouldbecomputedasfollows:
Step1. PrincipalinvestedtodayisRs.14600atarateofinterestofr%over25yearstoamountto
Rs.1,00,000.
Step2. Itcanbestatedas A=P
0
(1+r)
n
1,00,000=14,600(1+r)
25
Solvingforr,weget 1,00,000/14600=(1+r)
25
6.849 =(1+r)
25
Readingthecompoundvalue(FVIF)table,horizontallyalongthe25yearline,wefindrequals8%.
Therefore,bondgivesaneffectivereturnof8%perannum.
4.2.4 BondyieldMeasures
4.2.4.1 CurrentYield:
Current yield measures the rate of return earned on a bond if it is purchased at its current market
priceandthecouponinterestreceived.
CurrentYield=CouponInterest/CurrentMarketPrice
Example: Continuing with the same example above calculate the CY if the current market price is
Rs.920
58
Solution:
CY=CouponInterest/CurrentMarketPrice
=80/920
=8.7%
4.2.4.2YieldtoMaturity(YTM)
Itistherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity.TheYTMisthe
discountrateequalingthepresentvaluesofcashflowstothecurrentmarketprice.
Example:AbondhasafacevalueofRs.1000witha5yearmaturityperiod.Itscurrentmarketprice
isRs.883.4.Itcarriesaninterestrateof6%.Whatshallbetherateofreturnonthisbondifitisheld
tillitsmaturity?
Solution:
V
0
orP
0
=
n
t=1
I/(I+k
d
)
n
+F/(I+k
d
)
n
OR
=60*PVIFA(Kd,10)+1000*PVIF(Kd,10)=883.4
Weobtain10%forkd
Example:AbondhasafacevalueofRs.1000witha9yearmaturityperiod.Itscurrentmarketprice
isRs.850.Itcarriesaninterestrateof8%.Whatshallbetherateofreturnonthisbondifitisheldtill
itsmaturity?
Solution:
V
0
orP
0
=
n
t=1
I/(I+k
d
)
n
+F/(I+k
d
)
n
OR
=80*PVIFA(Kd%,9)+1000*PVIF(Kd%,9)=850
TofindoutthevalueofKd,trialanerrormethodistobefollowed.Letusthereforestartthevalueof
Kdtobe12%andtheequationnowlookslike
=80*PVIFA(12%,9)+1000*PVIF(12%,9)=850
LetusnowseeifLHSequalsRHSatthisrateof12%.LookingatthetableswegetLHSas
59
80*5.328+1000*0.361=Rs.787.24
SincethisvalueislessthanthevaluerequiredontheRHS,wetakealesserdiscountrateof10%.At
10%,theequationis
=80*PVIFA(10%,9)+1000*PVIF(10%,9)=850
LetusnowseeifLHSequalsRHSatthisrateof11%.LookingatthetableswegetLHSas
80*5.759+1000*0.424=Rs.884.72
WenowunderstandthatKdclearlyliesbetween10%and12%.Weshallinterpolatetofindoutthe
truevalueofKd.
10%+{(884.72850)/(884.72787.24)}*(12%10%)
10%+(34.72/97.48)*2
10%+0.71
ThereforeKd=10.71%
An approximation: The followingformula may be used togeta rough idea about Kd as Trial and
Error Method is a very tediousprocedure and requires lots of time. Thisformula can be usedas a
readyreferenceformula.
YTM={I+(FP)/n}/{(F+P)/2}
WhereYTM=YieldtoMaturity
I=Annualinterestpayment
F=Facevalueofthebond
P=Currentmarketpriceofthebond
n=Numberofyearstomaturity.
Example:Acompanyissuesabondwithafacevalueof5000.ItiscurrentlytradingatRs.4500.The
interestrateofferedbythecompanyis12%andthebondhasamaturityperiodof8years.Whatis
YTM?
Solution:
YTM={I+(FP)/n}/{(F+P)/2}
=600+{(50004500)/8}/{(5000+4500)/2}
={600+62.5}/4750
=13.94%
60
4.2.5 BondValueTheorems
Thefollowingfactorsaffectthebondvalues:
Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate.
Numberofyearstomaturity.
YTM
Relationshipbetweentherequiredrateofinterest(Kd)andthediscountrate:
WhenKdisequaltothecouponrate,theintrinsicvalueofthebondisequaltoitsfacevalue,that
is,ifKd=couponrate,thenvalueofbond=facevalue.
When Kd is greater than the coupon rate, the intrinsic value of the bond is less than its face
value,thatis,ifKd>couponrate,thenvalueofbond<facevalue.
When Kd is lesser than the coupon rate, the intrinsic value of the bond is greater than its face
value,thatis,ifKd<couponrate,thenvalueofbond>facevalue.
Example:SugamindustrieswishestoissuebondswithRs.100asparvalue,couponrate12%an
YTM5years.Whatisthevalueofthebondiftherequiredrateofreturnofaninvestoris12%,14%
and10%
IfKdis12%,
=12*PVIFA(12%,5)+100*PVIF(12%,5)
=12*3.605+100*0.567
=43.26+56.7
=Rs.99.96orRs.100
IfKdis14%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n)
=12*PVIFA(14%,5)+100*PVIF(14%,5)
=12*3.433+100*0.519
=41.20+51.9
=Rs.93.1
=12*PVIFA(10%,5)+100*PVIF(10%,5)
=12*3.791+100*0.621
=45.49+62.1
=Rs.107.59
61
Numberofyearstomaturity
When Kd is greater than the coupon rate, the discount on the bond declines as maturity
approaches.
When Kd is less than the coupon rate, the premium on the bond declines as maturity
approaches.
To show the effect of the above, consider a case of a bond whose face value is Rs. 100 with a
couponrateof11%andamaturityof7years.
IfKdis13%,then,V0=I*PVIFA(kd,n)+F*PVIF(kd,n)
=11*PVIFA(13%,7)+100*PVIF(13%,7)
=11*4.423+100*0.425
=48.65+42.50
=Rs.91.15
After1year,thematurityperiodis6years,thevalueofthebondis
=11*PVIFA(13%,6)+100*PVIF(13%,6)
=11*3.998+100*0.480
=43.98+48
=Rs.91.98.
Weseethatthediscountonthebondgraduallydecreasesandvalueofthebondincreaseswiththe
passageoftimeatKdbeingahigherratethanthecouponrate.
Continuingwiththesameexampleabove,letusseetheeffectonthebondvalueifrequiredrateis
8%.
=11*PVIFA(8%,7)+100*PVIF(8%,7)
=11*5.206+100*0.583
=57.27+58.3
=Rs.115.57
Oneyearlater,Kdat8%,V0=I*PVIFA(kd,n)+F*PVIF(kd,n)
=11*PVIFA(8%,6)+100*PVIF(8%,6)
=11*4.623+100*0.630
62
=50.85+63
=Rs.113.85
Forarequiredrateofreturnof8%,thebondvaluedecreaseswithpassageoftimeandpremiumon
bonddeclinesasmaturityapproaches.
YTM:YTMdeterminingthemarketvalueofthebond,thebondpricewillfluctuatetothechangesin
marketinterestrates.AbondspricemovesinverselyproportionaltoitsYTM.
4.3 ValuationofShares
Acompanyssharesmaybecategorizedas(a)OrdinaryorEquitysharesand(b)Preferenceshares.
Thereturnstheseshareholdersgetarecalleddividends.Preferenceshareholdersgetapreferential
treatment astothe paymentofdividend and repayment of capital in theevent of windingup. Such
holders are eligiblefor afixed rate of dividends.Some importantfeatures of preference and equity
shares.
Dividends:Rateisfixedforpreferenceshareholders.Theycanbegivencumulativerights,that
is, the dividend can be paid off after accumulation. The dividend rate is not fixed for equity
shareholders.Theychangewithanincreaseordecreaseinprofits.Duringyearsofbigprofits,the
management may declare a high dividend. The dividends are not cumulative for equity
shareholders, that is, they cannot be accumulated and distributed in later years. Dividends are
nottaxable.
Claims: In the event of the business closing down, the preference shareholders have a prior
claimontheassetsofthecompany.Theirclaimsshallbesettledfirstandthebalanceifanywill
be paid off to equity shareholders. Equity shareholders are residual claimants to the company
incomeandassets.
Redemption: Preference shares have a maturity date on which day the company pays off the
facevalueofthesharetotheholders.Preferencesharescanbeoftwotypesredeemableand
irredeemable. Irredeemable preference shares are perpetual. Equity shareholders have no
maturitydate.
Conversion: A company can issue convertible preference shares and not vice versa. After a
particular period as mentioned in the share certificate, the preference shares can be converted
intoordinaryshares.
63
4.3.1 ValuationofPreferenceShares:
Preference shares, like bonds carry a fixed rate of dividend/return. Symbolically, this can be
expressedas:
P
0
=Dp/{1+Kp)
n
}+P
n
/{(1+Kp)
n
}
OR
P
0
= Dp*PVIFA(Kp,n)+P
n
*PVIF(Kp,n)
WhereP0=Priceoftheshare
Dp=Dividendonpreferenceshare
Kp=Requiredrateofreturnonpreferenceshare
n=Numberofyearstomaturity
4.4 ValuationofOrdinaryShares
Peoplehold common stocksfor two reasons to obtaindividends in a timely mannerand togeta
higheramountwhensold.Generally,sharesarenotheldinperpetuity.Aninvestorbuystheshares,
holdsthemforsometimeduringwhichhegetsdividendsandfinallysellsitofftogetcapitalgains.
Thevalueofasharewhichaninvestoriswillingtopayislinkedwiththecashinflowsexpectedand
risks associated with these inflows. Intrinsic value ofa share is associated with theearnings (past)
andprofitability(future)ofthecompany,dividendspaidandexpectedandfuturedefiniteprospectsof
the company. It is the economic value of a company considering its characteristics, nature of
businessandinvestmentenvironment.
4.4.1 DividendCapitalizationModel
Whenashareholderbuysashare,heisactuallybuyingthestreamoffuturedividends.Thereforethe
valueofanordinaryshareisdeterminedbycapitalizingthefuturedividendstreamatanappropriate
rate of interest. So under the dividend capitalization approach, the value of an equity share is the
discountedpresent value ofdividends received plus the present value of the resale price expected
whentheshareisdisposed.Twoassumptionsaremadetoapplythisapproach:
Dividendsarepaidannually.
Firstpaymentofdividendismadeafteroneyeartheequityshareisbought.
64
4.4.1.1 Singleperiodvaluationmodel
Thismodelholdswellwhenaninvestorholdsanequityshareforoneyear.Thepriceofsuchashare
willbe:
P
0
= D
1
+ P1
(1+Ke)(1+Ke)
WhereP
0
=Currentmarketpriceoftheshare
D
1
=Expecteddividendafteroneyear
P
1
=Expectedpriceoftheshareafteroneyear
Ke=Requiredrateofreturnontheequityshare
Example:GammonIndiaLtd.sshareisexpectedtotouchRs.450oneyearfromnow.Thecompany
isexpectedtodeclareadividendofRs.25pershare.Whatisthepriceatwhichaninvestorwouldbe
willingtobuyifhisrequiredrateofreturnis15%?
Solution:
P
0
=D
1
/(1+Ke)+P
1
/(1+Ke)
{25/(1+0.15)}+{450/(1+0.15)}
=21.74+391.30
=Rs.413.04isthepriceheiswillingtopaytoday
4.4.1.2 Multiperiodvaluationmodel: Anequitysharecanbeheldoranindefiniteperiodasit
hasnomaturitydate,inwhichcasethevalueofapriceattimezerois:
P
0
=D
1
/(1+Ke)
1
+D
2
/(1+Ke)
2
+D
3
/(1+Ke)
3
+..+D
/(1+Ke)
Or P
0
=
t=1
D
n
{(1+Ke)
n
}
WhereP
0
=Currentmarketpriceoftheshare
D
1
=Expecteddividendafteroneyear
P
1
=Expectedpriceoftheshareafteroneyear
D
=Expecteddividendatinfiniteduration
Ke=Requiredrateofreturnontheequityshare.
Theaboveequationcanalsobemodifiedtofindthevalueofanequityshareforafiniteperiod.
65
P
0
=D
1
/(1+Ke)
1
+D
2
/(1+Ke)
2
+D
3
/(1+Ke)
3
+..+D
/(1+Ke)
+P
n
/(1+Ke)
n
=P
0
=
t=1
D
n
/{(1+Ke)
n
}+P
n
/(1+Ke)
n
Wecancomeacrossthreeinstancesofdividendsincompanies:
Constantdividends
Constantgrowthofdividends
Changinggrowthratesofdividends.
Valuation with constant dividends: If constant dividends are paid year after year, then
P
0
=D
1
/(1+Ke)
1
+D
2
/(1+Ke)
2
+D
3
/(1+Ke)
3
+..+D
/(1+Ke)
SimplifyingthiswegetP=D/Ke
Valuation with constant growth in dividends: Here we assume that dividends tend to increase
with time as and when businesses grow over time. If the increase in dividend is at a constant
compoundrate,thenP
0
=D
1
/Keg,wheregstandsforgrowthrate.
Example:Sagarautomobilesltd.sshareistradedatRs.180.Thecompanyisexpectedtogrowat
8%perannumandthedividendexpectedtobepaidoffisRs.8.Iftherateofreturnisexpectedtobe
12%,whatisthepriceoftheshareonewouldbeexpectedtopaytoday?
Solution:
P
0
=D
1
/Keg
=8/0.120.08
=Rs.200.
Example:MonicalabsisexpectedtopayRs.4asdividendpersharenextyear.Thedividendsare
expected to grow perpetually@8%. Calculate the share price today if the market capitalization is
12%.
Solution:
P
0
=D
1
/Keg
P
0
=4/(0.120.08)
=Rs.100
Valuationwithvariablegrowthindividends:Somefirmsmaynothaveaconstantgrowthrateof
dividendsindefinitely.Thereareperiodsduringwhichthedividendsmaygrowsupernormally,thatis,
thegrowthrateisveryhighwhenthedemandforthecompanysproductsisveryhigh.Afteracertain
periodoftime,thegrowthratemayfalltonormallevelswhenthereturnsfallduetofallindemandfor
66
products(withcompetitionsettinginorduetoavailabilityofsubstitutes).Thepriceoftheequityshare
ofsuchafirmisdeterminedinthefollowingmanner:
Step 1. Expected dividend flows during periods of supernormal growth is to be considered and
presentvalueofthisistobecomputedwiththefollowingequation:
P
0
=
t=1
D
n
/(1+Ke)
n
Valueoftheshareattheendoftheinitialgrowthperiodiscalculatedas:
P
n
=(D
n+1
)/(Kegn) (constant growth model). This is discounted to thepresent valueand we
get:
(D
n+1
)/(Kegn)*1/(1+Ke)
n
Add both the present value composites to find the value P0 of the share, that is, P
0
=
t=1
D
n
/(1+Ke)
n
+(D
n+1
)/(Kegn)*1/(1+Ke)
n
Example: Souparnika Pharmas current dividend is Rs. 5.It expects to have a supernormal growth
periodrunningto5yearsduringwhichthegrowthratewouldbe25%.Thecompanyexpectsnormal
growth rate of 8% after the period of supernormal growth period. The investors required rate of
returnis15%.Calculatewhatthevalueofoneshareofthiscompanyisworth.
Solution:D
0
=5,n=5y,ga(supernormalgrowth)=25%,gn(normalgrowth)=8%,Ke=14%
StepI:P
0
=
t=1
D
n
/(1+Ke)
n
D1=5(1.25)
1
D2=5(1.25)
2
D3=5(1.25)
3
D4=5(1.25)
4
D5=5(1.25)
5
Thepresentvalueofthisflowofdividendswillbe:
5(1.25)/(1.15)+5(1.25)
2
/(1.15)
2
+5(1.25)
3
/(1.15)
3
+5(1.25)
4
/(1.15)
4
+5(1.25)
5
/(1.15)
5
5.43+5.92+6.42+6.98+7.63=32.38
StepII:P
n
=(D
n+1
)/(Keg)
P5=D6/Kegn
=D5(1+gn)/Kegn
={5(1.25)
5
(1+0.08)}/(0.150.08)
=15.26(1.08)/0.07
67
=16.48/0.07
=235.42
Thediscountedvalueofthispriceis235.42/(1.15)
5
=Rs.117.12
StepIII:P
0
=
t=1
D
n
/(1+Ke)
n
+(D
n+1
)/(Kegn)*1/(1+Ke)
n
ThevalueoftheshareisRs.32.38+Rs.117.12=Rs.149.50
Otherapproachestoequityvaluation
In addition to the dividend valuation approaches discussed in the previous section, there are other
approachestovaluationofsharesbasedonRatioApproach.
Bookvalueapproach:Thebookvaluepershare(BVPS)isthenetworthofthecompanydividedby
thenumberofoutstandingequityshares.Networthisrepresentedbythesumtotalofpaidupequity
shares,reservesandsurplus.Alternatively,thiscanalsobecalculatedastheamountpershareon
the sale of the assets of the company at their exact book value minus all liabilities including
preferenceshares.
Example:
A One Ltd.has total assets worth Rs. 500 Cr., liabilities worth Rs. 300 Cr., and preference shares
worthRs.50Cr.andequitysharesnumbering10lakhsTheBVPSisRs.150Cr/10lakhs=R.150
BVPS does not give a true investment picture. This relies on historical book values than the
companysearningpotential.
Liquidationvalue:Theliquidationvaluepershareiscalculatedas:
{(Valuerealizedbyliquidatingallassets)(AmounttobepaidtoallCrsandPreSH)}divided
byNumberofoutstandingshares.
Intheaboveexample,iftheassetscanbeliquidatedatRs.450Cr.,theliquidationvaluepershareis
(450Cr350Cr)/10lakhshareswhichisequaltoRs.1000pershare.
4.4.2 PriceEarningsRatio:Thepriceearningsratioreflectstheamountinvestorsarewillingto
payforeachrupeeofearnings.
Expected earning per share = (Expected PAT) (Preference dividend) / Number of
outstanding shares. Expected PAT is dependent on a number of factors like sales, gross profit
68
margin, depreciation and interestand tax rate. The P/E ratio is also to considerfactors like growth
rate,stabilityofearnings,companysize,companymanagementteamanddividendpayoutratio.
P/Eratio=(1b)/r(ROE*b)
Where1bisdividendpayoutratio
risrequiredrateofreturn
ROE*bisexpectedgrowthrate.
1. ______________________istheminimumvaluethecompanyacceptsifitsolditsbusiness.
2. ______________per share is generally higher than the book value per share for profitable and
growingfirms.
3. Bondsissuedby____________aresecuredandthoseissuedbyprivatesectorcompaniesmay
be_________or___________.
4. ___________istherateearnedbyaninvestorwhopurchasesabondandholdsittillitsmaturity.
5. WhenKdislesserthanthecouponrate,thevalueofthebondis_________thanitsfacevalue.
6. ___________of a share is associated with the earnings (past) and profitability (future) of the
company,dividendspaidandexpectedandfuturedefiniteprospectsofthecompany.
7. The _______________is the net worth of the company divided by the number of outstanding
equityshares.
4.5 Summary
Valuationistheprocesswhichlinkstheriskandreturntoestablishtheassetworth.Thevalueofa
bond or a share is the discounted value of all their future cash inflows (interest/dividend) over a
periodoftime.Thediscountrateistherateofreturnwhichtheinvestorsexpectfromthesecurities.
In case of bonds, the stream of cash flows consists of annual interest payment and repayment of
principal(whichmaytakeplaceatpar,atapremiumoratadiscount).Thecashflowswhichoccurin
eachyearisafixedamount.
Cashflowsforpreferencesharearealsoafixedamountandthesesharesmayberedeemedatpar,
atapremiumoratadiscount.
The equity shareholders do not have a fixed rate of return. Their dividend fluctuates with profits.
Thereforetheriskofholdinganequityshareishigherthanholdingapreferenceshareorabond.
69
Solvedproblems
1. ThecurrentpriceofaAshokLeylandshareisRs.30.Thecompanyisexpectedtopayadividend
of Rs. 2.50 per share which goes up annually at 6%. If an investors required rate of return is
11%,shouldhebuythisshareornot?Advise.
Solution: P = D
1
(1+g) / Keg = 2.5(1+0.06) /0.110.06 =Rs. 53.The investor should certainly
buythisshareatthecurrentpriceofRs.30asthevaluationmodelsaystheshareisworthRs.
53.
2. A bond with a face value of Rs. 100 provides an annual return of 8% and pays Rs. 125 at the
timeofmaturity,whichis10yearsfromnow.Iftheinvestorsrequiredrateofreturnis12%,what
shouldbethepriceofthebond?
Solution:P=Int*PVIFA(12%,10y)+Redemptionprice*PVIF(12%,10y)
=8*PVIFA(12%,10y)+125*PVIF(12%,10y)
=8*5.65+125*0.322
=45.2+40.25=Rs.85.45
ThepriceofthebondshouldbeRs.85.45
3. The bond of Silicon Enterprises witha par value of Rs. 500 is currently traded at Rs. 435. The
couponrateis12%withamaturityperiodof7years.Whatwillbetheyieldtomaturity?
Solution:r=I+{(FP)/n}/(F+P)/2
=60+{(500435)/7}/(500+435)/2
=15.03%
4. The share of Megha Ltd is sold at Rs. 500 a share. The dividend likely to be declared by the
companyisRs.25pershareafteroneyearandthepriceoneyearhenceisexpectedtobeRs.
550.Whatisthereturnattheendoftheyearonthebasisoflikelydividendandpricepershare?
Solution:Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice
=(25+50)/500=15%
5. AbondoffacevalueofRs.1000andamaturityof3yearspays15%interestannually.Whatis
themarketpriceofthebondifYTMisalso15%?
Solution:P=Int*PVIFA(15%,3y)+Redemptionvalue*PVIF(15%,3y)
P=150*2.283+1000*0.658
P=342.45+658=Rs.1000.45
70
1. AperpetualsharepaysanannualdividendofRs.15onafacevalueofRs.100andtherateof
returnrequiredbyinvestorsonsuchinvestmentsis20%.Whatshouldbethemarketpriceofthe
preferenceshare?
Solution:Expectedyield=Expectedincome/currentmarketprice
Expectedyield=15/0.2=Rs.75
TerminalQuestions
1. WhatshouldbepriceofabondwhichhasaparvalueofRs.1000carryingacouponrateof8%
andhavingamaturityperiodof9years?Therequiredrateofreturnoftheinvestoris12%.
2. A bond of Rs. 1000 value carries a coupon rate of 10% and has a maturity period of 6 years.
Interestispayablesemiannually.Iftherequiredrateofreturnis12%,calculatethevalueofthe
bond.
3. AbondwhoseparvalueisRs.500bearingacouponrateof10%andhasamaturityof3years.
Therequiredrateofreturnis8%.Whatshouldbethepriceofthebond?
4. IfthecurrentyearsdividendisRs.24,growthrateofacompanyis10%andtherequiredreturn
onthestockis16%,whatistheintrinsicvalueofthestock?
5. IfastockispurchasedforRs.120andheldforoneyearduringwhichtimeRs.15dividendper
shareispaidandthepricedecreasestoRs.115,whatisthenominalreturnontheshare?
1. Liquidationvalue
2. Marketvalue
3. Governmentagencies,securedorunsecured
4. YieldtoMaturity
5. Greater
6. Intrinsicvalue
7. Bookvaluepershare(BVPS)
71
AnswerstoTerminalQuestions
1. P=Int*PVIFA(12%,9y)+Redemptionprice*PVIF(12%,10y)
80*PVIFA(12%,9)+1000*PVIF(12%,9y)
80*5.328+1000*0.361
426.24+361=Rs.787.24
2. 50*PVIFA(6%+12y)+1000*PVIF(12%,6y)
50*8.384+1000*0.497
Rs.916.2
3. P=Int*PVIFA(8%,3y)+Redemptionprice*PVIF(6%+12y)
50*2.577+500*0.794
128.85+397=Rs.525.85
4. Intrinsicvalue=24{(1+0.1)}/0.160.1=Rs.440
5. Holdingperiodreturn=(D1+Pricegain/loss)/purchaseprice
{15+(5)}/120=8.33%
72
Unit5 CostofCapital
Structure
5.1 Introduction
5.2 DesignofanIdealCapitalStructure
5.3 CostofDifferentSourcesofFinance
5.3.1 CostofDebentures
5.3.2 CostofTermLoans
5.3.3 CostofPreferenceCapital
5.3.4 CostofEquitycapital
5.3.5 CostofRetainedEarnings
5.3.5.1 CapitalAssetPricingModelApproach
5.3.5.2 EarningsPriceRatioApproach
5.4 WeightedAverageCostofCapital
5.5 Summary
SolvedProblems
TerminalQuestions
AnswerstoSAQsandTQs
5.1 Introduction
Capitalstructureisthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares,
equity sharesand retained earnings indifferent ratios. It is always advisablefor companies to plan
their capital structure. Decisionstakenbynot assessing things ina correct manner may jeopardize
the very existence of the company. Firms may prosper in the shortrun by not indulging in proper
planningbutultimatelymayfaceproblemsinfuture.Withunplannedcapitalstructure,theymayalso
failtoeconomizetheuseoftheirfundsandadapttothechangingconditions.
73
LearningObjectives:
1. Definecostofcapital.
2. Bringouttheimportanceofcostofcapital.
3. Explainhowtodesignanidealcapitalstructure.
4. ComputeWeightedAverageCostofCapital.
5.2 DesigninganIdealCapitalStructure
Itrequiresanumberoffactorstobeconsideredsuchas:
Return: The capital structure of a company should be most advantageous. It should generate
maximumreturnstotheshareholdersforaconsiderableperiodoftimeandsuchreturnsshould
keepincreasing.
Risk:Asalreadydiscussedinthepreviouschapteronleverage,useofexcessivedebtfundsmay
threatenthecompanyssurvival.Debtdoesincreaseequityholdersreturnsandthiscanbedone
tillsuchtimethatnoriskisinvolved.
Flexibility: The company should be able to adapt itself to situations warranting changed
circumstanceswithminimumcostanddelay.
Capacity:Thecapitalstructureofthecompanyshouldbewithinthedebtcapacity.Debtcapacity
dependsontheabilityforfundstobegenerated.Revenuesearnedshouldbesufficientenough
topaycreditorsinterests,principalandalsotoshareholderstosomeextent.
Control:Anidealcapitalstructureshouldinvolveminimumriskoflossofcontroltothecompany.
Dilutionofcontrolbyindulginginexcessivedebtfinancingisundesirable.
Withtheabovepointsonidealcapitalstructure,raisingfundsattheappropriatetimetofinancefirms
investment activities is an important activity of the Finance Manager. Golden opportunities may be
lost for delaying decisions to this effect. A combination of debt and equity is used to fund the
activities.Whatshouldbetheproportionofdebtandequity?Thisdependsonthecostsassociated
with raising various sources of funds. The cost of capital is the minimum rate of return a company
mustearntomeettheexpensesofthevariouscategoriesofinvestorswhohavemadeinvestmentin
theformofloans,debentures,equityandpreferenceshares.Acompanynobeingabletomeetthese
demands may face the risk of investors taking back their investments thus leading to bankruptcy.
74
Loansanddebenturescomewithapredeterminedinterestrate,preferencesharesalsohaveafixed
rate of dividend while equity holders expect a minimum return of dividend based on their risk
perceptionandthecompanyspastperformanceintermsofpayoutofdividends.
The following graph on riskreturn relationship of various securities summarizes the above
discussion.
Error!
5.3 CostofDifferentSourcesofFinance
Thevarioussourcesoffinanceandtheircostsareexplainedbelow:
5.3.1 Costofdebentures
Thecostofdebentureisthediscountratewhichequatesthenetproceedsfromissueofdebentures
totheexpectedcashoutflowsinterestandprincipalrepayments.
Kd=I(1T)+{(FP)/n}
(F+P)/2
WhereK
d
isposttaxcostofdebenturecapital,
Iistheannualinterestpaymentperunitofdebenture,
Tisthecorporatetaxrate,
Fistheredemptionpriceperdebenture,
Pisthenetamountrealizedperdebenture,
Riskfree
security
Govtbonds
Debt
Preference
share
Equity
share
RiskReturnrelationshipofvarioussecurities
R
e
q
u
i
r
e
d
r
a
t
e
o
f
r
e
t
u
r
n
75
nismaturityperiod.
Example:
Lakshmi Enterprise wants to have an issue of nonconvertible debentures for Rs. 10 Cr. Each
debenture is of a par value of Rs. 100 having an interest rate of 15%. Interest is payable annually
and they are redeemable after 8 years at a premium of5%. The company is planning to issue the
NCD ata discountof3%tohelp in quick subscription. If thecorporate tax rate is 50%, what is the
costofdebenturetothecompany?
Solution:
Kd= I(1T)+{(FP)/n}
(F+P)/2
15(10.5)+(10597)/8
(105+97)/2
=7.5+1
101
=0.084or8.4%
5.3.2 CostofTermLoans
Termloansareloanstakenfrombanksorfinancialinstitutionsforaspecifiednumberofyearsata
predeterminedinterestrate.Thecostoftermloansisequaltotheinterestratemultipliedby1tax
rate.Theinterestismultipliedby1taxrateasinterestontermloansisalsotaxed.
Kt=I(1T)
WhereIisinterest,
Tistaxrate.
Example:
YesLtd.hastakenaloanofRs.5000000fromCanaraBankat9%interest.Whatisthecostofterm
loan?
Solution
Kt=I(1T)=9(10.4)=5.4%
76
5.3.2 CostofPreferenceCapital
The cost of preference share Kp is the discount rate which equates the proceeds from preference
capitalissuetothedividendandprincipalrepaymentswhichisexpressedas:
Kp= D+{(FP)/n}
(F+P)/2
WhereKpisthecostofpreferencecapital,
Disthepreferencedividendpersharepayable,
Fistheredemptionprice,
Pisthenetproceedspershare,
nisthematurityperiod.
Example:
C2C Ltd. has recently come out with a preference share issue to the tune of Rs. 100 lakhs. Each
preference share has a face value of 100 and a dividend of 12% payable. The shares are
redeemableafter 10 years atapremium of Rs.4per share. The company hopes to realize Rs. 98
persharenow.Calculatethecostofpreferencecapital.
Solution
Kp= D+{(FP)/n}
(F+P)/2
=12+(10498)/10
(104+98)/2
= 12.6
101
Kp=0.1247or12.47%
5.3.4 CostofEquityCapital
Equity shareholders do not have a fixed rate of return on their investment. There is no legal
requirement(unlikeinthecaseofloansordebentureswheretheratesaregovernedbythedeed)to
pay regular dividends to them. Measuring the rate of return to equity holders is a difficult and
complex exercise. There are many approaches for estimating return the dividend forecast
approach,capitalassetpricingapproach,realizedyieldapproach,etc.Accordingtodividendforecast
77
approach,theintrinsicvalueofanequityshareisthesumofpresentvaluesofdividendsassociated
withit.
Ke=(D1/Pe)+g
ThisequationismodifiedfromtheequationPe={D1/Keg}.Dividendscannotbeaccuratelyforecast
astheymaysometimesbenilorhaveaconstantgrowthorsometimesupernormalgrowthperiods.
IsEquityCapitalfreeofcost?
Somepeopleareoftheopinionthatequitycapitalisfreeofcostforthereasonthatacompanyisnot
legally bound to pay dividends and also the rate of equity dividend is not fixed like preference
dividends. This is not a correct view as equity shareholders buy shares with the expectation of
dividends and capital appreciation. Dividends enhance the market value of shares and therefore
equitycapitalisnotfreeofcost.
Example:
SurajMetalsareexpectedtodeclareadividendofRs.5pershareandthegrowthrateindividends
isexpectedtogrow@10%p.a.ThepriceofoneshareiscurrentlyatRs.110inthemarket.Whatis
thecostofequitycapitaltothecompany?
Solution
Ke=(D1/Pe)+g
=(5/110)+010
=0.1454or14.54%
5.3.5 CostofRetainedEarnings
Acompanysearningscanbereinvestedinfulltofueltheeverincreasingdemandofcompanysfund
requirements or they may be paid off to equity holders in full or they may be partly held back and
invested and partly paid off. These decisions are taken keeping in mind the companys growth
stages. High growth companies may reinvest the entire earnings to grow more, companies withno
growth opportunities return the funds earned to their owners and companies with constant growth
invest a little and return the rest. Shareholders of companies with high growth prospects utilizing
funds for reinvestment activities have to be compensated for parting with their earnings. Therefore
thecostofretainedearningsisthesameasthecostofshareholdersexpectedreturnfromthefirms
ordinaryshares.Thatis,Kr=Ke
78
5.3.5.1CapitalAssetPricingModelApproach
This model establishes a relationship between the required rate of return of a security and its
systematicrisksexpressedas.Accordingtothismodel,
Ke=Rf+(RmRf)
WhereKeistherateofreturnonshare,
Rfistheriskfreerateofreturn,
isthebetaofsecurity,
Rmisreturnonmarketportfolio.
TheCAPMmodelisbasedonsomeassumptions,someofwhichare:
Investorsareriskaverse.
Investorsmaketheirinvestmentdecisionsonasingleperiodhorizon.
Transaction costs are low and therefore canbe ignored. This translates toassetsbeingbought
andsoldinanyquantitydesired.Theonlyconsiderationsmatteringarethepriceandamountof
moneyattheinvestorsdisposal.
Allinvestorsagreeonthenatureofreturnandriskassociatedwitheachinvestment.
Example:
Whatistherateofreturnforacompanyifitsis1.5,riskfreerateofreturnis8%andthemarket
rateorreturnis20%
Solution
Ke=Rf+(RmRf)
=0.08+1.5(0.20.08)
=0.08+0.18
=0.26or26%
5.3.5.2 EarningsPriceRatioApproach
Accordingtothisapproach,thecostofequitycanbecalculatedas:
Ke=E1/PwhereE1isexpectedEPSoneyearhenceandPisthecurrentmarketpricepershare.
E1iscalculatedbymultiplyingthepresentEPSwith(1+Growthrate).
CostofRetainedEarningsandCostofExternalEquity
79
As we have just learnt that if retained earnings are reinvested in business for growth activities the
shareholdersexpectthesameamountofreturnsandthereforeKe=Kr.Butitshouldbeborneinmind
bythepolicymakersthatfloatinganewissueandpeoplesubscribingtoitwillinvolvehugeamounts
of money towards floatation costs which need not be incurred if retained earnings are utilized
towardsfundingactivities.Usingthedividendcapitalizationmodel,thefollowingmodelcanbeused
forcalculatingcostofexternalequity.
Ke={D1/P0(1f)}+g
WhereKeisthecostofexternalequity,
D1isthedividendexpectedattheendofyear1,
P0isthecurrentmarketpricepershare,
gistheconstantgrowthrateofdividends,
fisthefloatationcostsasa%ofcurrentmarketprice.
Thefollowingformulacanbeusedasanapproximation:
Ke=ke/(1f)
WhereKeisthecostofexternalequity,
keistherateofreturnrequiredbyequityholders,
fisthefloatationcost.
Example:
AlphaLtd.requiresRs.400CrtoexpanditsactivitiesinthesouthernzoneofIndia.Thecompanys
CFOisplanningtogetRs.250Crthroughafreshissueofequitysharestothegeneralpublicandfor
thebalanceamountheproposestouseofthereserveswhicharecurrentlytothetuneofRs.300
Cr. The equity investors expectations of returns are 16%. The cost of procuring external equity is
4%.Whatisthecostofexternalequity?
Solution
WeknowthatKe=Kr,thatisKris16%
CostofexternalequityisKe=ke/(1f)
0.16/(10.04)=0.1667or16.67%
80
5.4 WeightedAverageCostofCapital
In theprevious section we have calculatedthe costof each component in theoverall capital of the
company. The term cost of capital refers to the overall composite cost of cap or the weighted
average cost of each specific type of fund. The purpose of using weighted average is to consider
each component in proportion of their contribution to the total fund available. Use of weighted
average is preferable to simple average method for the reason that firms do not procure funds
equallyfromvarioussourcesandthereforesimpleaveragemethodisnotused.Thefollowingsteps
areinvolvedtocalculatetheWACC.
StepI:Calculatethecostofeachspecificsourceoffund,thatofdebt,equity,preferencecapitaland
termloans.
StepII:Determinetheweightsassociatedwitheachsource.
StepIIIMultiplythecostofeachsourcebytheappropriateweights.
StepIV:WACC=WeKe+WrKr+WpKp+WdKd+WtKt
Assignmentofweights
Weightscanbeassignedbasedonanyofthebelowmentionedmethods:
(1) Thebookvaluesofthesourcesoffundsinthecapitalstructure, (2)Presentmarket
value of the funds in the capital structure and (3) in the proportion of financing planned for the
capitalbudgettobeadoptedforthenextperiod.
Asperthebookvalueapproach,weightsassignedwouldbeequaltoeachsourcesproportioninthe
overall funds. The book value method is preferable. The market value approach uses the market
values of each source and the disadvantage in this method is that these values change very
frequently.
Example:
PrakashPackersLtd.hasthefollowingcapitalstructure:
Rs.inlakhs
Equitycapital(Rs.10parvalue) 200
14% Preference share capital Rs. 100
each
100
Retainedearnings 100
12%debentures(Rs.100each) 300
11%TermloanfromICICIbank 50
Total 750
81
The market price per equity share is Rs. 32. The company is expected to declare a dividend per
shareofRs.2pershareandtherewillbeagrowthof10%inthedividendsforthenext5years.The
preference shares are redeemableatapremium of Rs. 5 per shareafter8 yearsand are currently
tradedat Rs.84 inthe market. Debenture redemption will takeplaceafter7 yearsatapremiumof
Rs.5perdebentureandtheircurrentmarketpriceisRs.90perunit.Thecorporatetaxrateis40%.
CalculatetheWACC.
Solution
StepIistodeterminethecostofeachcomponent.
Ke=(D1/P0)+g
=(2/32)+0.1
=0.1625or16.25%
Kp=[D+{(FP)/n}]/{F+P)/2}
=[14+(10584)/8]/(105+84)/2
=16.625/94.5
=0.1759or17.59%
Kr=Kewhichis16.25%
Kd=[I(1T)+{(FP)/n}]/{F+P)/2}
=[12(10.4)+(10590)/7]/(105+97)/2
=[7.2+2.14]/101
=0.092or9.2%
Kt=I(1T)
=0.11(10.4)
=0.066or6.6%
StepIIistocalculatetheweightsofeachsource.
We=200/750=0.267
Wp=100/750=0.133
Wr=100/750=0.133
Wd=300/750=0.4
Wt=50/750=0.06
82
Step III Multiply the costs of various sources of finance with corresponding weights and WACC
calculatedbyaddingallthesecomponents.
WACC=WeKe+WpKp+WrKr+WdKd+WtKt
=(0.267*0.1625)+(0.133*0.1759)+(0.133*0.1625)+(0.4*0.092)+(0.06*0.066)
=0.043+0.023+0.022+0.034+0.004
=0.1256or12.56%
Example:
JohnsonCoolAirLtdwouldliketoknowtheWACC.Thefollowinginformationismadeavailableto
youinthisregard.
Theaftertaxcostofcapitalare:
Costofdebt9%
Costofpreferenceshares15%
Costofequityfunds18%
Thecapitalstructureisasfollows:
DebtRs.600000
PreferencecapitalRs.400000
EquitycapitalRs.1000000
Solution
Fundsource Amount Ratio Cost Weighted
cost
Debt Rs.600000 0.3 0.09 0.027
Preference
capital
Rs.400000 0.2 0.15 0.03
Equitycapital Rs.
1000000
0.5 0.18 0.09
Total Rs.
2000000
1.0 0.147
WACCis14.7%
83
Example:
ManikyamPlasticsLtd.wantstoenterintothearenaofplasticmouldsnextyearforwhichitrequires
Rs.20Cr.topurchasenewequipment.TheCFOhasmadeavailablethefollowingdetailsbasedon
whichyouarerequiredtocomputetheweightedmarginalcostofcapital.
Theamountrequiredwillberaisedinequalproportionsbywayofdebtandequity(newissueand
retainedearningsputtogetheraccountfor50%).
ThecompanyexpectstoearnRs.4Crasprofitsbytheendofyearofwhichitwillretain50%and
payofftheresttotheshareholders.
ThedebtwillberaisedequallyfromtwosourcesloansfromIOBcosting14%andfromtheIDBI
costing15%.
ThecurrentmarketpriceperequityshareisRs.24anddividendpayoutoneyearhencewillbe
Rs.2.40.
Solution
Sourceoffunds Weights Aftertax
cost
Weightedcost
Equitycapital 0.4 0.1 0.04
Retainedearnings 0.1 0.1 0.01
14%loanfromIOB 0.25 0.07 0.0175
15%IDBIloan 0.25 0.075 0.01875
Total 0.0863or8.63%
Ke=(D1/P0)+g
=(2.40/24)=0.1or10%
Kt=I(1T)
=0.14(10.5)=0.07or7%
Kt=I(1T)
=0.15(10.5)=0.075or7.5%
Example:
CanaraPaintshaspaidadividendof40%onitsshareofRs.10inthecurrentyear.Thedividends
aregrowing@6%p.a.Thecostofequitycapitalis16%.TheCompanystopFinanceManagersof
variouszonesrecentlymettotakestockofthecompetitorsgrowthanddividendpoliciesandcame
out with the following suggestions to maximize the wealth of the shareholders. As the CFO of the
84
company you are required to analyze each suggestion and take a suitable course keeping the
shareholdersinterestsinmind.
Alternative1:Increasethedividendgrowthrateto7%andlowerKeto15%
Alternative2:Increasethedividendgrowthrateto7%andincreaseKeto17%
Alternative3:Lowerthedividendgrowthrateto4%andlowerKeto15%
Alternative4:Lowerthedividendgrowthrateto4%andincreaseKeto17%
Alternative5:increasethedividendgrowthrateto7%andlowerKeto14%
Solution
WeallknowthatP0=D1/(Keg)
Presentcase=4/(0.160.06)=Rs40
Alternative1=4.28/(0.150.07)=Rs.53.5
Alternative2=4.28/(0.170.07)=Rs.42.8
Alternative3=4.16/(0.150.04)=Rs.37.8
Alternative4=4.16/(0.170.04)=Rs.32
Alternative5=4.28/(0.140.07)=Rs.61.14
Recommendation:Thelastalternativeislikelytofetchthemaximumpriceperequitysharethereby
increasingtheirwealth.
1. _________isthemixoflongtermsourcesoffundslikedebentures,loans,preferenceshares,
equitysharesandretainedearningsindifferentratios.
2. Thecapitalstructureofacompanyshouldgenerate__________totheshareholders.
3. Thecapitalstructureofthecompanyshouldbewithinthe__________.
4. Anidealcapitalstructureshouldinvolve___________tothecompany.
5. ________________donothaveafixedrateofreturnontheirinvestment.
6. AccordingtoDividendForecastApproach,theintrinsicvalueofanequityshareisthesumof
______________associatedwithit.
85
5.5 Summary
Anyorganizationrequiresfundstorunitsbusiness.Thesefundsmaybeacquiredfromshorttermor
longtermsources.Longtermfundsareraisedfromtwoimportantsourcescapital(ownersfunds)
and debt. Each of these two has a cost factor, merits and demerits. Having excess debt is not
desirable as debtholders attach many conditions which may not be possible for the companies to
adhereto.Itisthereforedesirabletohaveacombinationofbothdebtandequitywhichiscalledthe
optimum capital structure. Optimum capital structure refers to the mix of different sources of long
termfundsinthetotalcapitalofthecompany.
Costofcapitalistheminimumrequiredrateofreturnneededtojustifytheuseofcapital.Acompany
obtains resourcesfrom various sources issueof debentures,availing term loansfrom banks and
financial institutions, issue of preference and equity shares or it may even withhold a portion or
complete profits earned to be utilized for further activities. Retained earnings are the only internal
sourcetofundthecompanysfutureplans.
WeightedAverageCostofCapitalistheoverallcostofallsourcesoffinance.
The debentures carry a fixed rate of interest. Interest qualifies for tax deduction in determining tax
liability.Thereforetheeffectivecostofdebtislessthantheactualinterestpaymentmadebythefirm.
Thecostoftermloaniscomputedkeepinginmindthetaxliability.
Thecostofpreferenceshareissimilartodebentureinterest.Unlikedebentureinterest,dividendsdo
notqualifyfortaxdeductions.
Thecalculationofcostofequityisslightlydifferentasthereturnstoequityarenotconstant.
Thecostofretainedearningsisthesameasthecostofequityfunds.
SolvedProblems
1. DeepaksteelhasissuednonconvertibledebenturesforRs.5Cr.Eachdebentureisofapar
value of Rs. 100 carrying a coupon rate of 14%. Interest is payable annually and they are
redeemableafter7yearsatapremiumof5%.ThecompanyissuedtheNCDatadiscountof
3%.Whatisthecostofdebenturetothecompany?Taxrateis40%.
86
Solution
Kd=I(1T)+{(FP)/n}
(F+P)/2
14(10.4)+(10597)/7
(105+97)/2
=8.4+1.14 =0.094or9.4%
101
2. SupersonicindustriesLtd.hasenteredintoanagreementwithIndianOverseasBankforaloan
ofRs.10Crwithaninterestrateof10%.Whatisthecostoftheloanifthetaxrateis45%?
Solution
Kt=I(1T)=10(10.45)=5.5%
3. Primegroupissuedpreferenceshareswithamaturitypremiumof10%andacouponrateof9%.
TheshareshaveafaceavalueofRs.100.andareredeemableafter8years.Thecompanyis
planningtoissuethesesharesatadiscountof3%now.Calculatethecostofpreferencecapital.
Solution
Kp=D+{(FP)/n}
(F+P)/2
=9+(11097)/8=9+1.625=10.27%
(110+97)/2 103.5
TerminalQuestions
1. Thefollowingdataisavailableinrespectofacompany:
EquityRs.10lakhs,costofcapital18%
DebtRs.5lakhs,costofdebt13%
Calculatetheweightedaveragecostoffundstakingmarketvaluesasweightsassumingtaxrate
is40%.
2. BharatChemicalshasthefollowingcapitalstructure:
Rs.10facevalueequityshares Rs.400000
Termloan@13% Rs.150000
9%PreferencesharesofRs.100,currentlytraded
atRs.95with6yearsmaturityperiod
Rs.100000
Total Rs.650000
87
The company is expected to declare a dividend of Rs. 5 next year and the growth rate of
dividends is expected to be 8%. Equity shares are currently traded at Rs. 27 in the market.
Assumetaxrateof50%.WhatisWACC?
3. The market value of debt of a firm is Rs. 30 lakhs, which of equity is
Rs.60lakhs.Thecostofequityanddebtare15%and12%.WhatistheWACC?
4. A company has 3 divisions X, Y and Z. Each division has a capital structure with debt,
preferencesharesandequitysharesintheratio3:4:3respectively.Thecompanyisplanningto
raisedebt,preferencesharesandequityforallthe3divisionstogether.Further,itisplanningto
takeabankloan@12%interest.ThepreferenceshareshaveafacevalueofRs.100,dividend
@12%,6yearsmaturityandcurrentlypricedatRs.88.Calculatethecostofpreferenceshares
anddebtiftaxesapplicableare45%
5. Tanishk Industries issues partially convertible debentures of face value of is Rs. 100 each and
realizes Rs. 96 per share. The debentures are redeemable after 9 years at a premium of 4%,
taxesapplicableare40%.Whatisthecostofdebt?
5.8 AnswerstoSelfAssessmentQuestions
1. Capitalstructure
2. Maximumreturns
3. Debtcapacity
4. Minimumriskoflossofcontrol
5. Equityshareholders
6. Presentvaluesofdividends
AnswerstoTerminalQuestions:
1,2,3:WACC=WeKe+WpKp+WrKr+WdKd+WtKt
4.Hint:ApplytheformulaKp= D+{(FP)/n}
(F+P)/2
5.Hint:ApplytheformulaKd=I(1T)+{(FP)/n}
(F+P)/2
SikkimManipalUniversity 88
Unit6 Leverage
Structure
6.1 Introduction
6.2 OperatingLeverage
6.2.1 ApplicationofOperatingLeverage
6.3 FinancialLeverage
6.3.1 UsesofFinancialLeverage
6.4 CombinedLeverage
6.4.1 UsesofCombinedLeverage
6.5 Summary
SolvedProblems
TerminalQuestions
AnswerstoSAQsandTQs
6.1 Introduction
Acompanyusesdifferentsourcesoffinancingtofunditsactivities.Thesesourcescanbeclassified
as those which carry a fixed rate of return and those whose returns vary. The fixed sources of
financehaveabearingonthereturnonshareholders.Borrowingfundsasloanshaveanimpacton
the returnon shareholders and this is greatly affected bythe magnitudeofborrowing in the capital
structureofafirm.Leverageistheinfluenceofpowertoachievesomething.Theuseofanassetor
sourceoffundsforwhichthecompanyhastopayafixedcostorfixedreturnistermedasleverage.
Leverage is the influence of an independent financial variable on a dependent variable. It studies
howthedependentvariablerespondstoaparticularchangeinindependentvariable.
There are two types of leverage operating leverage and financial leverage. Leverage
associatedwiththeassetpurchaseactivitiesisknownasoperatingleverage,whilethoseassociated
withfinancingactivitiesiscalledasfinancialleverage.
LearningObjectives:
1. Explainthemeaningofleverage.
2. Mentionthedifferenttypesofleverage.
3. Discusstheadvantagesofleverage.
6.2 OperatingLeverage
Operating leverage arises due to the presence of fixed operating expenses in the firms income
flows.Acompanysoperatingcostscanbecategorizedintothreemainsections:
Fixed costsarethose which donot vary with an increase inproduction or sales activitiesfora
particularperiodoftime.Theseareincurredirrespectiveoftheincomeandvolumeofsalesand
generallycannotbereduced.
Variable costs are those which vary in direct proportion to output and sales. An increase or
decreaseinproductionorsalesactivitywillhaveadirecteffectonsuchtypesofcostsincurred.
Semivariablecostsarethosewhicharepartlyfixedandpartlyvariableinnature.Thesecosts
aretypicallyoffixednatureuptoacertainlevelbeyondwhichtheyvarywiththefirmsactivities.
The operating leverage is the firms ability to use fixed operating costs to increase the effects of
changesinsalesonitsearningsbeforeinterestandtaxes.Operatingleverageoccursanytimeafirm
hasfixedcosts.Thepercentagechangeinprofitswithachangeinvolumeofsalesismorethanthe
percentagechangeinvolume.
Example:
A firm sells a product for Rs. 10 per unit, its variable costs are Rs. 5 per unit and fixed expenses
amount to R. 5000 p.a. Show the various levels of EBIT that result from sale of 1000 units, 2000
unitsand3000units.
Solution
Salesinunits 1000 2000 3000
SalesrevenueRs. 10000 20000 30000
Variablecost 5000 10000 15000
Contribution 5000 10000 15000
Fixedcost 5000 5000 5000
EBIT 000 5000 10000
Ifwetake2000unitsasthenormalcourseofsales,theresultscanbesummedasunder:
A50%increaseinsalesfrom2000unitsto3000unitsresultsina100%increaseinEBIT.
A50%decreaseinsalesfrom2000unitsto1000unitsresultsina100%decreaseinEBIT.
The illustration clearly tells us that when afirm has fixed operating expenses, an increase in sales
resultsinamoreproportionateincreaseinEBITandviceversa.Theformerisafavourableoperating
leverageandthelatterisunfavourable.
Another way of explaining this phenomenon is examining the effect of the degree of operating
leverageDOL.TheDOLisamoreprecisemeasurement.Itexaminestheeffectofthechangeinthe
quantityproducedonEBIT.
DOL=%changeinEBIT/%changeinoutput
Toputinadifferentway,(EBIT/EBIT)
(Q/Q)
EBITisQ(SV)FwhereQisquantity,Sissales,VisvariablecostandFisfixedcost.
Substitutingthisweget,{Q(SV)}
{Q(SV)F}
Example:
CalculatetheDOLofGupthaenterprises.
Quantityproducedandsold 1000units
Variablecost Rs.100perunit
Sellingpriceperunit Rs.300perunit
Fixedexpenses Rs.20000
Solution
DOL={Q(SV)}
{Q(SV)F}
=1000(300200)
1000(300200)20000
=100000/80000
DOL=1.25
Ifthecompanydoesnotincuranyfixedoperatingcosts,thereisnooperatingleverage.
Example:
Salesinunits 1000
SalesrevenueRs. 10000
Variablecost 5000
Contribution 5000
Fixedcost 0
EBIT 5000
Solution:
DOL={Q(SV)}
{Q(SV)F}
{1000(5000)}/{1000(5000)0}
=5000000/5000000
=DOL=1
Asoperatingleveragecanbefavourableorunfavourable,highrisksareattachedtohigherdegrees
of leverage. As DOL considers fixed expenses, a larger amount of these expenses increases the
operating risks of the company andhence ahigher degree ofoperating leverage. Higher operating
riskscanbetakenwhenincomelevelsofcompaniesarerisingandshouldnotbeventuredintowhen
revenuesmovesouthwards.
6.2.1 ApplicationofOperatingLeverage
Measurement of business risk: Risk refers to the uncertain conditions in which a company
performs.GreatertheDOL,moresensitiveistheEBITtoagivenchangeinunitsales.AhighDOLis
ameasureofhighbusinessriskandviceversa.
Production planning: A change in production method increases or decreases DOL. A firm can
change its cost structure by mechanizing its operations, thereby reducing its variable costs and
increasingitsfixedcosts.ThiswillhaveapositiveimpactonDOL.Thissituationcanbejustifiedonly
ifthecompanyisconfidentofachievingahigheramountofsalestherebyincreasingitsearnings.
6.3 FinancialLeverage
Financial leverage as opposedto operating leverage relates to thefinancing activities of afirmand
measures the effect of EBIT on EPSofthe company.A companys sourcesoffundsfallunder two
categoriesthosewhichcarryafixedfinancialchargedebentures,bondsandpreferenceshares
andthosewhichdonotcarryanyfixedchargeequityshares.Debenturesandbondscarryafixed
rateofinterestandhavetobepaidoffirrespectiveofthefirmsrevenues.Thoughdividendsarenot
contractualobligations,dividendonpreferencesharesisafixedchargeandshouldbepaidoffbefore
equityshareholdersarepaidany.Theequityholdersareentitledtoonlytheresidualincomeofthe
firmafterallpriorobligationsaremet.
Financialleveragereferstothemixofdebtandequityinthecapitalstructureofthefirm.Thisresults
fromthepresenceoffixedfinancialchargesinthecompanysincomestream.Suchexpenseshave
nothing to do with the firms performance and earnings and should be paid off regardless of the
amountofEBIT.Itisthefirmsabilitytousefixedfinancialchargestoincreasetheeffectsofchanges
in EBIT on the EPS. It is the use of funds obtained at fixed costs to increase the returns to
shareholders.A company earning more bythe use ofassetsfundedbyfixed sources is said tobe
havingafavourableorpositiveleverage.Unfavourableleverageoccurswhenthefirmisnotearning
sufficientlytocoverthecostoffunds.FinancialleverageisalsoreferredtoasTradingonEquity.
Example:
TheEBITofafirmisexpectedtobeRs.10000.Thefirmhastopayinterest@5%ondebentures
worth Rs. 25000. It also has preference shares worth Rs. 15000 carrying a dividend of 8%. How
doesEPSchangeifEBITisRs.5000andRs.15000?Taxratemaybetakenas40%andnumberof
outstandingsharesas1000.
Solution:
EBIT 10000 5000 15000
Interestondeb. 1250 1250 1250
EBT 8750 3750 13750
Tax40% 3500 1500 5500
EAT 5250 2250 8250
Preferencediv. 1200 1200 1200
Earningsavailable
toequityholders
4050 1050 7050
EPS 4.05 1.05 7.05
Interpretation:
A50%increaseinEBITfromRs.10000toRs.15000resultsin74%increaseinEPS.
A50%decreaseinEBITfromRs.10000toRs.5000resultsin74%decreaseinEPS.
This example shows that the presence of fixed interest source funds leads to a more than
proportional change in EPS. The presence of such fixed sources implies the presence of financial
leverage.Thiscanbeexpressedinadifferentway.ThedegreeoffinancialleverageDFLisamore
precisemeasurement.ItexaminestheeffectofthefixedsourcesoffundsonEPS.
DFL=%changeinEPS
%changeinEBIT
DFL={EPS/EPS}
{EBIT/EBIT}
OrDFL= EBIT
{EBITI{Dp/(1T)}}
IisInterest,Dpisdividendonpreferenceshares,Tistaxrate.
Example:
Kusuma Cements Ltd. has an EBIT of Rs. 500000 at 5000 units production and sales. The capital
structureisasfollows:
Capitalstructure AmountRs.
Paidupcapital500000equitysharesof
Rs.10each
5000000
12%Debentures 400000
10%PreferencesharesofRs.100each 400000
Total 5800000
Corporatetaxratemaybetakenat40%
Solution:
EBIT 500000
LessInterestondebentures 48000
EBT 452000
DFL= EBIT
{EBITI{Dp/(1T)}}
500000
(50000048000{40000/(10.40)}
DFL=1.30
6.3.1UseofFinancialLeverage
StudyingDFLatvariouslevelsmakesfinancialdecisionmakingontheuseoffixedsourcesoffunds
forfundingactivitieseasy.OnecanassesstheimpactofchangeinEBITonEPS.
Likeoperatingleverage,therisksarehighathighdegreesoffinancialleverage.Highfinancialcosts
areassociatedwithhighDFL.AnincreaseinfinancialcostsimplieshigherlevelofEBITtomeetthe
necessaryfinancialcommitments.Afirmnotcapableofhonouringitsfinancialcommitmentsmaybe
forcedtogointoliquidationbythelendersoffunds.Theexistenceofthefirmisshakyunderthese
circumstances. On the one hand trading on equity improves considerably by the use of borrowed
fundsandontheotherhand,thefirmhastoconstantlyworktowardshigherEBITtostayaliveinthe
business.Allthesefactorsshouldbeconsideredwhileformulatingthefirmsmixofsourcesoffunds.
Onemaingoaloffinancialplanningisdeviseacapitalstructureinordertoprovideahighreturnto
equityholders.Butatthesametime,thisshouldnotbedonewithheavydebtfinancingwhichdrives
thecompanyontothebrinkofwindingup.
Impactoffinancialleverage:
Highlyleveragedfirmsareconsideredveryriskyandlendersandcreditorsmayrefusetolendthem
further to fuel their expansion activities. On being forced to continue lending, they may do so with
theirownconditionslikeearningaminimumofX%EBITorstipulatinghigherinterestratesthanthe
marketratesornofurthermortgageofsecurities.Financialleverageisconsideredtobefavourable
till suchtime that the rateof return exceedsthe rateof return obtained when nodebt isused. This
canbeexplainedwiththehelpofthefollowingexample:
Followingarethebalancesheetsof2firmsAandB
BalancesheetofA BalancesheetofB
Equity
capita
l
10000
0
Assets 10000
0
Equity
capital
40000 Assets 10000
0
Debt
@
15%
60000
Total 10000
0
Total 10000
0
Total 10000
0
Total 10000
0
Both the companies earn an income before interest and tax of Rs. 40000. Calculate the DFL and
interprettheresultsthereof.
DFL=
)}} T 1 /( Dp { I EBIT {
EBIT
- - -
CompanyA= 1
0 0 40000
4000
=
- -
CompanyB= 29 . 1
0 9000 40000
4000
=
- -
ThecompanynotusingdebttofinanceitsassetshasahigherDFL.Financialleveragedoesnotexist
whenthereisnofixedchargefinancing.
6.4 TotalorCombinedLeverage
Thecombinationofoperatingandfinancialleverageiscalledcombinedleverage.Operatingleverage
affectsthefirmsoperatingprofitEBITandfinancialleverageaffectsPATortheEPS.Thesecause
widefluctuationinEPS.Acompanyhavingahighlevelofoperatingorfinancialleveragewillfinda
drasticchangeinitsEPSevenforasmallchangeinsalesvolume.Companieswhoseproductsare
seasonalinnaturehavefluctuatingEPS,buttheamountofchangesinEPSduetoleveragesismore
pronounced. The combined effect is quite significant for the earnings available to ordinary
shareholders.CombinedleverageistheproductofDOLandDFL.
DTL=
)} T 1 /( Dp { I F ) V S ( Q
) V S ( Q
- - - - -
-
Example:
CalculatetheDTLofM/sPoojaEnterprisesLtd.giventhefollowinginformation.
Quantitysold 10000units
Variablecostperunit Rs.100perunit
Sellingpriceperunit Rs.500perunit
Fixedexpenses Rs.1000000
Numberofequityshares 100000
Debt Rs.1000000@20%interest
Preferenceshares 10000sharesofRs.100each@10%dividend
Taxrate 50%
DTL=
)} T 1 /( Dp { I F ) V S ( Q
) V S ( Q
- - - - -
-
} 5 . 0 / 100000 { 200000 1000000 ) 100 500 ( 10000
) 100 500 ( 10000
- - - -
-
DTL=1.54
Crossverification:
DOL=
} F ) V S ( Q {
)} V S ( Q {
- -
-
1000000 ) 100 500 ( 10000
) 100 500 ( 10000
- -
-
=
DOL=1.33
DFL=
)}} T 1 /( Dp { I EBIT
EBIT
- - -
} 5 . 0 / 100000 { 200000 3000000
3000000
- -
DFL=1.15
DTL=DOL*DFL
1.33*1.15=1.54
6.4.1UsesofDTL
DTL measures the total risk of the company as it is a combined measure of both operating and
financialrisk.ItmeasuresthevariabilityofEPS.
1. ________________arisesdue to the presenceoffixed operating expenses in thefirms income
flows.
2. EBITiscalculatedas_____________.
3. Higheroperatingriskscanbetakenwhen_____________ofcompaniesarerising.
4. Dividendon__________isafixedcharge.
5.Financialleverageisalsoreferredtoas____________.
6.5 Summary
Leverage is the use of influence to attain something else. The advantage a company has with its
currentstatusisusedtogainsomeotherbenefit.Therearethreemeasuresofleverageoperating
leverage,financialleverageandtotalorcombinedleverage.Operatingleverageexaminestheeffect
of change in quantity produced upon EBIT and is useful to measure business risk and production
planning. Financial leverage measures theeffect of change in EBIT onthe EPSof the company.It
also refers to the debtequity mix of a firm. Total leverage is the combination of operating and
financialleverages.
SolvedProblems
1. ThefollowinginformationhasbeencollectedfromtheannualreportofGardenSilks.Whatisthe
degreeoffinancialleverage?
TotalsalesRs.1400000
Contributionratio25%
FixedexpensesRs.150000
OutstandingbankloanRs.400000@12.5%
Applicabletaxrate40%
Solution:DFL=EBIT/(EBITI)=200000/20000050000=1.33
EBIT=Sales*25%lessfixedexpenses
1400000*25%=350000150000=200000
2. XandYhaveprovidedthefollowinginformation.Whichfirmdoyouconsiderrisky?
XLtd. YLtd.
Salesinunits 40000 40000
Priceperunit 60 60
Variablecostp.u 20 25
Fixedfinancing
cost
Rs.100000 Rs.50000
Fixedfinancing
cost
Rs.300000 Rs.
200000
Solution:DOL=Q(SV)/Q(SV)F
CompanyX:40000(6020)/40000(6020)400000
1600000/1200000=1.33
CompanyY:40000(6025)/40000(6025)250000
1400000/1100000=1.22
3. CalculateEPSwiththefollowinginformation.
EBITRs.1180000
InterestRs.220000
No.ofsharesoutstanding40000
Taxrateapplicable40%
Solution:EBIT 1180000
LessInt 220000
EBT 960000
Tax40% 384000
EAT 576000
EPS=EAT/noofsharesoutstanding
576000/40000=Rs.14.4
4. Theleveragesofthreefirmsaregivenbelow.Whichoneofthecombinationsshouldbechosen
forthecombinedleveragetobemaximumandwhataretheinferences?
A B C
Operatingleverage 1.14 1.23 1.33
Financialleverage 1.27 1.3 1.33
Solution:Weshouldcalculatethecombinedleveragetodrawinferences.Combinedleverageof
Ais1.14*1.27=1.45,
CombinedleverageofBis1.23*1.3=1.60,
CombinedleverageofCis1.33*1.33=1.77
WefindthatthecombinedleverageishighestforfirmCandthissuggeststhatthisfirmisworking
underveryhighriskysituation.
TerminalQuestions
1. MishraLtd.providesthefollowinginformation.Whatisthedegreeofoperatingleverage?
Output 100000Units
Fixedcosts Rs.15000
Variablecostperunit Rs.0.50
Interestonborrowedfunds Rs.10000
Sellingpriceperunit Rs.1.50
2. XLtd.providesthefollowinginformation.Whatisthedegreeoffinancialleverage?
Output 25000units
Fixedcosts Rs.25000
Variablecost Rs.2.50perunit
Interestonborrowedfunds Rs.15000
Sellingprice Rs.8perunit
3. The following information is available in respect of 2 firms. Comment on their relative
performancethroughleverage
ALtd.(Rs.Inlakhs) BLtd.(Rs.Inlakhs)
Sales 1000 1500
Variablecost 300 600
Fixedcost 250 400
EBIT 450 500
Interest 50 100
4. ABCLtd.providesthefollowinginformation.CalculatetheDFL.
Output 200000units
Fixedcosts Rs.3500
Variablecost Rs.0.05perunit
Interestonborrowedfunds Nil
Sellingpriceperunit 0.20
1. Operatingleverage
2. Q(SV)F
3. Incomelevels
4. Preferenceshares
5. TradingonEquity
1.HintDOL=
} F ) V S ( Q {
)} V S ( Q {
- -
-
2.HintDFL=
)}} T 1 /( Dp { I EBIT {
EBIT
- - -
3. HintcalculateDFL
Unit7 CapitalStructure
Structure
7.1 Introduction
7.2 FeaturesofIdealCapitalStructure
7.3 FactorsAffectingCapitalStructure
7.4 TheoriesofCapitalStructure
7.4.1 NetIncomeApproach
7.4.2 NetOperatingIncomeApproach
7.4.3 TraditionalApproach
7.4.4 MillerandModiglianiApproach
7.4.4.1CriticismofMillerandModiglianiApproach
7.5 Summary
TerminalQuestions
AnswerstoSAQsandTQs
7.1 Introduction
Thecapitalstructureofacompanyreferstothemixoflongtermfinancesusedbythefirm.Inshort,it
isthefinancingplanofthecompany.Withtheobjectiveofmaximizingthevalueoftheequityshares,
the choice should be that pattern of using debt and equity in a proportion that will lead towards
achievementofthefirmsobjective.Thecapitalstructureshouldaddvaluetothefirm.Financingmix
decisionsareinvestmentdecisionsandhavenoimpactontheoperatingearningsofthefirm.Such
decisionsinfluencethefirmsvaluethroughtheearningsavailabletotheshareholders.
Thevalueofafirmisdependentonitsexpectedfutureearningsandtherequiredrateofreturn.The
objectiveofanycompanyistohaveanidealmixofpermanentsourcesoffundsinamannerthatwill
maximize the companys market price. The proper mix of funds is referred to as Optimal Capital
Structure.
The capital structuredecisions includedebtequity mix and dividend decisions.Both these have an
effectontheEPS.
LearningObjectives:
1. Explainthefeaturesofidealcapitalstructure.
2. Namethefactorsaffectingthecapitalstructure.
3. Mentionthevarioustheoriesofcapitalstructure.
7.2 FeaturesofanIdealCapitalStructure
Profitability:Thefirmshouldmakemaximumuseofleverageatminimumcost.
Flexibility:Itshouldbeflexibleenoughtoadapttochangingconditions.Itshouldbeinaposition
toraisefundsattheshortestpossibletimeandalsorepaythemoneysitborrowed,iftheyappear
tobeexpensive.Thisispossibleonlyifthecompanyslendershavenotputforthanyconditions
likerestrictingthecompanyfromtakingfurtherloans,norestrictionsplacedontheassetsusage
orlayingarestrictiononearlyrepayments.Inotherwords,thefinanceauthoritiesshouldhavethe
powertotakedecisionsonthebasisofthecircumstanceswarrant.
Control:Thestructureshouldhaveminimumdilutionofcontrol.
Solvency: Use ofexcessive debt threatens the very existence ofthe company. Additional debt
involves huge repayments. Loans with high interest rates are to be avoided however attractive
someinvestmentproposalslook.Somecompaniesresorttoissueofequitysharestorepaytheir
debtforequityholdersdonothaveafixedrateofdividend.
7.3 FactorsAffectingCapitalStructure
Leverage:Theuseoffixedchargessourcesoffundssuchaspreferenceshares,loansfrombanks
and financial institutions and debentures in the capital structure is known as trading on equity or
financial leverage. Creditors insist on a debt equity ratio of 2:1 for medium sized and large sized
companies, while they insist on 3:1 ratio for SSI. Debt equity ratio is an indicator of the relative
contribution of creditors and owners. The debt component includes both long term and short term
debtandthisisrepresentedasDebt/Equity.Adebtequityratioof2:1indicatesthatforevery1unitof
equity,thecompanycanraise2unitsofdebt.Bynormalstandards,2:1isconsideredahealthyratio,
but it is not always a hard and fast rule that this standard is insisted upon. A ratio of 1.5:1 is
considered good for a manufacturing company while a ratio of 3:1 is good for heavy engineering
companies. It is generally perceived that lower the ratio, higher is the element ofuncertainty in the
mindsoflenders.
Increaseduseofleverageincreasescommitmentsofthecompany,theoutflowsbeinginthenature
of higher interest and principal repayments, thereby increasing the risk of the equity shareholders.
Theotherfactorstobeconsideredbeforedecidingonanidealcapitalstructureare:
Cost of capital High cost funds should be avoided however attractive an investment
propositionmaylooklike,fortheprofitsearnedmaybeeatenawaybyinterestrepayments.
Cash flow projections of the company Decisions shouldbe taken inthe lightof cashflows
projected for the next 35 years. The company officials should not get carried away at the
immediateresultsexpected.Consistentlesserprofitsareanywaypreferablethanhighprofitsin
thebeginningandnotbeingabletogetanyafter2years.
Sizeofthecompany
DilutionofcontrolThetopmanagementshouldhavetheentireflexibilitytotakeappropriate
decisionsattherighttime.Thecapitalstructureplannedshouldbeoneinthisdirection.
Floatation costs A company desiring to increase its capital by way of debt or equity will
definitelyincurfloatationcosts.Effectively,theamountofmoneyraisedbyanyissuewillbelower
than the amount expected because of the presence of floatation costs. Such costs should be
comparedwiththeprofitsandrightdecisionstaken.
7.4 TheoriesofCapitalStructure
Asweareaware,equityanddebtarethetwoimportantsourcesoflongtermsourcesoffinanceofa
firm.Theproportionofdebtandequityinafirmscapitalstructurehastobeindependentlydecided
case to case. A proposal though not being favourable to lenders may be taken up if they are
convincedwiththeearningpotentialandlongtermbenefits.Manytheorieshavebeenpropoundedto
understandtherelationshipbetweenfinancialleverageandfirmvalue.
Assumptions
Thefollowingaresomecommonassumptionsmade:
Thefirmhasonlytwosourcesoffundsdebtandordinaryshares.
Therearenotaxesbothcorporateandpersonal.
Thefirmsdividendpayoutratiois100%,thatis,thefirmpaysofftheentireearningstoitsequity
holdersandretainedearningsarezero.
Theinvestmentdecisionsofacompanyareconstant,thatis,thefirmdoesnotinvestanyfurther
initsassets.
TheoperatingprofitsEBITarenotexpectedtoincreaseordecline.
AllinvestorsshallhaveidenticalsubjectiveprobabilitydistributionofthefutureexpectedEBIT.
A firm can change its capital structure at a short notice without the occurrence of transaction
costs.
Thelifeofthefirmisindefinite.
Basedontheabove,wederivethefollowing:
1. Debtcapitalbeingconstant,Kdisthecostofdebtwhichisthediscountrateatwhichdiscounted
futureconstantinterestpaymentsareequaltothemarketvalueofdebt,thatis,Kd=I/Bwhere,I
referstototalinterestpaymentsandBisthetotalmarketvalueofdebt.
ThereforevalueofthedebtB=I/Kd
2. Cost of equity capital Ke = (D1/P0) + g where D1 is dividend after one year, P0 is the current
marketpriceandgistheexpectedgrowthrate.
3. Retainedearningsbeingzero,g=brwhereristherateofreturnonequitysharesandbisthe
retentionrate,thereforegiszero.NowweknowKe=E1/P0+gandgbeingzero,soKe=NI/S
whereNIisthenetincometoequityholdersandSismarketvalueofequityshares.
4. Thenetoperatingincomebeingconstant,overallcostofcapitalisrepresentedasK0=W1K1+
W2K2.
Thatis,K0=(B/V)K1+(S/V)K2whereBisthetotalmarketvalueofthedebt,Smarketvalueof
equity and V total market value of the firm (B+S). The above equation can be expressed as
[B/(B+S)]K1 + [S/(B+S)]K2, ( K1 being the debt component and Ke being the equity
component)whichcanbeexpressedasK0=I+NI/VorEBIT/Vorinotherwords,netoperating
income/marketvalueoffirm.
7.4.1 NetIncomeApproach
ThistheoryissuggestedbyDurandandheisoftheviewthatcapitalstructuredecisionisrelevantto
the valuation of thefirm. Any change in thefinancial leverage will have a corresponding change in
theoverallcostofcapitalandalsothetotalvalueofthefirm.Astheratioofdebttoequityincreases,
theWACCdeclinesandmarketvalueoffirmincreases.TheNIapproachisbasedon3assumptions
notaxes,costofdebtlessthancostofequityanduseofdebtdoesnotchangetheriskperception
ofinvestors.
WeknowthatK0=[B/(B+S)]Kd+[S/(B+S)]Ke
Thefollowinggraphicalrepresentationofnetincomeapproachmayhelpusunderstandthisbetter.
Example:
Given below are two firms A and B, which are identical in all aspects except the degree of
leverageemployedbythem.Whatistheaveragecostofcapitalofbothfirms?
FirmA FirmB
NetoperatingincomeEBIT Rs.100000 Rs.100000
InterestondebenturesI Nil Rs.25000
EquityearningsE Rs.100000 Rs.80000
CostofequityKe 15% 15%
CostofdebenturesKd 10% 10%
MarketvalueofequityS=E/Ke Rs.666667 Rs.533333
MarketvalueofdebtB Nil Rs.250000
TotalvalueoffirmV Rs.666667 Rs.783333
AverageCostofcapitaloffirmA is:
10%*0/Rs.666667+15%*666667/666667whichis15%
K0
Ke
Kd
P
e
r
c
e
n
t
a
g
e
c
o
s
t
LeverageB/S
AverageCostofcapitaloffirmBis:
10%*25000/783333+15%*533333/783333whichis10.53%
Interpretation:Theuseofdebthascausedthetotalvalueofthefirmtoincreaseandtheoverallcost
ofcapitaltodecrease.
7.4.2 NetOperatingIncomeApproach
ThistheoryisagainpropoundedbyDurandandistotallyoppositeoftheNetIncomeApproach.He
saysanychangeinleveragewillnotleadtoanychangeinthetotalvalueofthefirm,marketpriceof
shares and overall cost of capital. The overall capitalization rate is the same for all degrees of
leverage.Weknowthat:
K0=[B/(B+S)]Kd+[S/(B+S)]Ke
AspertheNOIapproachtheoverallcapitalizationrateremainsconstantforalldegreesofleverage.
The market values the firm as a whole and the split in the capitalization rates between debt and
equityisnotverysignificant.
Theincreaseintheratioofdebtinthecapitalstructureincreasesthefinancialriskofequity
shareholdersandtocompensatethis,theyexpectahigherreturnontheirinvestments.Thusthecost
ofequityis
Ke=Ko+[(KoKd)(B/S)]
Costofdebt:Thecostofdebthastwopartsexplicitcostandimplicitcost.Explicitcostisthegiven
rateofinterest.Thefirmisassumedtoborrowirrespectiveofthedegreeofleverage.Thiscanmean
that the increasing proportion of debt does not affect the financial risk of lenders and they do not
chargehigherinterest.ImplicitcostisincreaseinKeattributabletoKd.Thustheadvantageofuseof
debtiscompletelyneutralizedbytheimplicitcostresultinginKeandKdbeingthesame.
Graphicallythisisrepresentedas:
Example:
Given below are two firms X and Y which are similar in all aspects except the degree of leverage
employed.
FirmA FirmB
NetoperatingincomeEBIT Rs.10000 Rs.10000
OverallcapitalizationrateKo 18% 18%
TotalmarketvalueV=EBIT/Ko 55555 55555
InterestondebtI Rs.1000 Rs.2000
DebtcapitalizationrateKd 11% 11%
MarketvalueofdebtB=I/Kd Rs.9091 Rs.18181
MarketvalueofequityS=VB Rs.46464 Rs.37374
LeverageB/S 0.1956 0.2140
Theequitycapitalizationratesare
FirmA=9000/46464whichis19.36%
FirmB=8000/37374whichis21.40%
Theequitycapitalizationratescanalsobecalculatedwiththeformula
Ke=Ko+[(KoKd)(B/S)]
FirmA=0.18+[(0.180.11)(0.1956)]=19.36%
FirmB=0.18+[(0.180.11)(0.4865)]=21.40%
Kd
Ko
Ke
LeverageB/S
P
e
r
c
e
n
t
a
g
e
c
o
s
t
7.4.3 TraditionalApproach:TheTraditionalApproachhasthefollowingpropositions:
Kdremainsconstantuntilacertaindegreeofleverageandthereafterrisesatanincreasingrate.
Keremainsconstantorrisesgraduallyuntilacertaindegreeofleverageandthereafterrisesvery
sharply.
Asasequencetotheabove2propositions,Kodecreasestillacertainlevel,remainsconstantfor
moderateincreasesinleverageandrisesbeyondacertainpoint.
Graphically,wecanrepresenttheseasunder:
7.4.4MillerandModiglianiApproach
Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a
reasonable limit and Ko being constant at all degrees of leverage. They state that the relationship
between leverage and cost of capital is elucidated as in NOI approach. The assumptions for their
analysisare:
Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and
sellsecurities(bothsharesanddebtinstruments),therearenohindrancesontheborrowings,no
presenceoftransactioncosts,securitiesinfinitelydivisible,availabilityof allrequiredinformation
atalltimes.
Investorsbehaverationally,thatis,theychoosethatcombinationofriskandreturnthatismost
advantageoustothem.
Ke
Ko
Kd
P
e
r
c
e
n
t
a
g
e
c
o
s
t
LeverageB/S
Homogeneity of investors risk perception, that is, all investors have the same perception of
businessriskandreturns.
Taxes:Thereisnocorporateorpersonalincometax.
Dividendpayoutis100%,thatis,thefirmsdonotretainearningsforfutureactivities.
Basic propositions: The following three propositions can be derived based on the above
assumptions:
Proposition I: The market value of the firm is equal to the total market value of equity and total
marketvalueofdebtandisindependentofthedegreeofleverage.Itcanbeexpressedas:
ExpectedNOI
Expectedoverallcapitalizationrate
V+(S+D)whichisequaltoO/KowhichisequaltoNOI/Ko
V+(S+D)=O/Ko=NOI/Ko
WhereVisthemarketvalueofthefirm,
Sisthemarketvalueofthefirmsequity,
Disthemarketvalueofthedebt,
Oisthenetoperatingincome,
Koisthecapitalizationrateoftheriskclassofthefirm.
Error!
Ke
LeverageD/V
C
o
s
t
o
f
c
a
p
i
t
a
l
Ko
The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage
mechanism.Arbitrageistheprocessofbuyingasecurityatlowerpriceinonemarketandsellingitin
another market at a higher price bringing about equilibrium. This is a balancing act. Miller and
Modigliani perceive that the investors of a firm whose value is higher will sell their shares and in
returnbuysharesofthefirmwhosevalueislower.Theywillearnthesamereturnatloweroutlayand
lowerperceivedrisk.Suchbehavioursareexpectedtoincreasethesharepriceswhosesharesare
beingpurchasedandloweringthesharepricesofthosesharewhicharebeingsold.Thisswitching
operationwillcontinuetillthemarketpricesofidenticalfirmsbecomeidentical.
PropositionII:Theexpectedyieldonequityisequaltodiscountrate(capitalizationrate)applicable
plusapremium.
Ke=Ko+[(KoKd)D/S]
PropositionIII:Theaveragecostofcapitalisnotaffectedbythefinancingdecisionsasinvestment
andfinancingdecisionsareindependent.
7.4.4.1 CriticismsofMMProposition
Riskperception:Theassumptionthatrisksaresimilariswrongandtheriskperceptionsofinvestors
arepersonalandcorporateleverageisdifferent.Thepresenceoflimitedliabilityoffirmsincontrast
tounlimitedliabilityofindividualsputsfirmsandinvestorsonadifferentfooting.Allinvestorsloseifa
leveredfirmbecomesbankruptbutaninvestorlosesnotonlyhissharesinacompanybutwouldalso
beliabletorepaythemoneyheborrowed.Arbitrageprocessisonewayofreducingrisks.Itismore
riskytocreatepersonalleverageandinvestinunleveredfirmthaninvestinginleveredfirms.
Convenience: Investors find personal leverage inconvenient. This is so because it is the firms
responsibility to observe corporate formalities and procedures whereas it is the investors
responsibilitytotakecareofpersonalleverage.Investorsprefertheformerratherthantakingonthe
responsibilityandthustheperfectsubstitutabilityissubjecttoquestion.
Transactioncosts:Anothercostthatinterferesinthesystemofbalancingwitharbitrageprocessis
thepresenceoftransactioncosts.Duetothepresenceofsuchcostsinbuyingandsellingsecurities,
itisnecessarytoinvestahigheramounttoearnthesameamountofreturn.
Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani
approachfailstoexplainthefinancingdecisionandfirmsvalue.
Agency costs: A firm requiring loan approach creditors and creditors may sometimes impose
protectivecovenantstoprotecttheirpositions.Suchrestrictionmaybeinthenatureofobtainingprior
approvalofcreditorsforfurtherloans,appointmentofkeypersons,restrictionondividendpayouts,
limitingfurtherissueofcapital,limitingnewinvestmentsorexpansionschemesetc.
1. Financingmixdecisionsare_______________andhavenoimpactonthe_____________ofthe
firm.
2. Thevalueofafirmisdependentonits_____________andthe________.
3. _________and_______aretwoimportantsourcesoflongtermsourcesoffinanceofafirm.
4. Astheratioofdebttoequityincreases,the________declinesand_____________offirm
increases.
5. AspertheNOIapproachthe____________remainsconstantforalldegreesofleverage.
6. ________istheprocessofbuyingasecurityatlowerpriceinonemarketandsellingitinanother
marketatahigherpricebringingabout_______.
7.5 Summary
AccordingtotheNIApproach,overallcostofcapitalcontinuouslydecreasesasandwhendebtgoes
upinthecapitalstructure.Optimalcapitalstructureexistswhenthefirmborrowsmaximum.
NOIApproachbelievesthatcapitalstructureisnotrelevant.Koisdependentbusinessriskwhichis
assumedtobeconstant.
TraditionalApproachtellsusthatKodecreaseswithleverageinthebeginning,reachesitsmaximum
pointandfurtherincreases.
MillerandModiglianiApproachalsobelievesthatcapitalstructureisnotrelevant.
TerminalQuestions
1. WhataretheassumptionsofMMapproach?
2. Thefollowingdataareavailableinrespectof2firms.Whatistheaveragecostofcapital?
FirmA FirmB
Netoperatingincome Rs.500000 Rs.500000
Interestondebt Nil Rs.50000
Equityearnings Rs.500000 Rs.450000
Costofequitycapital 15% 15%
Costofdebt Nil 10%
Marketvalueofequityshares Rs.2000000 Rs.1400000
Marketvalueofdebt Nil Rs.400000
Totalvalueoffirm Rs.2000000 Rs.1800000
3. Twocompaniesareidenticalinallrespectsinallaspectsexceptthedebtequityprofile.Company
X has 14% debentures worth Rs. 2500000 whereas company Y does not have any debt. Both
companiesearn20%beforeinterestandtaxesontheirtotalassetsofRs.5000000.Assuminga
taxrateof40%,andcostofequitycapitaltobe22%,whatisthevalueofthecompanyXandY
usingNetoperatingincomeapproach?
4. ThemarketvalueofdebtandequityofafirmareRs.10crandRs.20Cr.respectivelyandtheir
respective costs are 12% and 14%. The overall capital is 13%. Assuming the company has a
100% dividend payout ratio and there are no taxes, calculate the net operating income of the
firm.
5. If a company has equity worth Rs. 300 lakhs, debentures worth Rs. 400 lakhs and term loan
worthRs.50lakhs,calculatetheWACC.
SelfAssessmentQuestions
1. Investmentdecisions,operatingearnings
2. Expectedfutureearnings,requiredrateofreturn
3. Equitydebt
4. WACCmarketvalue
5. Overallcapitalizationrate
6. Arbitrageequilibrium
1. Referto6.4.4
2,3,4.K0=[B/(B+S)]Kd+[S/(B+S)]Ke
5.WACC= WeKe+WpKp+WrKr+WdKd+WtKt
Hint:W
e
=0.4W
d
=0.533W
t
=0.067
113
Unit8 CapitalBudgeting
Structure
8.1. Introduction
8.2. ImportanceofCapitalbudgeting
8.3. ComplexitiesinvolvedinCapitalbudgetingdecisions
8.4. PhasesofCapitalexpendituredecisions
8.5. Identificationofinvestmentopportunities
8.6. RationaleofCapitalbudgetingproposals
8.7. CapitalBudgetingprocess
8.7.1 Technicalappraisal
8.7.2 EconomicAppraisal
8.8. InvestmentEvaluation
8.9. Appraisalcriteria
8.9.1 Traditionaltechniques
8.9.2 Discountedpaybackperiod
8.10. Summary
TerminalQuestions
AnswertoSAQsandTQs
8.1 Introduction
HDFC BanktakesoverCenturionBankofPunjab.ICICIBanktookoverBankofMadurai.The
motive behind all these mergers is to grow because in this era of globalization theneed of the
hour is to grow as big as possible. In all these, one could observe that the desire of the
managementtocreatevalueforshareholdersisthemotivatingforce.
Another way of growing is through branch expansion, expanding the product mix and reducing
cost through improved technology for deeper penetration into the market for the companys
products.Forexample,abankwhichisurbanbased,forexpansiontakesoverabankwithrural
network. HereurbanbasedbankcanopenmoreurbanbranchesonlywhenitmeetstheReserve
BankofIndiaguidelineofhavingaminimumnumberofruralbranches.Thisisthemotiveforthe
mergerofurbanbasedbankofICICIwiththeruralbasedBankofMadurai.
114
In this competitive arena proactive organization makes attempts to convert challenges into
opportunities. Indianeconomy isgrowingat9%. It hasfar reachingimplications. New lines of
businesssuch as retailing, investment advisory services and private bankingare emerging. All
theseinvolveinvestmentdecisions.Theseinvestmentdecisionsthatcorporatestaketoreapthe
benefits arising out of the emerging business opportunities are known as Capital Budgeting
decisions.Capitalbudgetingdecisionsinvolveevaluationofspecificinvestmentproposals.Here
the word capital refers to the operating assets used in production of goods or rendering of
services. Budgeting involves formulating a plan of the expected cash flows during the future
period.When we combine Capital with budget we get Capital budget. Capitalbudgetisablue
printofplannedinvestmentsin operatingassets.Therefore,Capitalbudgetingistheprocessof
evaluatingtheprofitabilityoftheprojectsunderconsiderationanddecidingontheproposaltobe
includedintheCapitalbudgetforimplementation.Capitalbudgetingdecisionsinvolveinvestment
ofcurrentfundsinanticipationofcashflowsoccurringoveraseriesofyearsinfuture.Allthese
decisions are Strategic because they change the profile of the organizations. Successful
organizations have created wealth for their shareholders through Capital budgeting decisions.
Investmentofcurrentfundsinlongtermassetsforgenerationofcashflowsinfutureoveraseries
ofyearscharacterizesthenatureofCapitalBudgetingdecisions.
LearningObjectives:
1. Explaintheconceptofcapitalbudgeting.
2. Bringouttheimportanceofcapitalbudgeting.
3. Examinethecomplexityofcapitalbudgetingprocedures.
4. Discussthevarioustechniquesofappraisalmethods.
5. Evaluatecapitalbudgetingdecision
8.2 ImportanceofCapitalbudgeting
CapitalbudgetingdecisionsarethemostimportantdecisionsinCorporatefinancialmanagement.
Thesedecisionsmakeormarabusinessorganization.Thesedecisionscommitafirmtoinvest
its currentfundsin the operating assets (i,elongterm assets) with the hopeof employing them
mostefficientlytogenerateaseriesofcashflowsinfuture.
Thesedecisionscouldbegroupedinto
115
1. Replacement decisions: These decisions may be decision to replace the equipments for
maintenanceofcurrentlevelofbusinessordecisionsaimingatcostreductions.
2. Decisions on expenditure for increasing the present operating level or expansion through
improvednetworkofdistribution.
3. Decisionsforproductsofnewgoodsorrenderingofnewservices.
4. Decisionsonpenetrating intonewgeographicalarea.
5. Decisions to comply with the regulatory structure affecting the operations of the company.
InvestmentsinassetstocomplywiththeconditionsimposedbyEnvironmentalProtectionAct
comeunderthiscategory.
6. Decisions on investment to build township for providing residential accommodation to
employeesworkinginamanufacturingplant.
Thereare many reasons that make the Capitalbudgetingdecisions the most crucialforfinance
managers
1. Thesedecisionsinvolvelargeoutlayoffundsnowinanticipationofcashflowsinfuture.For
example, investment in plant and machinery. The economic life of such assets has long
periods. The projections of cash flows anticipated involve forecasts of many financial
variables.Themostcrucialvariableisthesalesforecast.
a. For example, Metal Box spent large sums of money on expansion of its production
facilitiesbasedonitsownsalesforecast.Duringthisperiod,hugeinvestmentsinR&Din
packaging industry brought about new packaging medium totally replacing metal as an
importantcomponentofpackingboxes.AttheendoftheexpansionMetalBoxLtdfound
itself that the market for itsmetal boxes had declined drastically. The end result is that
Metal Box became a sick company from the position it enjoyed earlier prior to the
executionofexpansionasabluechip.Employeeslosttheirjobs.Itaffectedthestandard
ofliningandcashflowpositionofitsemployees.
Thishighlightstheelementofriskinvolvedinthesetypeofdecisions.
b. Equally we have empirical evidence of companies which took decisions on expansion
throughtheadditionofnewproductsandadoptionofthelatesttechnologycreatingwealth
forshareholders.ThebestexampleistheReliancegroup.
c. Any serious error in forecasting Sales and hence the amount of capital expenditure can
significantlyaffectthefirm.Anupwardbiasmayleadtoasituationofthefirmcreatingidle
capacity,layingthepathforthecancerofsickness.
116
d. Anydownwardbiasinforecastingmayleadthefirmtoasituationoflosingitsmarkettoits
competitors.Bothareriskyfraughtwithgraveconsequences.
2. Alongterminvestmentoffundssometimesmaychangetheriskprofileofthefirm.AFMCG
company withitscorecompetenciesinthebusinessdecidedtoenterintoanewbusinessof
power generation. This decision will totally alter the risk profile of the business of the
company.Investorsperceptionofriskofthenewbusinesstobetakenupbythecompany
willchangehisrequiredrateofreturntoinvestinthecompany.Inthisconnectionitistobe
noted that the power pricing is a politically sensitive area affecting the profitability of the
organization. Therefore, Capital budgeting decisions change the risk dimensions of the
companyandhencetherequiredrateofreturnthattheinvestorswant.
3. MostoftheCapitalbudgetingdecisionsinvolvehugeoutlay.Thefundsrequirementsduring
thephaseof execution must be synchronized with theflow offunds. Failure to achieve the
requiredcoordinationbetweentheinflowandoutflowmaycausetimeoverrunandcostover
run. These two problems of time over run and cost over run have to be prevented from
occurring in the beginning of execution of the project. Quite a lot empirical examples are
thereinpublicsectorinIndiainsupportofthisargumentthatcostoverrunandtimeoverrun
can make a companys operations unproductive. But the major challenge that the
management of a firm faces in managing the uncertain future cash inflows and out flows
associatedwiththeplanandexecutionofCapitalbudgetingdecisions.
4. Capital budgeting decisions involve assessment of market for companys products and
services, deciding on the scale of operations, selection of relevant technology and finally
procurementofcostlyequipment.Ifafirmweretorealizeaftercommittingitselfconsiderable
sumsofmoneyintheprocessofimplementingtheCapitalbudgetingdecisionstakenthatthe
decision to diversify or expand would become a wealth destroyer to the company, then the
firm would have experienced a situation of inability to sell the equipments bought. Loss
incurred by the firm on account of this would be heavy if the firm were to scrap the
equipments bought specifically for implementing the decision taken. Sometimes these
equipmentswillbespecializedcostlyequipments.Therefore,Capitalbudgetingdecisionsare
irreversible.
5. ThemostdifficultaspectofCapitalbudgetingdecisionsistheinfluenceoftime.Afirmincurs
Capitalexpenditure to buildup capacity in anticipation of theexpectedboom in thedemand
foritsproducts.ThetimingoftheCapitalexpendituredecisionmustmatchwiththeexpected
boomindemandforcompanysproducts.Ifitplansinadvanceitmayeffectivelymanagethe
117
timingandthequalityofassetacquisition.Butmanyfirmssufferfromitsinabilitytoforecast
the future operations and formulate strategic decision to acquire the required assets in
advanceatthecompetitiverates.
6. All Capital budgeting decisions have three strategic elements. These three elements are
cost, quality and timing. Decisions must be taken at the right time which would enable the
firm toprocure theassets at theleast costfor producingthe products of required quality for
customer.Anylapseonthepartofthefirminunderstandingtheeffectoftheseelementson
implementation of Capital expenditure decision taken will strategically affect the firms
profitability.
7. Liberalization and globalization gave birth to economic institutions like World Trade
organization.GeneralElectricalcanexpanditsmarketintoIndiasnatchingthesharealready
enjoyedbyfirmslikeBajajElectricalsorKirloskarElectricCompany.AbilityofGEtosellits
products in India at a rate less than the rate at which Indian Companies sell cannot be
ignored. Therefore, the growth and survival of any firm in todays business environment
demandsafirmtobeproactive.Proactivefirmscannotavoidtherisk oftakingchallenging
Capitalbudgetingdecisionsforgrowth.
Therefore,Capitalbudgetingdecisionsforgrowthhavebecomeanessentialcharacteristicsof
successfulfirmstoday.
8. The social, political, economic andtechnological forces generate high level ofuncertainty in
futurecashflows streams associatedwith Capitalbudgeting decisions. Thesefactors make
thesedecisionshighlycomplex.
9. Capital expenditure decisions are very expensive. To implement these decisions firms will
havetotaptheCapitalmarketforfunds.Thecompositionofdebtandequitymustbeoptimal
keepinginviewtheexpectationofinvestorsandriskprofileoftheselectedproject.
1. ______________makeormarabusiness.
2. _____decisionsinvolvelargeoutlayoffundsnowinanticipationofcashinflowsinfuture.
3. Social, political, economic and technological forces make capital budgeting decisions
________________.
4. ________areveryexpensive.
118
8.3 ComplexitiesinvolvedinCapitalbudgetingdecisions
Capitalexpendituredecisioninvolvesforecastingoffutureoperatingcashflows.Suchforecasting
suffersfromuncertaintybecausethefutureishighlyuncertain.Forecastingthefuturecashflows
demandsthenecessitytomakecertainassumptionsaboutthebehaviourofcostsandrevenues
infuture.Fastchangingenvironmentmakesthetechnologyconsideredforimplementationmany
times obsolete. For example, thearrival of mobile revolution totally made the pager technology
obsolete.Thefirmswhichinvestedinpagersfacedtheproblemofpagerslosingitsrelevanceas
a means of communication. The firms with the ability to adapt the new knowhow in mobile
technology could survive the effect of this phase of technological obsolescence. Others who
could not manage the effect of change in technology had a natural death and so most Capital
expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting
decisions is really complex and difficult commitment of funds on long term basis along with the
associated problem of irreversibility of decisions and difficulty in estimating cash flows makes
Capitalexpendituredecisionscomplexinnature.
1. Capitalexpendituredecisionsare____________.
2. Forecasting of future operating cash flows suffers from ____ because the future is
____________________.
8.4 PhasesofCapitalexpendituredecisions:
ThefollowingstepsareinvolvedinCapitalbudgetingdecisions:
1. Identificationofinvestmentopportunities.
2. Evaluationofeachinvestmentproposal.
3. Examinetheinvestmentsrequiredforeachinvestmentproposal.
4. PreparethestatementsofCostsandbenefitsofinvestmentproposals.
5. Estimate and compare the net present values of the investment proposals that have been
clearedbythemanagementonthebasisofscreeningcriteria.
6. Examine the government policies and regulatory guidelines to be observed for execution of
each investment proposal screened and cleared based on the criteria stipulated by the
management.
7. Budgetingforcapitalexpenditureforapprovalbythemanagement.
8. Implementation.
9. Post_completionaudit.
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1. Postcompletionauditis_____inthephasesofcapitalbudgetingdecisions.
2. Identification of investment opportunities is the ______ in the phases of capital budgeting
decisions.
8.5 Identificationofinvestmentopportunities:
Afirmisina position toidentify investment proposal only when itis responsiveto theideasfor
capital projects emerging from various levels of the organization. The proposal may be adding
newproductstothecompanysproductline,expansionofcapacitytomeettheemergingmarket
atdemandforcompanysproductstomeettheemergingmarketdemandforcompanysproduct
ornewtechnologybasedprocessofmanufacturethatwillreducethecostofproduction.
For example,a sales manager may come with a proposaltoproducea newproductas per the
requirements of companys consumers. Marketing manager, based on the sales managers
proposal may conduct a market survey to determine the expected demand for the new product
under consideration. Once the marketing manager is convinced of the market potential for
proposednewproducttheproposalgoestotheengineerstoexaminethesamewithallaspects
of production process. Then the proposal goes to the cost accountant to translate the entire
gamutoftheproposalinto costs and revenuesin termsof incremental cashflows bothoutflows
and inflows. The costbenefit statement generated by cost accountant shall include all
incremental costs and benefits that the firm will incur and derive on commercialization of the
proposal under consideration. Therefore, generation of ideas with the feasibility to convert the
same into investment proposals occupies a crucial place in the Capital budgeting decisions.
Proactive organizations encourage a continuous flow of investment proposals from all levels in
theorganization.
Inthisconnectionfollowingdeservestobeconsidered:
1. MarketCharacteristics: Analysingthedemandandsupplyconditions ofthemarketforthe
companysproductcouldbeafertilesourceofpotentialinvestmentproposals.
2. Various reports submitted by production engineers coupled with the information obtained
through marketsurveysoncustomersperception of companysproduct could beapotential
investmentproposaltoredefinethecompanysproductsintermsofcustomersexpectations.
3. CompanieswhichinvestinResearchandDevelopmentconstantlygetexposuretothebenefit
of adapting the new technology quite relevant to keep the firm competitive in the most
dynamic business environment. Reports emerging from R & D section could be a potential
sourceofinvestmentproposal.
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4. Economic growth of the country and the emerging middle class endowed with purchasing
power could generate new business opportunities to existing firms. These new business
opportunitiescouldbepotentialinvestmentideas.
5. Public awareness of their rights compels many firms to initiate projects from environmental
protection angle. If ignored, the firm may have to face the public wrath through PILs
entertainedattheSupremecourtandHighcourts.
Therefore, project ideas that would improve the competitiveness of the firm by constantly
improving the production process with the sole objective of cost reduction and costumer
welfareareacceptedbywellmanagedfirms.
Therefore,generationofideasforcapitalprojectsandscreeningthesamecanbeconsidered
themostcrucialphaseofCapitalbudgetingdecisions.
1. Analyzingthedemandandsupplyconditionsofthemarketforthecompanysproductscould
be________ofpotentialinvestmentproposal.
2. Generationofideasforcapitalbudgetsandscreeningthesamecanbeconsidered
__________ofcapitalbudgetarydecisions.
8.6RationaleofCapitalbudgetingproposals:
Theinvestorsandstakeholdersexpectafirmtofunctionefficientlytosatisfytheirexpectations.
Through the stake holders expectation of the performance of the company may clash among
themselves,theonethattouchesallthesestakeholdersexpectationcouldbevisualizedinterms
of the firms obligation to reduce the operating costs on a continuous basis and increasing its
revenues. These twin obligations of a firm form the basis of all Capital budgeting decisions.
Therefore,Capitalbudgetingdecisionscouldbegroupedintotwocategories:
1. Decisionsoncostreductionprogrammes.
2. Decisionsonrevenuegenerationthroughexpansionofinstalledcapacity.
1._________decisionscouldbegroupedintotwocategories.
2.____________andrevenuegenerationarethetwoimportantcategriesofcapitalbudgeting.
8.7CapitalBudgetingprocess:Oncethescreeningofproposalsforpotentialinvolvementis
overthenext.ThecompanyshouldtakeupthefollowingaspectsofCapitalBudgetingprocess.
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1. Commercial: A proposal should be commercially viable. The following aspects are
examinedtoascertainthecommercialviabilityofanyinvestmentproposal.
a. Marketfortheproduct
b. Availabilityofrawmaterials
c. Sourcesofrawmaterials
d. Theelementsthatinfluencethelocationofaplanti,e,thefactorstobeconsideredinthesite
selection.
2. Infrastructural facilities such as roads, communications facilities, financial services such as
banking,publictransportservices.
Amongtheaspectsmentionedabovethecrucialoneistheneedtoascertainthedemandfor
the product or services. It is done by market appraisal. In appraisal of market for the new
product,thefollowingdetailsarecompiledandanalyzed.
a. Consumptiontrends.
b. Competitionandplayersinthemarket
c. Availabilityofsubstitutes
d. Purchasingpowerofconsumers
e. RegulationsstipulatedbyGovernmentonpricingtheproposedproductsorservices
f. Production constraints: Relevant forecasting technologies are employed to get a realistic
picture of the potential demand for the proposed product or service. Many projects fail to
achieve the planned targets on profitability and cash flows if the firm could not succeed in
forecastingthedemandfortheproductonarealisticbasis.
8.7.1 Technicalappraisal: Thisappraisalisdonetoensurethatalltechnicalaspectsofthe
implementationoftheprojectareconsidered.
Thetechnicalexaminationoftheprojectconsidersthefollowing:
a. Selectionofprocessknowhow
b. Decisionondeterminationofplantcapacity
c. Selectionofplantandequipmentandscaleofoperation
d. Plantdesignandlayout
e. Generallayoutandmaternalflow
f. Constructionschedule
8.7.2 Economic Appraisal: This appraisal examines the project from the social point of
view.Itisalsoknownassocialcostbenefitanalysis.Itexamines:
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g. Theimpactoftheprojectontheenvironment
h. Theimpactoftheprojectontheincomedistributioninthesociety.
i. The impact of the project on fulfillment of certain social objective like generation of
employment,attainmentofselfsufficiencyetc.
j. Willitmateriallyalterthelevelofsavingsandinvestmentinthesociety?
3. Financial appraisal: This appraisal is to examine the financial viability of the project. It
assesses the risk and returns at various stages of project execution. Besides, it examines
whether the risk adjusted return from the project exceeds the cost of financing the project.
Thefollowingaspectsareexaminedintheprocessofevaluatingaprojectinfinanciallyterms.
a. Costoftheproject
b. Investmentoutlay
c. Meansoffinancingandthecostofcapital
d. Expectedprofitability
e. Expectedincrementalcashflowsfromtheproject
f. Breakevenpoint
g. Cashbreakevenpoint
h. Riskdimensionsoftheproject
i. Willtheprojectmateriallyaltertheriskprofileofthecompany?
j. Iftheprojectisfinancedbydebt,expectedDebtServiceCoverageRatio
k. Taxholidaybenefits,ifany
1. ______________examinestheprojectfromthesocialpointview.
2. Alltechnicalaspectsoftheimplementationoftheprojectareconsideredin_____.
3. ___ofaprojectisexaminedbyfinancialappraisal.
4. Among the elements that are to be examined under commernal appraised the most crucial
oneisthe_________________.
8.8 InvestmentEvaluation: followingstepsareinvolvedintheevaluationofanyinvestment
proposal:
1. EstimatesofCashflowsbothinflowsand outflows occurringatdifferentstagesofprojectlife
cycle.
2. Examinationoftheriskprofileoftheprojecttobetakenupandarrivingattherequiredrateof
return
123
3. Formulatingthedecisioncriteria.
Estimation of Cash flows: Estimating the cash flows associated with the project under
considerationisthemostdifficultandcrucialstepintheevaluationofaninvestmentproposal.It
istheresultoftheteamworkofmanyprofessionalsinanorganization.
1. Capital outlays are estimated by engineering departments after examining all aspects of
productionprocess.
2. Marketing department on the basis of market survey forecasts the expected sales revenue
duringtheperiodofaccrualofbenefitsfromprojectexecutions.
3. Operatingcostsareestimatedbycostaccountantsandproductionengineers
4. Incrementalcashflowsandcashoutflowstatementispreparedbythecostaccountantonthe
basisofthedetailsgeneratedintheabovesteps.Theabilityofthefirmtoforecastthecash
flows with reasonable accuracy lies at the root of the success of the implementation of any
capitalexpendituredecision.
Investment (Capital budgeting) decision required the estimation of incremental cash flow
stream over the life of the investment. Incremental cash flows are estimated on after tax
basis.
Incrementalcashflowsstreamofacapitalexpendituredecisionhasthreecomponents.
1. InitialCashoutlay(Initialinvestment):Initialcashoutlaytobeincurredisdeterminedafter
consideringanyposttaxcashinflowsifany,Inreplacementdecisionsexistingoldmachinery
is disposed of and a new machinery incorporating the latest technology is installed in its
place.Ondisposalofexistingoldmachinerythefirmhasacashinflow.Thiscashinflowhas
tobecomputedonposttaxbasis.Thenetcashoutflow(totalcashrequiredforinvestmentin
capitalassetsminusposttaxcashinflowondisposaloftheoldmachinerybeingreplacedby
anewone)therefore istheincrementalcashoutflow.Additionalnet workingcapitalrequired
onimplementationofnewprojectistobeaddedtoinitialinvestment.
2. OperatingCashinflows:OperatingCashinflowsareestimatedfortheentireeconomiclifeof
investment(project).Operatingcashinflowsconstitute astreamofinflowsandoutflowsover
the life of the project. Here also incremental inflows and outflows attributable to operating
activitiesareconsidered.Anysavingsincostoninstallationofanewmachineryintheplace
of the old machinery will have to be accounted to on post tax basis. In this connection
incrementalcashflowsrefertothechangeincashflowsonimplementationofanewproposal
overtheexistingpositions.
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3. TerminalCashinflows: Attheendoftheeconomiclifeoftheproject,theoperatingassets
installednowwillbedisposedoff.Itisnormallyknownassalvagevalueofequipments.This
terminalcashinflowsiscomputedonposttaxbasis.
Prof. Prasanna Chandra in his book Financial Management has identified certain basic
principles of cash flow estimation. The knowledge of these principles will help a student in
understandingthebasisofcomputingincrementalcashflows.
Theseprinciples,asgivenbyProf.PrasannaChandraare:
a. Separationprinciple
b. Incrementalprinciple
c. Posttaxprinciple
d. Consistencyprinciple
a. Separationprinciple: Theessenceofthisprincipleisthenecessitytotreatinvestment
element of the project separately (i,e independently) from that of financing element. The
financing cost is computed by the cost of capital. Cost of capital isthe cut off rate and rate of
returnexpectedonimplementationoftheprojectiscomparedwiththecostofcapital.Therefore,
we compute separately cost of funds for execution of project through the financing mode. The
rateof returnexpected onimplementation if theprojectisarrivedat by theinvestmentprofile of
theprojects.Therefore,interestondebtisignoredwhilearrivingatoperatingcashinflows.
Thefollowingformulaeisusedtocalculateprofitaftertax.
IncrementalPAT=IncrementalEBIT(1t)
(Incremental)(Incremental)
EBIT=Earnings(Profit)beforeinterestandtaxes.
t=taxrate
EBITinfactrepresentsincrementalearningsbeforeinterestandtax
Whendepreciationchargesoncomputingincrementalposttaxprofitisaddedbacktoincremental
profitaftertax,wegetincrementaloperatingcashinflow.
b. Incrementalprinciple:Incrementalprinciplesaysthatthecashflowsofaprojectareto
beconsideredinincrementalterms.Incrementalcashflowsarethechangesinthefirms
totalcashflowsarisingdirectlyfromtheimplementationoftheproject.
Thefollowingaretobekeptinmindindeterminingincrementalcashflows.
1. IgnoreSunkcosts: Asunkcostmeansanoutlayalreadyincurred.Itisnotarelevantcost
for the project decisions to be taken now. It is ignored when the decisions on project now
underconsiderationistobetaken.
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2. OpportunityCosts: Ifthefirmalreadyownsanassetorresourcewhichcouldbeusedinthe
execution of the project under consideration the asset or resource has an opportunity cost.
Theopportunityofcostofsuchresourceswillhavetobetakenintoaccountintheevaluation
of the project for acceptance or rejection. For example, the firm wants to open a branchin
Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in
Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs.1
Crore. Thefirm takesadecision to opena brandsat Chennai. Foropeningthe branch at
Chennai thefirm uses thebuildingit owns by sacrificingthe rental income whichit receives
now. The opportunity cost of the building at Chennai is Rs.1 crores. This will have to be
considered in arriving at the operating cash flows associated with the decision to open a
branchatChennai.
3. Need to take into account all incident effect: Effects of a project on the working of other
parts of a firm also known as externalities must be taken into account. For example,
expansion or establishment of a branch at a new place may increase the profitability of
existing branches because the branch at the new place has a complementary relationship
with the other existing branchesorreduce the profitability ofexisting branchesbecause the
branchatthenewplacecompeteswiththebusinessofotherexistingbranchesortakesaway
somebusinessactivitiesfromtheexistingbranches.
Cannibalization: Another problem that a firm faces on introduction of a new product is the
reductioninthesaleofanexistingproduct.Thisiscalledcannibalization.Themostchallenging
task is the handling of problems of cannibalization. Depending on the companys position with
that of the competitors in the market, appropriate strategy has to follow. Correspondingly the
costofcannibalizationwillhavetobetreatedeitherasrevelentcostofthedecisionorignored.
Product cannibalization will affect the companys sales if the firm is marketing its products in a
marketcharacterizedbyseverecompetition,withoutanyentrybarriers.
In this case costs are not relevant for decision. On the other hand if the firms sales are not
affected by competitors activities due to certain unique protection that it enjoys on account of
brand positioning or patent protection the costs of cannibalization cannot be ignored in taking
decisions
c.PostTaxPrinciple: allcashflowsshouldbecomputedonposttaxbasis
d. Consistencyprinciple: cashflowsanddiscountratesusedinprojectevaluationneedto
consistentwiththeinvestorgroupandinflation.
126
In capital budgeting, the cash flows applicable to all investors (i.e equity, preference share
holders and debt holders) and weighted average cost of capital are considered. Nominal cash
flowsandnominaldiscountsareconsideredincapitalbudgetingdecision.
Example(illustration)
Afirmconsideringreplacementofitsexistingmachinebyanewmachine.Thenewmachinewill
costRs1,60,000andhavealifeoffiveyears.Thenewmachinewillyieldannualcashrevenue
of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the
newmachineattheendofitseconomiclifeisRs8,000.Theexistingmachinehasabookvalue
ofRs40,000andcanbesoldforRs20,000.Theexistingmachine,ifusedforthenextfiveyears
is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash
expensesofRs1,40,000.Ifsoldafterfiveyears, thesalvagevalueoftheexistingmachine will
benegligible.
Thecompanypaystaxat30%.Itwritesoffdepreciationact25%onthewrittendownvalue.The
companyslostofcapitalis20%
Computetheincrementalcashflowsofreplacementdecisions.
Solution:
InitialInvestment:
Grossinvestmentforthenewmachine (1,60,000)
Less:Cashreceivedfromthesaleof
Existingmachine 20,000
Netcashoutlay (1,40,000)
AnnualCashflowsfromoperations
Incrementalcashflowsfromrevenue50,000
Incrementaldecreaseinexpenditure(10,000)
IncrementalDepreciationSchedule
Year Depreciation
(NewMachine(Rs.)
Depreciation
(OldMachine)
Incremental
Depreciation(Rs.)
1 45,000 10,000 35,000
2 33,750 7,500 26,250
3 25,312 5,625 19,687
127
4 18,984 4,219 14,765
5 14,238 3,164 11,074
Depreciationiscalculatedasunder
BookValue 40,000
Add:Costofnewmachine 1,60,000
2,00,000
Less:SaleproceedsofOldMachine 20,000
1,80,000
DepreciationforIyear25% 45,000
1,35,000
DepreciationforIIyear25% 33,750
1,01,250
DepreciationforIIIyear25% 25,312
75,938
DepreciationforIVyear25% 18,984
56,954
DepreciationforVyear25% 14,238
Bookvalueafter5years 42,716
StatementofincrementalCashflows
Particulars Year
0Rs 1Rs 2Rs 3Rs 4Rs 5Rs
1.Investmentinnew
machine
(1,60,000)
2.Aftertaxsalvagevalue
ofoldmachine
20,000
3.NetCashOutlay (1,40,000)
128
4.Increaseinrevenue 50,000 50,000 50,000 50,000 50,000
5.Decreaseinexpenses 10,000 10,000 10,000 10,000 10,000
6.Increaseindepreciation 35,000 26,250 19,687 14,765 11,074
7.IncreaseinEBIT 25,000 33,750 40,313 45,235 48,926
8.EBIT(1T) 17,500 23,625 28,219 31,665 34,248
9.IncrementalCashflows
fromoperation(8+6)
52,500 49,875 47,906 46,430 45,322
10.Salvagevalueofnew
machine
8,000
11.IncrementalCash
flows
(1,40,000)
negative
52,500 49,875 47,906 46,430 53,322
Thefollowingpointstobekeptindecidingontheappraisaltechnique:
1. Appraisaltechniqueshouldmeasuretheeconomicworthoftheproject.
2. Wealthmaximizationofshareholdersshallbetheguidingprinciple.
3. Itshallconsiderallcashflowsovertheentirelifeoftheprojecttoascertaintheprofitabilityof
theproject.
4. Itshallranktheprojectsonascientificbasis.
5. It should ensure an accepted criterion when faced with the need to select from among the
projectswhicharemutuallyexclusivesoastomakeacorrectchoice.
6. Itshouldrecognizethefactthatinitialhighercashflowsaretobepreferredtosmallerones.
7. Earliercashflowsarepreferredtothatoccurringlater.
1. Formulating_isthethirdstepintheevaluationofinvestmentproposal.
2. A_____________isnotarelevantcostfortheprojectdecision.
3. Effectofaprojectontheworkingofotherpartsofafirmisknowas________.
4. Theessenceofseparationprincipleisthenecessitytotreat________ofaprojectseparately
fromthatof________.
5. Paybackperiod________timevalueofmoney.
6. IRRgivesarateofreturnthatreflectsthe__theproject.
129
8.9 Appraisal Criteria: The methods of appraising an investment proposal can be grouped
into
1. Traditionalmethods.
2. Modernmethods.
TraditionalMethodare:
i. Paybackmethod.
ii. AccountingRateofReturn.
Moderntechniquesare:
a. Netpresentvalue.
b. InternalRateofRate.
c. Modifiedinternalrateofreturn.
d. Profitabilityindex.
8.9.1TraditionalTechniques:
a. Payback method: payback period is defined as the length of time required to recover the
initialcashoutlay.
Example:ThefollowingdetailsareavailableinrespectofthecashflowsoftwoprojectsA&B
Year ProjectA ProjectB
Cashflows(Rs.) Cashflows(Rs.)
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,000
5 1,50,000 2,00,000
ComputepaybackperiodforAandB
Solution:
Year ProjectA ProjectB
Cashflows(Rs.) Cumulative
Cashflows
Cashflows(Rs.) Cumulative
Cashflows
1 2,00,000 2,00,000 1,00,000 1,00,000
2 1,75,000 3,75,000 2,00,000 3,00,000
130
3 25,000 4,00,000 3,00,000 6,00,000
4 2,00,000 6,00,000 4,00,000 10,00,000
5 1,50,000 7,50,000 2,00,000 12,00,000
From the cumulative cash flows column project A recovers the initial cash outlay of Rs
4,00,000attheendofthethirdyear.Therefore,paybackperiodofprojectAis3years.
FromthecumulativecashflowcolumntheinitialcashoutlayofRs5,00,000liesbetween
2
nd
yearand3
rd
yearinrespectofprojectB.Therefore,paybackperiodforprojectBis:
5,00,0003,00,000
3,00,000
=2.67years
Evaluationofpaybackperiod:
Merits:
1. Simpleinconceptandapplication.
2. Since emphasis is on recovery of initial cash outlay it is the best method for evaluation of
projectswithveryhighuncertainty.
3. Withrespecttoacceptorrejectcriterionpaybackmethodfavorsaprojectwhichislessthan
orequaltothestandardpaybacksetbythemanagement.Inthisprocessearlycashflows
getduerecognition thanlatercashflows.Therefore,paybackperiodcouldbeusedasatool
todealwiththerankingofprojectsonthebasisofriskcriterion.
4. Forfirmswithshortagefundsthisispreferredbecauseitmeasuresliquidityoftheproject.
Demerits:
1. Itignorestimevalueofmoney.
2. Itdoesnotconsiderthecashflowsthatoccurafterthepaybackperiod.
3. Itdoesnotmeasuretheprofitabilityoftheproject.
4. It does notthrow any lighton thefirmsliquiditypositionbutjust tells abouttheability ofthe
projecttoreturnthecashoutlayoriginallymade.
5. Project selected on the basis of pay back criterion may be in conflict with the wealth
maximizationgoalofthefirm.
Acceptorrejectcriterion:
a. Ifprojectsaremutuallyexclusive,selecttheprojectwhichhastheleastpaybackperiod.
b. Inrespectofotherprojects,selecttheprojectwhichhavepaybackperiodlessthanorequal
tothestandardpaybackstipulatedbythemanagement.
Illustration:
2+
131
Followingdetailsareavailable
Paybackperiod:
ProjectA=3years
ProjectB=2.5years
Standardsetupbymanagement=3years
Ifprojectsaremutuallyexclusive,acceptprojectBwhichhastheleastpaybackperiod.
Ifprojectsarenotmutuallyexclusive,acceptboththeprojectbecausebothhavepaybackperiod
lessthanorequaltooriginaltothestandardpaybackperiodsetbythemanagement
Paybackperiod formula
YearPriortofullrecovery + Balanceofinitialoutlaytoberecovered
Ofinitialoutlay atthebeginningoftheyearinwhichfull
Recoverytakesplace
Cashinflowoftheyearinwhichfullrecovery
takesplace
8.9.2 DiscountedPayBackPeriod:
Thelengthinyearsrequiredtorecovertheinitialcashoutlayonthepresentvaluebasisiscalled
the discounted pay back period. The opportunity cost of capital is used for calculating present
valuesofcashinflows.
Discounted pay back period for a project will be always higher than simple pay back period
becausethecalculationofdiscountedpaybackperiodisbasedondiscountedcashflows.
Forexample:
Year ProjectA
Cashflows
PVfactorat10
%
PVofCash
flows
Cumulativepositive
Cashflows
0 (4,00,000) 1 (4,00,000)
1 2,00,000 0.909 1,81,800 1,81,800
2 1,75,000 0.826 1,44,550 3,26,350
3 25,000 0.751 18,775 3,45,125
4 2,00,000 0.683 1,36,600 4,81,725
5 1,50,000 0.621 93,150 5,74,875
DiscountedPaybackperiod:
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4,00,0003,45,125
1,36,600 =3.4years
Accountingrateofreturns:
ARR measures the profitability of investment (project) using information taken from financial
statements:
Averageincome
Averageinvestment
Averageofposttaxoperatingprofits
Averageinvestment
Averageinvestment=
Bookvalueoftheinvestment + Bookvalueofinvestmentattheendof
Inthebeginning thelifeoftheprojectorinvestment
2
Illustration:
Thefollowingparticularrefertotwoprojects:
X Y
Cost 40,000 60,000
Estimatedlife 5years 5years
Salvagevalue Rs.3,000 Rs.3,000
Estimateincome
Aftertax
Rs Rs
1 3,000 10,000
2 4,000 8,000
3 7,000 2,000
4 6,000 6,000
5 8,000 5,000
Total 28,000 31,000
Average 5,600 6,200
3+
ARR=
=
133
Averageinvestment21,50031,500
ARR 5,600 6,200
21,500 31,500
=26% 19.7%
MeritsofAccountingrateofreturn:
1. Itisbasedonaccountinginformation.
2. Simpletounderstand.
3. Itconsiderstheprofitsofentireeconomiclifeoftheproject.
4. Since it is based on accounting information the business executives familiar with the
accountinginformationunderstandthistechnique.
Demerits:
1. Itisbasedonaccountingincomeandnotbasedoncashflows,asthecashflowapproachis
consideredsuperiortoaccountinginformationbasedapproach.
2. Itdoesnotconsiderthetimevalueofmoney.
3. Different investment proposals which require different amounts of investment may have the
same accounting rate of return. The ARR fails to differentiate projects on the basis of the
amountrequiredforinvestment.
4. ARRisbasedontheinvestmentrequiredfortheproject.Therearemanyapproachesforthe
calculation of denominator of average investment. Existence of more than one basis for
arriving at the denominator of average investment may result in adoption of many arbitary
bases.
BecauseofthisthereliabilityofARRasatechniqueofappraisalisreducedwhentwoprojects
withthesameARRbutwithdifferinginvestmentamountsaretobeevaluated.
AnyprojectwhichhasanARRmoretheminimumratefixedbythemanagementisaccepted.If
actual ARR is less than the cuff rate (minimum rate specified by the management ) then that
projectis rejected). When projectsare to be ranked for deciding on the allocation ofcapital on
account of the needfor capital rationing, project with higher ARR are preferred tothe ones with
lowerARR.
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Discountedcashflowmethod:
Discounted cashflow methodor time adjusted techniqueisanimprovementover the traditional
techniques. In evaluation of the projects the need to give weight age to the timing of return is
effectively considered in all DCF methods. DCF methods are cash flow based and take the
cognizanceofboththeinterestfactorsandcashflowafterthepaybackperiod.
DCFtechniqueinvolvesthefollowing.
1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the
project.
2. Discountingthecashflowsbyanappropriateinterestfactor(discountfactor).
3. Sumofthepresentvalueofcashoutflowsisdeductedfromthesumofpresentvalueofcash
inflows to arrive at net present value of cash flows, the most popular techniques of DCF
methods.
DCFmethodsareof3types:
1. Thenetpresentvalue.
2. Theinternalrateofreturn.
3. Profitabilityindex.
Thenetpresentvalue:
NPVmethodrecognizesthetimevalueofmoney.Itcorrectlyadmitsthatcashflowsoccurringat
differenttimeperiodsdifferinvalue.Therefore,thereistheneedtofindoutthepresentvaluesof
allcashflows.
NPVmethodisthemostwidelyusedtechniqueamongtheDCFmethods.
StepsinvolvedinNPVmethod:
1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for
execution.
2. Decisionsondiscountfactororinterestfactor.Theappropriatediscountrateisthefirmscost
ofcapitalorrequiredrateofreturnexpectedbytheinvestors.
3. Computethepresentvalueofcashinflowsandoutflowsusingthediscountfactorselected.
4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash
inflows.
If NPV is positive, the project should be accepted. If NPV is negative the project should be
rejected.
135
Acceptorrejectcriterioncanbesummarizedasgivenbelow:
1. NPV>Zero=accept
2. NPV<Zero=reject
NPV method can be used to select between mutually exclusive projects by examining whether
incrementalinvestmentgeneratesapositivenetpresentvalue.
MeritsofNPVmethod:
1. Ittakesintoaccountthetimevalueofmoney.
2. Itconsiderscashflowsoccurringovertheentirelifeoftheproject.
3. NPVmethodisconsistentthegoalofmaximizingthenetwealthofthecompany.
4. Itanalysesthemeritsofrelativecapitalinvestments.
5. Sincecostofcapitalofthefirmisthehurdlerate,theNPVensuresthattheprojectgenerates
profitsfromtheinvestmentmadeforit.
Demerits:
1. Forecasting of cash flows in difficult as it involves dealing with the effect of elements of
uncertaintiesonoperatingactivitiesofthefirm.
2. Todecideonthediscountingfactor,thereistheneedtoassesstheinvestorsrequiredrateof
returnButitisnotpossibletocomputethediscountrateprecisely.
3. Therearepracticalproblemsassociatedwiththeevaluationofprojects withunequallives or
underfundsconstraints.
For ranking of projects under NPV approach the project with the highest positive NPV is
preferredtothatwithlowerNPV.
Example:AprojecttcostsRs.25000andisexpectedtogeneratecashinflowsas
Year Cashinflows
1 10,000
2 8,000
3 9,000
46,000
5 7,000
Thecostofcapitalis12%.Thepresentvaluefactorsare:
Year PVfactorat12%
1 0.893
2 0.797
3 0.712
136
40.636
5 0.567
ComputetheNPVoftheproject
Solution:
Year Cashflows PVfactorat12
%
PVofCash
flows
1 10,000 0.893 8,930
2 8,000 0.797 6,376
3 9,000 0.712 6,408
4 6,000 0.636 3,816
5 7,000 0.567 3,969
29,499
Sumofthepresentvalueofcashinflows
Less:Sumofthepresentvalueofcashoutflows 25,500
NPV 4,499
TheprojectgeneratesapositiveNPVofRs.4499.Therefore,projectshouldbeaccepted.
Problem: A company is evaluating two alternatives for distribution within the plant. Two
alternativesare
1. Csystemwithahighinitialcostbutlowannualoperatingcosts.
2. Fsystemwhichcostslessbuthaveconsiderablyhigheroperatingcosts.
The decision to construct the plant has already been made, and the choice here will have no
effect on the overall revenues of the project. The cost of capital of the plant is 12% and the
projectsexpectednetcostsarelistedbelow:
Year ExpectedNetCashCosts
CSystems FSystems
0 (3,00,000) (1,20,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)
137
Whatisthepresentvalueofcostsofeachalternative?
Whichmethodshouldbechosen.?
Solution:Computationofpresentvalue
Year
CSystems FSystemsIncremental
1 (66,000) (96,000) 30,000
2 (66,000) (96,000) 30,000
3 (66,000) (96,000) 30,000
4 (66,000) (96,000) 30,000
5 (66,000) (96,000) 30,000
Presentvalueofincrementalsavings=30,0000xPVIFA(12%,5)
=30,000x3.605=1,08,150
Incrementalcashoutlay= 1,80,000
(71,850)
SincethepresentvalueofincrementalnetcashinflowsofCsystemoverFsystemisnegative.C
systemisnotrecommended.
Therefore,Fsystemisrecommended.
PropertiesoftheNPV
1. NPVsareadditive. IftwoprojectsAandBhaveNPV(A)andNPV(B)thenbyadditive rule
thenetpresentvalueofthecombinedinvestmentisNPV(A+B)
2. Intermediatecashinflowsarereinvestedatarateofreturnequaltothecostofcapital.
DemeritsofNPV:
1. NPVexpressestheabsolutepositiveornegativepresentvalueofnetcashflows.Therefore,
itfailstocapturethescaleofinvestment.
2. In the application of NPV rule in the evaluation of mutually exclusive projects with different
lives,biasoccursinfavourofthelongtermprojects.
InternalRateofReturn: Itistherateofreturn(i,ediscountrate)whichmakestheNPVofany
projectequaltozero.IRRistherateofinterestwhichequatesthePVofcashinflowswiththePV
ofcashflows.
IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of
capital,rateofreturn,timeadjustedrateofreturn.IRRistherateofreturnthataprojectearns.
138
EvaluationofIRR:
1. IRRtakesintoaccountthetimevalueofmoney
2. IRR calculates the rate of return of the project, taking into account the cash flows over the
entirelifeoftheproject.
3. Itgivesarateofreturnthatreflectstheprofitabilityoftheproject.
4. Itisconsistentwiththegoaloffinancialmanagementi,emaximizationofnetwealthofshare
holders
5. IRRcanbecomparedwiththefirmscostofcapital.
6. TocalculatetheNPVthediscountratenormallyusediscostofcapital.ButtocalculateIRR,
there is no need to calculate and employ the cost of capital for discounting because the
projectisevaluatedattherateofreturngeneratedbytheproject.Therateofreturnisinternal
totheproject.
Demerits:
1. IRRdoesnotsatisfytheadditiveprinciple.
2. Multipleratesofreturnorabsenceofauniquerateofreturnincertainprojectswillaffectthe
utilityofthistechniquesasatoolofdecisionmakinginprojectevaluation.
3. Inprojectevaluation,theprojects withthehighestIRRare givenpreferencetotheoneswith
lowinternalrates.
Applicationofthiscriteriontomutuallyexclusiveprojectsmayleadundercertainsituationsto
acceptanceofprojectsoflowprofitabilityatthecostofhighprofitabilityprojects.
4. IRRcomputationisquitetedious.
AcceptorRejectCriterion:
Iftheprojectsinternalrateofreturnisgreaterthanthefirmscostofcapital,accepttheproposal.
Otherwiserejecttheproposal.
IRRcanbedeterminedbysolvingthefollowingequationforr=
C
t
wheret=1ton
(1+r)
t
CF
0
=Investment
Sumofthepresentvaluesofcashinflowsattherateofinterestofr:
C
t
wheret=1ton
(1+r)
t
CF
0
=
139
Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the
followingcashinflows:
Year Cashinflows
1 50,000
2 50,000
3 30,000
4 40,000
WhatistheIRRoftheproject?
StepI
Computetheaverageofannualcashinflows
Year Cashinflows
1 50,000
2 50,000
3 30,000
4 40,000
Total 1,70,000
Average=1,70,000=Rs.42,500
4
StepII:Dividetheinitialinvestmentbytheaverageofannualcashinflows:
=1,00,000=2.35
42,500
StepIII:FromthePVIFAtablefor4years,theannuityfactorverynear2.35is25%.Therefore
thefirstinitialrateis25%
%
PVofCash
flows
1 50,000 0.800 40,000
2 50,000 0.640 32,000
3 30,000 0.512 15,360
4 40,000 0.410 16,400
Total 1,03,760
SincetheinitialinvestmentofRs.1,00,000islessthanthecomputedvalueat25%ofRs.1,03,760
thenexttrialrateis26%.
140
%
PVofCash
flows
1 50,000 0.7937 39,685
2 50,000 0.6299 31,495
3 30,000 0.4999 14,997
4 40,000 0.3968 15,872
Total 1,02,049
Thenexttrialrateis27%
%
PVofCash
flows
1 50,000 0.7874 39,370
2 50,000 0.6200 31,000
3 30,000 0.4882 14,646
4 40,000 0.3844 15,376
Total 1,00,392
Thenexttrialrateis28%
%
PVofCash
flows
1 50,000 0.7813 39,065
2 50,000 0.6104 30,520
3 30,000 0.4768 14,3047
4 40,000 0.3725 14,900
Total 98,789
SinceinitialinvestmentofRs.1,00,000liesbetween98789(28%)and1,00,392(27%)theIRRby
interpolation.
1,00,3921,00,000
1,00,39298,789
.
392
1603
27+
X1
27+ X1
141
=27+0.2445
=27.2445=27.24%
ModifiedInternalRateofReturn:
MIRRisadistinctimprovementovertheIRR.ManagersfindIRRintuitivelymoreappealingthan
the rupees of NPV because IRR is expressed on a percentage rates of return. MIRR modifies
IRR.MIRRisabetterindicatorofrelativeprofitabilityoftheprojects.
MIRRisdefinedas
PVofCosts=PVofterminalvalue
TV
(1+MIRR)
n
PVC=PVofcosts
TocalculatePVC,thediscountrateusedisthecostofcapital.
Tocalculatetheterminalvalue,thefuturevaluefactorisbasedonthecostofcapital
ThenobtainMIRRonsolvingthefollowingequation.
TV
(1+MIRR)
n
SuperiorityofMIRRoverIRR
1. MIRRassumesthatcashflowsfromtheprojectarereinvestedatthecostofcapital.The
IRRassumesthatthecashflowsfromtheprojectarereinvestedattheprojectsownIRR.
Since reinvestment at the cost of capital is considered realistic and correct, the MIRR
measurestheprojectstrueprofitability
2. MIRRdoesnothavetheproblemofmultiplerateswhichwecomeacrossinIRR.
Illustration:
Year 0 1 2 3 4 5 6
Cashflows (100)(100)306090120130
(Rsinmillion)
CostofCapital is12%
Presentvalueofcost=100+100
1.12
=100+89.29=189.29
PVC=
PVofCosts=
142
Terminalvalueofcashflows:
=30(1.12)
4
+60(1.12)
3
+90(1.12)
2
+120(1.12)+130
=30x1.5735+60x1.4049+90x1.2544+120x1.12+130
=47.205+84.294+112.896+134.4+130
=508.80
MIRRisobtainedonsolvingthefollowingequation
508.80
(1+MIRR)
6
508.80
189.29
(1+MIRR)
6
=2.6879
MIRR=17.9%
ProfitabilityIndex:itisalsoknownasBenefitcostratio.
Profitability index is the ratio of the present value of cash inflows to initial cash outlay.The
discountfactorbasedontherequiredrateofreturnisusedtodiscountthecashinflows.
Presentvalueofcashinflows
InitialCashoutlay
AcceptorRejectCriterion:
1. AccepttheprojectifPIisgreaterthan1
2. RejecttheprojectifPIislessthan1
If profitability index is 1 then the management may accept the project because the sum of the
present value of cash inflows is equal to the sum of present value of cash outflows. It neither
addsnorreducestheexistingwealthofthecompany.
MeritsofPI:
1. Ittakesintoaccountthetimevalueofmoney
2. Itisconsistentwiththeprincipleofmaximizationofshareholderswealth.
3. Itmeasurestherelativeprofitability.
Demerits:
1. Estimationofcashflowsanddiscountratecannotbedoneaccuratelywithcertainty.
189.29=
(1+MIRR)
6
=
PI=
143
2. A conflict may arise between NPV and profitability index if a choice between mutually
exclusiveprojectshastobemade.
Example
X Y
PVofCashinflows 4,00,000 2,00,000
Initialcashoutlay 2,00,000 80,000
NPV 2,00,000 1,20,000
ProfitabilityIndex 2 2.5
AsperNPVmethodprojectXshouldbeaccepted.AsperprofitabilityindexprojectYshouldbe
accepted.Thisleadstoaconflictingsituation.TheNPVmethodistobepreferredtoprofitability
indexbecausetheNPVrepresentsthenetincreaseinthefirmswealth.
Example: AfirmisconsideringaninvestmentproposalwhichrequiresanintialcashoutlayofRs
8lakh nowandRs2lakhattheendofthethirdyear.Itisexpectedtogeneratecashflowsas
under:
Year Cashinflows
1 3,50,000
2 8,00,000
3 2,50,000
Applythediscountrateof12%calculateprofitabilityindex
Solution: PresentValueofCashoutflows
Year PVfactorat12
%
Cashoutflows PVofCash
flows
1 Rs.8lakhs Rs.8lakhs
2
3 0.712 2lakhs 1.424lakhs
Total 9.424lakhs
144
PresentValueofCashinflows
Year PVIF(12%) Cashinflows PVofCash
flows
1 0.893 3,50,000 3.1255lakhs
2 0.797 8,00,000 6.376lakhs
4 0.636 2,50,000 1.5900lakhs
Total 11.0915lakhs
PI=Totalofpresentvalueofcashinflows
Totalofpresentvalueofcashoutflows
=11.0915 =1.177
9.424
ForeveryRe.1investedtheprojectisexpectedtogiveacashinflowofRs.1.177i,eforevery
rupeeinvestedaprofitofRs.0.177isobtained.
8.10 Summary
Capital investment proposals involve current outlay of funds in the expectation of a stream of
cashinflow infuture. Various techniques are availableforevaluatinginvestment projects. They
aregroupedintotraditionalandmoderntechniques.Themajortraditionaltechniquesarepayback
period and accounting rate of return. The important discounting criteria are net present value,
internalrateofreturnandprofitabilityindex.Amajordeficiencyofpaybackperiodisthatitdoes
not take into account the time value of money. DCF techniques overcome this limitation. Each
methodhasbothpositiveandnegativeaspect.Themostpopularmethodforlargeprojectisthe
internal rate of return. Payback period and accounting rate of return are popular for evaluating
smallprojects.
TerminalQuestions
1. Examinetheimportanceofcapitalbudgeting.
2. Briefly examine the significance of identification of investment opportunities in capital
budgetingprocess.
3. Criticallyexaminethepaybackperiodasatechniqueofapprovalofprojects.
4. SummariesthefeaturesofDCFtechniques.
145
AnswerforSelfAssessmentQuestions
1. Capitalbudgeting
2. Capitalbudgeting
3. Highlycomplex
4. Capitalbudgetingdecisions
1. Irreversible.
2. Uncertainty,highlyuncertain.
1. Finalstep.
2. Firststep
1. Afertilesource
2. Themostcrucialphase
1. Capitalbudgeting
2. Costreduction.
1. Economicappraisal
2. Technicalappraisal
3. Financialviability
4. Demandfortheproductorservice.
1. Decisioncriteria
2. Sunkcost
3. Externalities.
4. Investmentelement.
5. Ignores.
146
6. Profitabilityof
AnswerforTerminalQuestions.
1. Refertounit8.2
2. Refertounit8.5
3. Refertounit8.8.1
4. Refertounit8.8.2
147
Unit9 RiskAnalysisinCapitalBudgeting
Structure
9.1 Introduction
9.2 TypesandsourcesofRiskincapitalBudgeting
9.3 RiskAdjustedDiscountRate
9.4 CertaintyEquivalent
9.5 SensitivityAnalysis
9.6 ProbabilityDistributionApproach:
9.7 Decisiontreeapproach
9.8 Summary:
TerminalQuestions
AnswertoSAQsandTQs
9.1 Introduction
Inthepreviouschapteroncapitalbudgetingtheprojectappraisaltechniqueswereappliedonthe
assumptionthattheprojectwillgenerateagivensetofcashflows.
ItisquiteobviousthatoneofthelimitationsofDCFtechniquesisthedifficultyinestimating cash
flowswithcertaindegreeofcertainty.Certainprojectswhentakenupbythefirmwillchangethe
businessriskcomplexionofthefirm.
Thisbusiness risk complexionof the firm influences the required rate of return ofthe investors.
Suppliersofcapitaltothefirmtendtoberiskaverseandtheacceptanceofaprojectthatchanges
theriskprofileofthefirmmaychangetheirperceptionofrequiredratesofreturnforinvestingin
firmsproject.
Generallythe projectsthatgeneratehighreturnsarerisky. Thiswillnaturallyalterthebusiness
risk of the firm. Because of this high risk perception associated with the new project a firm is
forced to asses the impact of the risk on the firms cash flows and the discount factor to be
employedintheprocessofevaluation.
Definitionof Risk: Risk may be defined asthevariation of actual cashflows from the expected
cashflows.Thetermriskincapitalbudgetingdecisionsmaybedefinedasthevariabilitythatis
likelytooccurinfuturebetweentheestimatedandtheactualreturns.Riskexistsonaccountof
theinabilityofthefirmtomakeperfectforecastsofcashflows.
148
Riskarisesinprojectevaluationbecausethefirmcannotpredicttheoccurrenceofpossiblefuture
events with certainty and hence, cannot make any correct forecast about the cash flows. The
uncertaineconomicconditionsarethesourcesofuncertaintyinthecashflows.
For example, a company wants to produce and market a new product to their prospective
customers.Thedemandisaffectedbythegeneraleconomicconditions.Demandmaybevery
highifthecountryexperienceshighereconomicgrowth.Ontheotherhandeconomiceventslike
weakening of US dollar, subprime crises may trigger economic slow down. This may create a
pessimisticdemanddrasticallybringingdowntheestimateofcashflows.
Riskisassociatedwiththevariabilityoffuturereturnsofaproject.Thegreaterthevariabilityof
theexpectedreturns,theriskiertheproject.
Everybusinessdecisioninvolvesrisk.Riskarisesoutoftheuncertainconditionsunderwhicha
firmhastooperateitsactivities. Becauseoftheinabilityoffirmstoforecastaccuratelycashflows
of future operations the firms face the risks of operations. The capital budgeting proposals are
notbasedon perfectforecast ofcostsand revenuesbecause the assumptions about thefuture
behaviourofcostsand revenuemaychange.Decisionshavetobemadeinadvanceassuming
certainfutureeconomicconditions.
ThereareManyfactorsthataffectforecastsofinvestment,costandrevenue.
1) Thebusinessisaffectedbychangesinpoliticalsituations,monetarypolicies,taxation,interest
rates,policiesofthecentralbankofthecountryonlendingbybanksetc.
2) Industry specific factors influence the demand for the products of the industry to which the
firmbelongs.
3) Company specific factors like change in management, wage negotiations with the workers,
strikesorlockoutsaffectcompanyscostandrevenuepositions.
Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management.
Thebest business decisions may not yield thedesired resultsbecausethe uncertain conditions
likelytoemergeinfuturecanmateriallyalterthefortunesofthecompany.
Every change gives birth to new challenges. New challenges are the source of new
opportunities.Aproactivefirmwillconverteveryproblemintosuccessfulenterpriseopportunities.
A firm which avoids new opportunities for the inherent risk associated with it, will stagnate and
degenerate.Successfulfirmshaveempiricalhistoryofsuccessfulmanagementofrisks.
Therefore,analysingtherisksoftheprojecttoreducetheelementofuncertaintyinexecutionhas
becomeanessential aspectoftodayscorporateprojectmanagement.
149
LearningObjectives:
1. Defineriskincapitalbudgeting.
2. Examinetheimportanceofriskanalysisincapitalbudgeting.
3. Methodsofincorporatingtheriskfactorincapitalbudgetingdecision.
4. Understandthetypesandsourcesofriskincapitalbudgetingdescision
9.2TypesandsourcesofRiskincapitalBudgeting
Risksinaprojectare many. Itispossibletoidentifythreeseparate and distinct typesof riskin
anyproject.
1) Standalonerisk:itismeasuredbythevariabilityofexpectedreturnsoftheproject.
2) Portfolio risk: Afirm can be viewed asportfolioofprojectshavingas certain degreeof risk.
When new project added to the existing portfolio ofproject the risk profile thefirm will alter.
Thedegreeofthechangeintheriskdependonthecovarianceofreturnfromthenewproject
andthereturnfrom theexistingportfolio ofthe projects.Ifthereturnfromthenewprojectis
negativelycorrelatedwiththereturnfromportfolio,theriskofthefirmwillbefurtherdiversified
away.
3) Market or beta risk: It is measured by theeffect of the projectonthe beta of thefirm. The
marketriskforaprojectisdifficulttoestimate.
Standaloneriskistheriskofaprojectwhentheprojectisconsideredinisolation.Corporate
riskistheprojectsriskstotheriskofthefirm.Marketriskissystematicrisk.Themarketrisk
isthemostimportantriskbecauseofthedirectinfluenceithasonstockprices.
Sourcesofrisk:Thesourcesofrisksare
1. Projectspecificrisk
2. CompetitiveorCompetitionrisk
3. Industryspecificrisk
4. Internationalrisk
5. Marketrisk
1. Projectspecificrisk:Thesourcesofthisriskcouldbetracedtosomethingquitespecific
to the project. Managerial deficiencies or error in estimation of cash flows or discount rate
mayleadtoasituationofactualcashflowsrealisedbeinglessthanthatprojected.
2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will
materially affect the cash flows expected from a project. Because of this the actual cash
flowsfromaprojectwillbelessthanthatoftheforecast.
150
3. Industryspecific:industryspecificrisksarethosethataffectallthefirmsintheindustry.
Itcouldbeagaingroupedintotechnologicalrisk,commodityriskandlegalrisk.Alltheserisks
willaffecttheearningsandcashflowsoftheproject.Thechangesintechnologyaffectallthe
firmsnotcapableofadaptingthemselvestoemergingnewtechnology.
The best example is the case of firms manufacturing motor cycles with two strokes engines.
Whentechnologicalinnovationsreplacedthetwostrokeenginesbythefourstrokeenginesthose
firmswhichcouldnotadapttonewtechnologyhadtoshutdowntheiroperations.
Commodity risk is the risk arising from the effect of price changes on goods produced and
marketed.
Legalriskarisesfromchangesinlawsandregulationsapplicabletotheindustrytowhichthefirm
belongs.ThebestexampleistheimpositionofservicetaxonapartmentsbytheGovernmentof
India when the total number of apartments built by a firm engaged in that industry exceeds a
prescribedlimit.SimilarlychangesinImportExportpolicyoftheGovernmentofIndiahaveled
totheclosureofsomefirmsorsicknessofsomefirms.
4. InternationalRisk: thesetypesofrisksarefacedbyfirms whosebusinessconsistsmainly
of exports or those who procure their main raw material from international markets. For
example,rupeedollarcrisisaffectedthesoftwareandBPOsbecauseitdrasticallyreduced
their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu,
exporting their major part of the garments produced. Rupee gaining and dollar Weakening
reduced their competitiveness in the global markets. The surging Crude oil prices coupled
with the governments delay in taking decision on pricing of petro products eroded the
profitabilityofoilmarketingCompaniesinpublicsectorlikeHindustanPetroleumCorporation
Limited.AnotherexampleistheimpactofUSsubprimecrisisoncertainsegmentsofIndian
economy.
Thechangesininternationalpoliticalscenarioalsoaffecttheoperationsofcertainfirms.
5. MarketRisk: Factorslikeinflation,changesininterestrates,andchanginggeneraleconomic
conditionsaffectallfirmsandallindustries.
Firmscannotdiversifythisriskinthenormalcourseofbusiness.
Techniquesusedforincorporationofriskfactorincapitalbudgetingdecisions
There are many techniques of incorporation of risk perceived in the evaluation of capital
budgeting proposals. They differ in their approach and methodology so far as incorporation of
riskintheevaluationprocessisconcerned.
Conventionaltechniques
PayBackPeriod
151
The oldest and commonly used method of recognising risk associated with a capital budgeting
proposalispaybackperiod.Underthismethod,shorterpaybackperiodisgivenpreferenceto
longer ones. Firms establish guidelines for acceptance or rejections of projects based on
standardsofpaybackperiods.
Paybackperiodprefersprojectsofshorttermpaybackstothatoflongtermpaybacks.The
emphasisisontheliquidityofthefirmthroughrecoveryofcapital.TraditionallyIndianbusiness
communityemploysthistechniqueinevaluatingprojects withveryhighlevelofuncertainty.The
changing trendsinfashion make thefashion business, oneofhigh risk andtherefore, pay back
period has been endorsed by tradition in India to take decisions on acceptance or rejection of
suchprojects.Theusualriskinbusinessismoreconcernedwiththeforecastofcashflows.Itis
thedownsideriskoflowercashflowsarisingfromlowersalesandhighercostsofoperationthat
mattersinformulatingstandardsofpayback.
Paybackperiodignorestimevalueofmany(cashflows).Forexample,thefollowingdetailsare
availableinrespectoftwoprojects.
Particulars ProjectA(Rs) ProjectB(Rs)
Initialcashoutlay 10lakhs 10lakhs
Cashflows
Year1 5lakhs 2lakhs
Year2 3lakhs 2lakhs
Year3 1lakhs 3lakhs
Year4 1lakhs 3lakhs
Boththeprojectshaveapaybackperiodof4years.TheprojectBisriskierthanthe ProjectA
becauseProjectArecovers80%ofinitialcashoutlayinthefirsttwoyearsofitsoperationwhere
as Project B generates higher Cash inflows only in the latter half of the payback period. This
underminestheutilityofpaybackperiodasatechniqueofincorporatingriskinprojectevaluation.
This method considers only time related risks and ignores all other risks of the project under
consideration.
1. _____________ismeasuredbythevariabilityofexpectedreturnsoftheproject.
2. Marketriskismeasuredbytheeffectoftheprojectonthe____ofthefirm.
3. Firmscannot____marketriskinthenormalcourseofbusiness.
4. Impact of U.S sub prime crisis on certain segments of Indian economy is and example of
_______________________.
152
9.3RiskAdjustedDiscountRate
Thebasisofthisapproachisthatthereshouldbeadequaterewardintheformofreturntofirms
whichdecide toexecute riskybusinessprojects.Man by natureis riskaverse and tries toavoid
risk. Tomotivatefirmstotakeupriskyprojectsreturnsexpectedfromtheprojectshallhavetobe
adequate, keepinginview the expectations of theinvestors. Therefore riskpremiumneedtobe
incorporatedindiscountrateintheevaluationofriskyprojectproposals.
Thereforethediscountrateforappraisalofprojectshastwocomponents.
Thosecomponentsare
1. Risk freerateandriskpremium
RiskAdjustedDiscountrate=Riskfreerate+Riskpremium
Riskfreerateiscomputedbasedonthereturnongovernmentsecurities.
Risk premium is the additional return that investors require as compensation for assuming the
additionalriskassociatedwiththeprojecttobetakenupforexecution.
The more uncertain the returns of the project the higher the risk. Higher the risk greater the
premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk
premiumoftheproject.
Example:AninvestmentwillhaveaninitialoutlayofRs100,000.Itisexpectedtogeneratecash
inflowsasunder:
Year Cashinflows
1 40,000
2 50,000
3 15,000
4 30,000
Riskfreerateofinterestis10%.Riskpremiumis10%(theriskcharacterisingtheproject)
(a) computetheNPVusingriskfreerate
(b) ComputeNPVusingriskadjusteddiscountrate
Solutions=(a)usingriskfreerate
Year Cashflows(inflows)Rs PVFactorat10% PVofCashflows(inflows)
1 40,000 0.909 36,360
2 50,000 0.826 41,300
3 15,000 0.751 11,265
4 30,000 0.683 20,490
PVofcashinflows 1,09,415
153
PVofCashoutflows 1,00,000
NPV 9,415
(b) Usingriskadjusteddiscountrate
Year CashinflowsRs PVfactorat20% PVofcashinflows
1 40,000 0.833 33,320
2 50,000 0.694 34,700
3 15,000 0.579 8,685
4 30,000 0.482 14,460
PVofCashinflows 91,165
PVofCashoutflows 100,000
NPV (8,835)
Theprojectwouldbeacceptablewhennoallowanceismadeforrisk.
Butitwillnotbeacceptableifriskpremiumisaddedtotheriskfreerate.Itmovesfrompositive
NPVtonegativeNPV.
Ifthefirmweretousetheinternalrateofreturn,thentheprojectwouldbeacceptedwhenIRRis
greaterthantheriskadjusteddiscountrate.
EvaluationofRiskadjusteddiscountrate:
Advantages:
1. Itissimpleandeasytounderstand.
2. Riskpremiumtakescareoftheriskelementinfuturecashflows.
3. Itsatisfiesthebusinessmenwhoarerisk averse.
Limitations:
1. There are no objective bases of arriving at the risk premium. In this process the premium
ratescomputedbecomearbitrary.
2. Theassumptionthatinvestorsareriskaversemaynotbetrueinrespectofcertaininvestors
who are willing to take risks. To suchinvestors,as thelevelof riskincreases, the discount
ratewouldbereduced.
3. Cashflowsarenotadaptedtoincorporatetheriskadjustmentfornetcashinflows.
1.Riskpremiumisthe__________________thattheinvestorsrequireascompensationfor
154
assumptionofadditionalrisksofproject.
2.RADRisthesumof______________and______________.
3.Highertherisk__________________thepremium.
4.Manbynatureisriskaverseandtriestoavoidrisk.
9.4 CertaintyEquivalent:
Underthismethodtheriskinguncertain,expectedfuturecashflowsareconvertedintocashflows
with certainty. Here we multiply uncertain future cash flows by the certainty equivalent
coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent
coefficient is also known as the risk adjustment factor. Risk adjustment factor is normally
denotedbyt(Alpha).Itistheratioofcertainnetcashflowtoriskynetcashflow
=CertaintyEquivalent=CertainCashflow
RiskyCashflow
Thediscountfactortobeusedistheriskfreerateofinterest.Certaintyequivalentcoefficientis
between0and1.Thisriskadjustmentfactorvariesinversely withrisk.Ifriskishighalower
valueisusedforriskadjustment.Ifriskislowahighercoefficientofcertaintyequivalentis used
Illustration(Example)
AprojectcostsRs50,000.Itisexpectedtogeneratecashinflowsasunder
Year Cashinflows CertaintyEquivalent
1 32,000 0.9
2 27,000 0.6
3 20,000 0.5
4 10,000 0.3
Riskfreediscountrateis10%computeNPV
Answer:
Year Uncertaincash
inflows
CE Certaincash
flows
PVFactorat
10%
PVofcertaincash
inflows
1 32,000 0.9 28,800 0.909 26,179
2 27,000 0.6 16,200 0.826 13,381
3 20,000 0.5 10,000 0.751 7,510
4 10,000 0.3 3,000 0.683 2,049
155
PVofcertaincashin
flows
49,119
Initialcashoutlay 50,000
NPV (881)negative
TheprojecthasanegativeNPV.
Therefore,itisrejected.
IfIRRisusedtherateofdiscountatwhichNPVisequaltozeroiscomputedandthencompared
withtheminimum(required)riskfreerate.IfIRRisgreaterthanspecifiedminimumriskfreerate,
theprojectisaccepted,otherwiserejected.
Evaluation:
Itrecognisesrisk.Recognitionofriskbyriskadjustmentfactorfacilitatestheconversionofrisky
cashflowsintocertaincashflows.Buttherearechancesofbeinginconsistentintheprocedure
employedfromoneprojecttoanother.
Whenforecastspassthroughmanylayersofmanagement,originalforecastsmaybecomehighly
conservative.
Becauseofhighconservationinthisprocessonlygoodprojectsarelikelytobeclearedwhenthis
methodisemployed.
Certainty equivalent approach is considered to be theoretically superior to therisk adjusted
discountrate.
1.CEcoefficientisthe_______.
2.DiscountfactorstobeusedunderCEapproachis_____________.
3.Becauseofhigh______________CEclearsonlygoodprojects.
4.___________isconsideredtobesuperiortoRADR
9.5 SensitivityAnalysis:
There are many variables like sales, cost of sales, investments, tax rates etc which affect the
NPV and IRR of a project. Analysing the change in the projects NPV or IRR on account of a
givenchangeinoneofthevariablesiscalledSensitivityAnalysis.Itisatechniquethatshowsthe
changeinNPVgivenachangeinoneofthevariablesthatdeterminecashflowsofaproject.It
measuresthesensitivityofNPVofaprojectinrespecttoachangeinoneoftheinputvariablesof
NPV.
156
The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on
account of changes in assumed economic environments, reliability of NPV & IRR is lost.
Therefore,forecastsaremadeunderdifferenteconomicconditionsvizpessimistic,expectedand
optimistic.NPVisarrivedatforallthethreeassumptions.
FollowingstepsareinvolvedinSensitivityanalysis:
1. IdentificationofvariablesthatinfluencetheNPV&IRRoftheproject.
2. Examininganddefiningthemathematicalrelationshipbetweenthevariables.
3. AnalysisoftheeffectofthechangeineachofthevariablesontheNPVoftheproject.
Example: A company has two mutually exclusive projects under consideration viz project A &
projectB.
Each project requires aninitial cashoutlay of Rs 3,00,000andhas aneffectivelife of 10 years.
The companys cost of capital is 12%. The following fore cast of cash flows are made by the
management.
Economic ProjectA ProjectB
Environment Annualcashinflows Annualcashinflows
Pessimistic 65,000 25,000
Expected 75,000 75,000
Optimistic 90,000 1,00,000
WhatistheNPVoftheproject?
Whichprojectshouldthemanagementconsider?
GivenPVIFA=5.650
Answer/Solutions
NPVofprojectA
Economic Project PVIFA PVofcashinflows NPV
Environment cashinflows at 12% 10
years
Pessimistic 65,000 5.650 3,67,250 67,250
Expected 75,000 5.650 4,23,750 1,23,750
Optimistic 90,000 5.650 5,08,500 2,08,500
157
NPVofProjectB
Pessimistic 25,000 5.650 1,41,250 (1,58,750)
Expected 75,000 5.650 4,23,750 1,23,750
Optimistic 1,00,000 5.650 5,65,000 2,65,000
Decision
1. UnderpessimisticconditionsprojectAgivesapositiveNPVofRs67,250andProjectBhasa
negativeNPVofRs1,58,750ProjectAisaccepted.
2. Under expected conditions, both gave some positive NPV of Rs 1,23,000. Any one of two
maybeaccepted.
3. Under optimistic conditions ProjectB has a higher NPV of Rs 2,65,000 compared to that of
AsNPVofRs2,08,500.
4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for
ProjectBthedifferenceisRs4,23,750.
5. ProjectBisriskycomparedtoProjectAbecausetheNPVrangeisoflargedifferences.
StatisticalTechniques:
Statisticaltechniquesuseanalyticaltoolsforassessingrisksofinvestments.
1._____________analysisthechangesintheprojectNPVonaccountofagivenchangeinone
oftheinputvariablesoftheproject.
2. Examining and defining the mathematical relation between the variable of the NPV is
_________________________.
3.Forecastsundersensitivityanalysisaremadeunder__________.
9.6 ProbabilityDistributionApproach:
When we incorporate the chances of occurrences of various economic environments computed
NPV becomes more reliable. The chances of occurrences are expressed in the form of
probability.Probabilityisthelikelihoodofoccurrenceofaparticulareconomicenvironment.After
assigningprobabilitiestofuturecashflowsexpectednetpresentvalueiscomputed.
Illustration: A company has identified a project with an initial cash outlay of Rs 50,000. The
followingdistributionofcashflowisgivenbelowforthelifeoftheprojectof3years.
158
Year1 Year2 Year3
Cashinflow Probability Cashinflow Probability Cashinflow Probability
15,000 0.2 20,000 0.3 25,000 0.4
18,000 0.1 15,000 0.2 20,000 0.3
35,000 0.4 15,000 0.2 20,000 0.3
32,000 0.3 30,000 0.2 45,000 0.1
Discountrateis10%
Year1
=15,000x0.2+18,000x0.1+35,000x0.4+32,000x0.300
3,000+1,800+14,000+9,600=28,400
Year2
20,000x0.3+15,000x0.2+30,000x0.3+30,000x0.2
=6,000+3,000+9,000+6,000=24,000
Year3
25,000x0.4+20,000x0.3+40,000x0.2+5,000x0.1=
10,000+6,000+8,000+4,500==28,500
Year Expectedcashinflows PVfactorat10%
PVofexpected
cashinflows
1 28,400 0.909 25,816
2 24,000 0.826 19,824
3 28,500 0.751 21,403
PVofexpectedcashinflows 67,043
PVofinitialcashoutlay 50,000
ExpectedNPV 17,043
Variance:
A study of dispersion of cash flows of projects will help the management in assessing the risk
associated with the investment proposal. Dispersion is computed by variance or standard
deviation. Variance measures the deviation of each possible cash flow from the expected.
Squarerootofvarianceisstandarddeviation.
Example:Followingdetailsareavailableinrespectofaproject whichrequiresaninitialcostof
Rs5,00,000.
159
Year EconomicConditions Cashflows Probability
1 Highgrowth 2,00,000 0.3
Averagegrowth 1,50,000 0.6
Nogrowth 40,000 0.1
Nogrowth 5,00,000 0.2
Nogrowth 30,000 0.2
Discountrateis10%
Solution:
Year1
EconomicCondition Cashinflow Probability ExpectedvalueofCashinflow
1 2 3
Highgrowth 2,00,000 0.3 60,000
Averagegrowth 1,50,000 0.6 90,000
Nogrowth 40,000 0.1 4,000
ExpectedValue 1,54,000
Year2
Highgrowth 3,00,000 0.3 90,000
Averagegrowth 2,00,000 0.5 1,00,000
Nogrowth 50,000 0.2 10,000
ExpectedValue 2,00,000
Year3
Highgrowth 4,00,000 0.2 80,000
Averagegrowth 2,50,000 0.6 1,50,000
Nogrowth 30,000 0.2 6,000
160
ExpectedValueof
Cashinflows
2,36,000
1,54,0002,00,000 2,36,000
1.10(110)
2
(1.10)
3
=1,40,000+1,65,289+1,77,3105,00,000=(17,401)negativeNPV
StandardDeviationforIyear
Cashinflow
C
ExpectedValue
E
(CE)
2
(CE)
2
xprob
2,00,000 1,54,000 (46,000)
2
(46,000)
2
x0.3=634800000
1,50,000 1,54,000 (4000)
2
(4,000)
2
x0.3=9600000
40,000 1,54,000 (1,14,000)
2
(1,14,000)
2
x0.3=1299600000
Total 1944000000
StandarddeviationofCashflowsforIyear=44091
For2
nd
year
Cashinflow
C
ExpectedValue
E
(CE)
2
(CE)
2
xprob
3,00,000 2,00,000 (1,00,000)
2
(1,00,000)
2
x0.3=3000000000
2,00,000 2,00,000 (0)
2
(0)
2
x0.5=0
50,000 2,00,000 (1,50,000)
2
(1,50,000)
2
x0.2=4500000000
Total 750000000
VarianceofCashflowsfor2
nd
year=7500000000
StandardDeviationofcashflowsfor2
nd
year=8660
Forthethirdyear
Cashinflow
C
ExpectedValue
E
(CE)
2
(CE)
2
xprob
4,00,000 2,36,000 (1,64,000)
2
(1,64,000)
2
x0.2=5379200 000
2,50,000 2,36,000 (14,000)
2
(14,000)
2
x0.6=117600000
30,000 2,36,000 (2,00,000)
2
(2,00,000)
2
x0.2=8000000000
Total 13496800000
ExpectedNPV= + + 5,00,000
161
VarianceofCashflowsfor3
rd
year=13496800000
StandardDeviationofcashflowsfor3
rd
year=116175
StandardDeviationofNPV
(44091)
2
(8660)
2
(116175)
2
(1.10)
2
(1.10)
4
(1.10)
6
= 1606625026+51223004+7618496131
= 9276344161
=96314
Heretheassumptionisthatthereisnorelationshipbetweencashflowsfromoneperiodto
another.Underthisassumptionthestandarddeviation ofNPV isRs96,314.
On the other hand, if cash flows are perfectly correlated, cash flows of all years have
linearcorrelationtooneanother,then
440918660116175
1.10 (1.10)
2
(1.10)
3
=40083+7157+87284=134524
The standard deviation of NPV when cash flows are perfectly correlated will be higher
thanthatunderthesituationofindependentcashflows.
SelfAssessmentQuestions.5
1. Probability distribution approach incorporates the probability of occurrences of various
economicenvironment,tomaketheNPV________.
2._______islikelihoodofoccurrenceofaparticulareconomicenvironment.
9.7 Decisiontreeapproach:
Many project decisions are complex investment decisions. Such complex investment decisions
involveasequenceofdecisionsovertime.Decisionstreecanhandlethesequentialdecisionsof
complex investment proposals. The decision of taking up an investment project is broken into
differentstages.Ateachstagetheproposalisexaminedtodecidewhethertogoaheadornot.
The multi stages approach can be handled effectively with the help of decision trees. A
decisiontreepresentsgraphicallytherelationshipbetweenapresentdecisionandfutureevents,
futuredecisionsandtheconsequencesofsuchdecisions.
s
NPV
=
+ +
s
NPV
=
+ +
162
Example
R&Dsectionofacompanyhasdevelopedanelectricmoped.Thefirmisreadyforpilot
production and test marketing. This will cost Rs 20 million and take six months. Management
believesthatthereisa70%chancethatthepilotproductionandtestmarketingwillbesuccessful.
IfsuccessfulthecompanycanbuildaplantcostingRs200million.
TheplantwillgenerateannualcashinflowofRs50millionfor20yearsifthedemandishighor
anannualcashinflowor20millionifthedemandislow.
Highdemandhasaprobabilityof0.6andlowdemandhasaprobabilityof0.4.Costofcapitalis
12%.
Suggest the optimal course of action using decision tree analysis (Bangalore University MBA,
adapted).
WorkingNotes:Fromrighthandsideofthedecisiontree
I step: Computation of Expected Monetary Value at point C2. Here EMV represents expected
NPV.
Cashinflow Probability Expectedvalueofcashinflows
50 0.6 30
20 0.4 8
EMV 38
PresentValueofEMV=ExpectedvalueofcashinflowxPVIFA(12%20)
38x7.469=Rs283.82million
D
C
1
D
3
C
2
D
2
D
11
Carryoutpilot
Production
AndMarket
test(20million)
D
12
DoNothing
C
11
Success
C12
failure
Probability0.3
D
31
Stop
D
22
Stop
D
21
Investment
Rs.200million
HighDemand
Probability 0.6
C
21
C
22
LowDemand
Probability 0.4
AnnualCashinflow
Rs.50million
AnnualCashinflow
Rs.20million
0.7
163
Step2:
ComputationofEMVatdecisionpointD2.
Decisiontaken Consequences TheresultingEMVatthislevel
D2 InvestRs200million 283.8220083.82million
D22 Stop 0
HerethedecisioncriterionisselecttheEMVwiththehighestvalue.
Stage3:
ThereforeEMVwithRs83.82millionwillbeconsideredthereforeweselectthedecisiontakenat
D2,
Stage4:
ComputationofEMVatthepointC,
EMV Probability ExpectedValue
83.82 0.7 58.67
0 0.3 0
EMVatthisstage 58.67
Step5:
ComputeEMVatdecisionspointD,
Decisiontaken Consequences TheresultingEmatthis
level
D11carry outpilot
productionandmarkettest
Invest
20million
58.6720=Rs38.67Million
D12Donothing 0 0
EMVatthisstage 38.67Million
(ApplytheEMVcriterion)i.e
selecttheEMVwiththe
highestvalue
Thereforeoptimalstrategyis
1. Carryoutpilotproductionandmarkettest.
2. If the result of pilot production and market test is successful, go ahead with the investment
decisionofRs200millioninestablishingaplant.
3. Iftheresultofpilotproductionandmarkettestisfuture,stop.
164
EvaluationofDecisiontreeapproach:
1. It portraysinter related,sequential and criticalmulti dimensionalelements of major project
decisions.
2. Adequateattentionisgiventothecriticalaspectsinaninvestmentdecisionwhichspreadover
atimesequence.
3. Complex projects involve huge out lay and hence risky. There is the need to define and
evaluate scientifically the complex managerial problems arising out of the sequence of
interrelateddecisionswithconsequentialoutcomesofhighrisk.Itiseffectivelyansweredby
decisiontreeapproach.
4. Structuring a complex project decision with many sequential investment decisions demands
effectiveprojectriskmanagement.Thisispossibleonlywiththehelpofananalyticaltoollike
decisiontreeapproach.
5. Able to eliminate unprofitable outcomes andhelps in arriving at optimum decision stages in
timesequence.
1.Decisiontreecanhandlethe_____________ofcomplexinvestmentproposals.
2._____portraysinterrelated,sequentialandcriticalmultidimensionalelementsofmajorproject
decisions.
3. Adequate attention is given to the ______ in an investment decision under decision tree
approachs.
4.____________areeffectivelyhandledbydecisiontreeapproachs.
9.8Summary
Riskinprojectevaluationarisesonaccountoftheinabilityofthefirmtopredicttheperformance
of the firm with certainty. Risk in capital budgeting decision may be defined as the variability of
actual returns from the expected. There are many factors that affect forecasts of investment,
costsandrevenuesofaproject.Itispossibletoidentifythreetypeofriskinanyproject,vizstand
alonerisk,corporateriskandmarketrisk.Thesourcesofrisksare:
a. Project
b. Competition
c. Industry
d. Internationalfactorsand
e. Market
165
Thetechniquesforincorporationofriskfactorincapitalbudgetingdecisioncouldbegroupedinto
conventionaltechniquesandstatisticaltechniques.
TerminalQuestions
1. Definerisk.Examinetheneedforassessingtherisksinaproject.
2. Examinethetypeandsourcesofriskincapitalbudgeting.
3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital
budgeting.
4. Examinethestepsinvolvedinsensitivityanalysis.
5. ExaminethefeaturesofDecisiontreeapproaches.
1. Standalonerisk.
2. Beta
3. Diversify
4. Internationalrisk
1. Additionalreturn
2. Riskfreerate,riskpremium.
3. Greater.
1. Riskadjustmentfactor
2. Riskfreerateofinterest.
3. Conservation.
4. CE
1. Sensitivityanalysis
2. Oneofthestepsofsensitivityanalysis
3. Differenteconomicconditions
166
1. Morereliable
2. Probability
1. Sequentialdecisions
2. Decisiontree.
3. Criticalaspects
4. Complexprojects.
1. Refertounits9.1
2. Refertounits9.2
3. Refertounits9.3
4. Refertounit9.5
5. Refertounit9.7
167
Unit10 CapitalRationing
Structure
10.1 Introduction
10.2 MeaningofCapitalRationing
10.3 StepsinvolvedinCapitalRationing
10.4 Summary
TerminalQuestions
AnswertoSAQsandTQs
10.1 Introduction:
Capital budgeting decisions involve huge outlay of funds. Funds available for projects may be
limited. Therefore, a firm has to prioritize the projects on the basis of availability of funds and
economiccompulsionofthefirm.Itisnotpossibleforacompanytotakeupalltheprojectsata
time.Thereistheneedtorankthemonthebasisofstrategiccompulsionandfundsavailability.
Sincecompanieswillhavetochooseonefromamongmanycompetinginvestmentproposalthe
needtodevelopcriteriaforCapitalrationingcannotbeignored.Thecompaniesmayhavemany
profitable and viable proposals but cannot execute because of shortage of funds. Another
constraintisthatthefirmsmaynotbeabletogenerateadditionalfundsfortheexecutionofallthe
projects.Whenafirmimposesconstraintsonthetotalsizeoffirmscapitalbudget,itisrequires
CapitalRationing.WhenCapitalisrationedthereisaneedtodevelopamethodofselectingthe
projects that could be executed with the companys resources yet give the highest possible net
presentvalue.
LearningObjectives:
1.Explainthemeaningofcapitalrationing.
2.Explaintheneedforcapitalrationing.
3.Explaintheprocessofcapitalrationing.
4.Explainthevariousapproachestocapitalrationing.
168
10.2 MeaningofCapitalRationing:
Because of the limited financial resources, firms may have to make a choice from among
profitableinvestmentopportunities.Capitalrationingreferstoasituationinwhichthefirmisunder
aconstraintoffunds,limitingitscapacitytotakeupandexecutealltheprofitableprojects.Sucha
situationmaybeduetoexternalfactorsorduetotheneedtoimposeinternalconstraints,keeping
inviewoftheneedtoexercisebetterfinancialcontrol.
WhyCapitalRationing
ReasonsforCapitalRationing:
CapitalRationingmaybedueto
a.Externalfactors b.Internalconstraintsimposedbymanagement
External Capital Rationing: External Capital Rationing is due to the imperfections of capital
marketsImperfectionmaybecausedby:
a. Deficienciesinmarketinformation
b. RigiditiesthathampertheforceflowofCapitalbetweenfirms.
Whencapitalmarketsarenotfavourabletothecompanythefirmcannottapthecapitalmarketfor
executingnewprojectseventhoughtheprojectshavepositivenetpresentvalues.Thefollowing
reasonsattributetotheexternalcapitalrationing:
1. Inabilityof thefirm to procure requiredfundsfrom Capital marketbecausethe firm does not
commandtherequiredinvestorsconfidence.
2. Nationalandinternationaleconomicfactorsmaymakethemarkethighlyvolatileandinstable.
3. Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the
marketforfunds.
4. HighCostofissueofSecuritiesI,eHighfloatationcost.Smallerfirmssmallerfirmsmayhave
toincurhighcostsofissueofsecurities.Thisdiscouragessmallfirmsfromtappingthecapital
marketsforfunds.
InternalCapitalRationing:Impositionsofrestrictionsbyafirmonthefundsallocatedforfresh
investmentis calledinternal capital rationing. Thisdecision may be the resultofa conservative
policy pursued by a firm. Restriction may be imposed on divisional heads on the total amount
thattheycancommitonnewprojects.
AnotherinternalrestrictionforCapitalbudgetingdecisionmaybeimposedbyafirmbasedonthe
need to generate a minimum rate of return. Under this criterion only projects capable of
169
generatingthemanagementsexpectationontherateofreturnwillbecleared.Generallyinternal
capitalrationingisusedbyafirmasameansoffinancialcontrol.
1. When a firm imposes constraints on the total size of its capital budget, it is known as
_____________.
2.Internalcapitalrationingisusedbyafirmasa______________________.
3.Rigiditiesthataffectthefreeflowofcapitalbetweenfirmscause_________________.
4.Inabilityofafirmtosatisfytheregularitynormsforissueofequitysharesfortappingthemarket
forfundscauses__________________.
10.3 StepsinvolvedinCapitalRationing
StepsinvolvedinCapitalRationingare:
1. Rankingofdifferentinvestmentproposals
2. Selectionofthemostprofitableinvestmentproposal
Rankingofdifferentinvestmentproposals
Thevariousinvestmentproposalsshouldberankedonthebasisoftheirprofitability.Rankingis
doneonthebasisofNPV,ProfitabilityindexorIRRinthedescendingorder.
ProfitabilityindexasthebasisofCapitalRationing
Thefollowingdetailsareavailable:
CashInflows
Project InitialCashoutlay Year1 Year2 Year3
A 1,00,000 60,000 50,000 40,000
B 50,000 20,000 40,000 20,000
C 50,000 20,000 30,000 30,000
CostofCapitalis15%
ComputationofNPV
Year Cashinflows PVfactorat15% PVofCashin
flows
1 60,000 0.870 52,200
2 50,000 0.756 37,800
3 40,000 0.658 26,320
170
PVofCashinflow 1,16,320
InitialCashoutlay 1,00,000
NPV 16,320
PVofCashinflows
PVofCashoutflows
1,16,320
1,00,000
ProjectB
flows
1 20,000 0.870 17,400
2 40,000 0.756 30,240
3 20,000 0.658 13,160
PVofCashinflow 60,800
InitialCashoutlay 50,000
NPV 10,800
Profitabilityindex=60,800=1.216
50,000
ProjectC
flows
1 20,000 0.870 17,400
2 30,000 0.756 22,680
3 30,000 0.658 19,740
PVofCashinflow 59,820
InitialCashoutlay 50,000
NPV 9,820
Profitabilityindex=
=
=1.1632
171
Profitabilityindex=59,820=1.1964
50,000
RankingofProjects
Project NPV ProfitabilityIndex
Absolute Rank Absolute Rank
A 16320 1 1.1632 3
B 10800 2 1.216 1
C 9820 3 1.1964 2
If the firm has sufficient funds and no capital rationing restriction, then all the projects can be
acceptedbecauseallofthemhavepositiveNPVs.
Let us assume that the firm is forced to resort to capital rationing because the total funds
availableforexecutionofprojectisonlyRs.1,00,000.
InthiscaseonthebasisofNPVCriterion,projectAwillbecleared.Itincursaninitialcashoutlay
ofRs.1,00,000.AfterallocatingRs.1,00,000toprojectA,leftoverfundsisnil.Therefore,onthe
basisofNPVcriterionotherprojectsi,eB&Ccannotbetakenupforexecutionbythefirm.Itwill
increasethenetwealthofthefirmbyRs.16,320.
On the other hand on the basis of profitability index, project B and C can be executed with
Rs.1,00,000 because both of them incur individually an initial cash outlay of Rs.50,000.
Therefore,withtheexecutionofprojectsBandC,increaseinnetwealthofthefirmwillbe10800
+9820=Rs20620
The objective is to maximize NPV per rupee of Capital and projects should be ranked on the
basis of the profitability index. Funds should be allocated on the basis ranks assigned by
profitabilityindex.
Evaluation:
1. PIruleofselectingprojectsunderCapitalrationing maynotyieldsatisfactoryresult because
of project indivisibility. When projects involving high investment is accepted many small
projectswillhavetobeexcluded.Butthesumofthe NPVsofsmallprojectstobeaccepted
maybehigherthantheNPVofsinglelargeproject.
2. ItalsosuffersfromthemultiperiodCapitalconstraints.
Programmingapproach: There are many programming techniques to Capital rationing. Among
themare:
172
1. LinearProgramming:LPapproachtoCapitalrationingtriestoachievemaximumNPVsubject
to many constraints. Here the objectivefunction is maximisationof sum ofthe NPVsof the
projects.
Here the constraints matrix incorporates all the restrictions associated with Capital rationing
imposedbythefirm.
2. IntegerProgramming:LPmaygiveanoptimalmixofprojectsinwhichtheremaybeneedto
accept fraction of a project. Accepting fraction of a project is not feasible. Therefore,
optimummaynotbeattainable.Theactualimplementationofprojectsmaybesuboptimal.
When projectsare not divisible, integer programming canbe employed toavoid the chancesof
acceptingfractionofprojects.
Theadvantageofprogrammingapproachisthatitprovidesinformationondualvariables.Italso
givesinformationonshadowpricesofbudgetconstraints.Dualvariablesprovideinformationfor
decisionontransferoffundsfromoneyeartoanotheryear
Thedemeritsofprogrammingapproachisthat
a. Costlytousewhenlarge,indivisibleprojectsarebeingexamined.
b. They are deterministic models. But variables of Capital budgeting are subject to change
makingtheassumptionofdeterministichighlyinvalid.
1. Thetwostepsinvolvedincapitalrationingare__________and__________________.
2. Projectindivisibilitycanleadtosuboptimalresultwhen____________isusedforcapital
rationing.
3. Objectivefunctionunderlinearprograminingapproachis___________.
4. Whenprojectarenotdivisible______________canbeemployedtoavoidthechangesof
acceptingfractionofaproject.
10.4Summary
Oftenfirmsareforcedtorationthefundsamongtheeligibleprojectsthatthefirmwantstotake
up.Theinabilityofthefirminfindingadequatefundsforexecutionoftheprojectscouldbedueto
manyfactors.Itmaybeduetoexternalfactorsorinternalconstraintsimposedbythe
management.Externalcapitalrationingoccursmainlybecauseofimperfectionsincapital
markets.Internalcapitalrationingiscausedbyrestrictionsimposedbythemanagements.
173
TerminalQuestions
1. Examinetheneedforcapitalrationing.
2. Examinethereasonsforexternalcapitalrationing.
3. InternalcapitalrationingisusesbyfirmsforexercisingfinancialcontrolHowdoesafirm
achievethis?
4. Briefexplaintheprocessofcapitalrationing.
AnswertoSelfAssessmentQuestions
1. Capitalrationing.
2. Meansoffinancialcontrol.
3. Externalcapitalrationing.
4. Externalcapitalrationing.
1. Rankingtheproject,selectionofthemostprofitableinvestmentproposal
2. Profitabilityindex
3. MaximisationofsumofNPVsoftheprojects.
4. Integerprogramming
1. Refertounit10.1
2. Refertounit10.1
3. Refertounit10.1
4. Refertounit10.3
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Unit11 WorkingCapitalManagement
Structure
11.1 Introduction
11.2 ComponentsofCurrentAssetsandCurrentLiabilities
11.3 ConceptsofWorkingCapital
11.4 ObjectiveofWorkingCapitalManagement
11.5 NeedforworkingCapital
11.6 OperatingCycle
11.7 DeterminantsofWorkingCapital
11.8 EstimationofWorkingCapital
11.9 Summary
TerminalQuestions
AnswertoSAQsandTQs
11.1 Introduction
SoundworkingCapitalManagementhasbecomeanecessityinaneraofinformationtechnology
foracompanytosucceed.ThebestexampletosupportthisargumentistheperformanceofDell
computersasreportedinoneoftherecentFortunearticle.
AperusalofthearticlewillgiveusaninsightintohowDellcouldusetechnologyforimprovingthe
performanceofcomponentsofworkingcapital.
1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and
dealers.
2. Outsourcing an operationsif thefirmscorecompetencedoesnotpermittheperformanceof
theoperationeffectively.
3. Traintheemployeestoacceptchange.
4. Introductionofinternetbusiness
5. Releasing Capital by reduction in investment in inventory for improving the profitability of
operatingcapital.
Afinancialmangerspendsalargepartofhistimeinmanagingworkingcapital.
Therearetwoimportantelementsofworkingcapitalmanagement.
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1. Decisionsontheamount ofcurrent assets to beheld by afirm for efficientoperations ofits
business.
2. Decisionsonfinancingworkingcapitalrequirement.
Inadequacy or mismanagement of Working Capital is the leading cause of many business
failures. Working Capital is that portion of asset of a business which are used in current
operations. They are used in the operating cycle of the firm. It is defined as the excess of
CurrentAssetsoverCurrentLiabilitiesandprovisions.
LearningObjectives:
1. Explainthemeaning,definitionandconceptsofWorkingCapital
2. StatetheobjectivesofWorkingCapitalmanagement.
3. BringouttheimportanceofWorkingCapitalmanagement.
4. ExplaintheprocessofestimationofWorkingCapital.
11.2 ComponentsofCurrentAssetsandCurrentLiabilities
11.2.1 CurrentAssetsare:
1)Inventories 2)SundryDebtors3)BillsReceivables
4)CashandBankBalances5)Shortterminvestments
6) Advances such as advances for purchase of raw materials, components and
consumablestores,prepaidexpensesetc.
11.2.2 CurrentLiabilitiesare:
1)SundryCreditors2)BillsPayable3)Creditorsforoutstandingexpenses
4)Provisionfortax5)Otherprovisionsagainsttheliabilitiespayablewithinaperiodof
12months.
Working Capital Management is concerned with managing the different components of current
assets and current liabilities. A firm must have adequate Working Capital neither excess nor
shortage.MaintainingadequateWorkingCapitalatthesatisfactoryleveliscrucialformaintaining
thecompetitivenessofafirm.
Anylapseofafirmonthisaccountmayleadafirmtothestateofinsolvency.
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1. Maintaining adequate working capital at the satisfactory level is crucial for
______________the_____________ofafirm.
2. Prepaidexpensesare____________.
3. Provisionfortaxis______________.
4. Afirmmust___________________neitherexcessnorshortage.
11.3 ConceptsofWorkingCapital
TherearetwoimportantconceptsofWorkingCapitalgrossandnet
Gross Working Capital: Gross Working Capital refers to the amounts invested in the various
componentsofcurrentassets.Thisconcepthasthefollowingpracticalrelevance.
a. ManagementofcurrentassetsisthecrucialaspectofWorkingCapitalManagement.
b. Itisanimportantcomponentofoperatingcapital.Therefore,forimprovingtheprofitabilityon
itsinvestmentafinancemanagerofacompanymustgivetopprioritytoefficientmanagement
ofcurrentassets.
c. The need to plan and monitor the utilization of funds of a firm demands working capital
managementasappliedtocurrentassets.
d. Ithelpsinthefixationofvariousareasoffinancialresponsibility.
NetWorkingCapital
Net Working Capital is the excess of current assets over current liabilities and provisions. Net
Working Capital is positive. when current assets exceed current liabilities and negative when
currentliabilitiesexceedcurrentassets.Thisconcepthasthefollowingpracticalrelevance.
1. Itindicates the ability of thefirm to effectively use the spontaneousfinancein managing the
firmsWorkingCapitalrequirements.
2. A firms short term solvency is measured through the net Working Capital position it
commands.
PermanentWorkingCapital
PermanentWorkingCapitalistheminimumamountofinvestmentrequiredtobemadeincurrent
assetsatalltimestocarryonthedaytodayoperationoffirmsbusiness.Thisminimumlevelof
current asset has been given the name of core current assets by the Tandon Committee. It is
alsoknownasfixedWorkingCapital.
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TemporaryWorkingCapital
It is also known as Variable Working Capital or fluctuating Working Capital. The firms working
capital requirements vary depending upon the seasonal and cyclical changes in demands for a
firms products. The extra Working Capital required as per the changing production and sales
levelsofafirmisknownasTemporaryWorkingCapital.
1._______________referstotheamountsinvestedincurrentassets.
2. To _______ and monitor the ________________________________ to (current assets)is to
begiventoppriority.
3.Whencurrentassetsexceedcurrentliabilitiesthenetworkingcapitalis_____.
4.Permanentworkingiscalled____workingcapital.
11.4 ObjectiveofWorkingCapitalManagement
Thebasicobjectiveoffinancialmanagementismaximizingthenetwealthofshareholders.Afirm
mustearnsufficientreturnsfromitsoperationstoensuretherealizationofthisobjective.There
exists a positive correlation between sales and firms return on its investment. The amount of
earnings that a firm earns depends upon the volume of sales achieved. There is the need to
ensure adequate investment in current assets, keeping pace with accelerating sales volume.
Firmsmakesalesoncredit.Thereisalwaysatimegapbetweensaleofgoodsoncreditandthe
realizationofproceedsofsalesfromthefirmscustomers.Financemangerofafirmisrequired
to finance the operation during this time gap. Therefore, objective of Working Capital
Management is to ensure smooth functioning of the normal business operations of a firm. The
firmhastodecideontheamountofWorkingCapitaltobeemployed.
The firm may have a conservative policy of holding large quantum of current assets to ensure
largermarketshareandtopreventthecompetitorsfromsnatchinganymarketfortheirproducts.
Butsuchapolicywillaffectthefirmsreturnonitsinvestment.Thefirmwillhavehigherthanthe
required amountofinvestment in current asset.This excessfundslocked in current assets will
reducethefirmsprofitabilityonoperatingcapital.
Ontheotherhandafirmmayhaveanaggressivepolicyofdependingonspontaneousfinanceto
the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous
finance. Hereafirmwilltryto reduceitsinvestmentsincurrentassetsas muchaspossiblebut
withoutaffectingthefirmsabilitytomeetworkingcapitalneedsforsalesgrowthtargets.Sucha
policy will ensure higher return on its investment as the firm will not be locking in any excess
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funds in current assets. However, any error in forecasting can affect the operations of the firm
unfavorablyiftheerrorisfraughtwiththedownsiderisk.Thereisalsoanotherriskoffirmlosing
onmaintainingitsliquidityposition.
Objective of working capital management is achieving a trade off between liquidity and
profitability ofoperationsforthesmoothconductofnormalbusinessoperationsofthefirm.
SelfAssessmentsQuestions3
1. Objective of working capital management is achieving a trade off between ______ and
________.
2.Creditobtainedbyfirmfromitssuppliersisknowas_________.
3. An aggressive policy of working capital management means depending on
____________________tothemaximumextent.
4.Topreventthecompetitorsfromsnatching anymarketfortheirproductsthefirmmay havea
________________policyofholding__________ofcurrentassets.
11.5 NeedforworkingCapital
Theneedforworkingcapitalarisesonaccountoftworeasons:
a. Tofinanceoperationsduringthetimegapbetweensaleofgoodsoncreditandrealization
ofmoneyfromcustomersofthefirm.
b. Tofinanceinvestmentsincurrentassetsforachievingthegrowthtargetinsales.
Thereforefinancetheoperationsinoperatingcycleofafirmworkingcapitalisrequired.
1.Tofinancetheoperationsin_______ofafirmworkingcapitalisrequired.
2.Tofinanceoperationsduringthetimegapbetween______and____________workingcapital
isrequired.
11.6OperatingCycle
Operatingcycleofafirmhasthefollowingelements.
1. Acquisitionofresourcesfromsuppliers.
2. Makingpaymentstosuppliers.
3. Conversionofrawmaterialsintofinishedproducts.
4. Saleoffinishedproductstocustomers.
5. Collectionofcashfromcustomersforthegoodssold.
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Thetimegapbetweenacquisitionofresourcesandcollectionofcashfromcustomersisknownas
theoperatingcycle.Thesefivephasesoccuronacontinuousbasis.Thereisnosynchronization
between the activities in operating cycle. Cash out flows occur before the occurrences of cash
inflows in operating cycle cash out flows are certain. On the other hand cash in flows are
uncertain because of uncertainty associated. With effecting sales as per the sales forecast and
ultimatetimelycollectionofamountduefromthecustomerstowhomthefirmhassolditsgoods.
Sincecashinflowsdonotmatchwithcashoutflows,firmhastoinvestinvarious currentassets
toensuresmoothconductofdaytodaybusinessoperations.Therefore, thefirmhastoassess
the operating cycle time of its operation for providing adequately for its working capital
requirements.
Operatingcycle=ICperiod+RCperiod
ICperiod=Inventoryconversionperiod
RCperiod=Receivablesconversionperiod
Inventory conversion period is the average length of time required to produce and sell the
product.
1. InventoryConversionperiod=AverageInventory x365
Annualcostofgoodssold
2. Receivablesconversionperiod=AverageAccountsReceivables x365
AnnualSales
Accountspayablesperiodisalsoknownaspayablesdeferralperiod.
3. Accountspayablesperiod= Averagecreditors
(Payablesdeferralperiod) purchasesperday
Purchasesperday =TotalPurchasesforyear
365
Receivablesconversionperiodistheaveragelengthoftimerequiredtoconvertthefirms
receivablesintocash.
4. CashConversionCycle:Isthelengthoftimebetweenthefirmsactualcashexpenditure
anditsowncashreceipt.Thecashconversioncycleistheaveragelengthoftimearupee
istiedupincurrentassets.
CashConversionCycleis
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CCC=ICP+RCPPDP
CCC=CashConversionCycle
ICP=InventoryConversionPeriod
RCP=ReceivablesConversionPeriod
PDP=Payablesdeferralperiod
Example: ThefollowingdetailsareavailableforXYZLtdfortheyearended31.03.08
Sales 80,000 Inventory
Costofgoods 56,000 31.03.07 9,000
31.03.08 12,000
AccountsReceivables
31.03.07 12,000
31.03.08 16,000
AccountsPayable
31.03.07 7,000
31.03.08 10,000
Whatisthelengthoftheoperatingcycle?
Whatisthecashcycle?
Assume365daysintheyear(MBAAdopted)
Answer
OperatingCycle=InventoryConversionPeriod+AccountsReceivablesconversionPeriod
InventoryConversionPeriod
AverageInventory (9000+12000)/2
AnnualCostofgoodssold56000
10500x365
56000
AverageAccountsReceivables
Annualsales
(12000+16000)/2x365
80000
X365 X365
=68.4days
X365
ReceivablesConversionPeriod=
=63.9days
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AverageAccountsPayables
AnnualCostofgoodssold
(7000+10000)/2x365
56000
8500x365
56000
OperatingCycle=ICP+RCP
=68.4+63.9=132.3days
CashConversioncycle
=OCPDP
=132.355.4=76.9days
The Cash conversion cycle shows the time interval over which additional non spontaneous
sourcesofworkingcapitalfinancingmustbeobtainedtocarryoutfirmsactivities.Anincreasein
the length of operating cycle, without a corresponding increase in payables deferral period,
increasesthe cashconversion cycle. Any increasein cash conversion cycleleads to additional
workingcapitalneedsofthefirm.
1. The time gap between acquisition of resources from suppliers and collection of cash from
customersisknownas______.
2.__________istheaveragelengthoftimerequiredtoproduceandselltheproduct.
3. ______________ is the average lenth of time required to concept the firms receivables into
cash.
4. _______________ is conversion cycle is the length of time between firms actual cash
expenditureanditsownreceipt.
11.7 DeterminantsofWorkingCapital
A large number of factors influence Working Capital needs of a firm. The basic objective of a
firmsWorkingCapitalmanagementistoensurethatthefirmhasadequateworkingcapitalforits
operations,neithertoomuchnottoolittle.Investingheavilyincurrentassetswilldrainthefirms
earningsandinadequateinvestmentincurrentassetswillreducethefirmscredibilityasitaffects
X365
ReceivablesConversionPeriod=
=63.9days
=55.4days
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the firms liquidity. Therefore, the need to strike a balance between liquidity and profitability
cannotbeignored.Thefollowingfactorsdetermineafirmsworkingcapitalrequirements.
1. Natureofbusiness:WorkingCapitalrequirementsarebasicallyinfluencedbythenatureof
businessofthefirm.Tradingorganizationsareforcedtocarrylargestocksoffinishedgoods,
accounts receivables and accounts payables. Public utilities require lesser investment in
workingcapital.
2. SizeofBusinessOperation:Sizeismeasuredintermsofascaleofoperation.Afirmwith
largescaleofoperationnormallyrequiresmoreWorkingCapitalthanafirmwithalowscaleof
operation.
3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will
have higher requirements ofWorking Capital because of the need to runtheir sophisticated
andlongproductionprocess.
4. ProductsPolicy:Productionscheduleofafirminfluencestheinvestmentsininventories.A
firm,exposedtoseasonalchangesindemandwhenfollowingasteadyproductionpolicy will
havetofacethecostsandrisksassociatedwithinventoryaccumulationduringtheoffseason
periods. On the other hand a firm with a variable production policy will be facing different
dimensions of management of working capital. Such a firm may have to effectively handle
problem of production planning and control associated with utilization of installed plant
capacityunderconditionsofvaryingvolumesofproductionofproductsofseasonaldemand.
5. Volumeofsales:Thereisapositivedirectcorrelationbetweenthevolumeofsalesandthe
sizeofworkingcapitalofafirm.
6. Term of Purchase and Sales: A firm which allows liberal credit to its customers will need
more working capital than that of a firm with strict credit policy. A firm which enjoys liberal
creditfacilitiesfromitssuppliersrequiresloweramountofworkingcapitalwhencomparedtoa
firmwhichdoesnothavesuchafacility.
7. Operating efficiency: The firm with high efficiency in operation can bring down the total
investmentinworkingcapitaltolowerlevels.Hereeffectiveutilizationofresourceshelpsthe
firminbringingdowntheinvestmentinworkingcapital.
8. Price level changes: Inflation affects the working capital levels in a firm. To maintain the
operating efficiency under an inflationary set up a firm should examine the maintenance of
working capital position under constant price level. The financial capital maintenance
demands a firm to maintain higher amount of working capital keeping pace with rising price
levels. Under inflationary conditions same levels of inventory will require increased
183
investment.Theabilityofafirmtoreviseitsproductspriceswithrisingpricelevelswilldecide
theadditionalinvestmenttobemadetomaintaintheworkingcapitalintact.
9. BusinessCycle: Duringboom,salesriseasbusinessexpands.Depressionismarkedbya
decline in sale. During boom, expansion of business can be achieved only by augmenting
investmentinvariousassetsthatconstituteworkingcapitalofafirm.Whenthereadeclinein
business on account of depression in economy, inventory glut forces a firm to maintain
workingcapitalatalevelfarinexcessoftherequirementsundernormalconditions.
10. Processing technology: Longer the manufacturing cycle the larger the investment in
working capital when raw material passes through several stages in the production process
workinprocessinventorywillincreasecorrespondingly.
11. Fluctuationsinthesupplyofrawmaterials: Companieswhichuserawmaterialsavailable
onlyfromoneortwosourcesareforcedtomaintainbufferstockofrawmaterialstomeetthe
requirementsofuncertaintyinleadtime
Suchfirmsnormallycarrymoreinventorythanitwouldhave,hadthematerialsbeenavailable
innormalmarketconditions.
1.Capitalintensiveindustriesrequired___amountofworkingcapital.
2. There is a _______________ between volume of sales and the size of working capital of a
firm.
3.Underinflationingconditionssamelevel ofinventory willrequire____________investmentin
workingcapital
4.Longerthemanufacturingcyclethe_theinvestmentinworkingcapital.
11.8 EstimationofWorkingCapital
The bestapproachto estimate is basedon operating cycle. Therefore,the two componentsof
working capital are current assets and current liabilities. This approach is based on the
assumption that production and sales occur on a continuous basis and all costs occur
accordingly.
EstimationofCurrentAssets.
1. Rawmaterialsinventory:Averageinvestmentinrawmaterialisestimated.
2. Averageinvestmentinworkinprogressinventoryisestimated.
3. Averageinvestmentinfinishedgoodsinventoryisestimated.
184
4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated
basedoncreditpolicythatthefirmwishestopursue.
5. Basedon thefirmsattitudetowards risk, access toborrowing sources, pastexperience and
natureofbusiness,firmsdecideonthepolicyofmaintainingtheminimumcashbalances.
EstimationofCurrentLiabilities:
1. Trade Creditors: Based on production budget, raw material consumption, credit period
enjoyedfromsuppliersaverageamountoffinancingavailabletothefirmisestimated.
2. Direct wages: Based on production budget, direct labour cost per unit, average timelag in
paymentofwagesestimationismadeontotalwagestobepaidonanaveragebasis.
3. Overheads: Based on production budget, overhead cost per unit and average timelag in
paymentofoverheadanestimationonanaveragebasisoftheamountoutstandingtobepaid
tocreditorsforoverhead.
Example:AProformacostsheetofacompanyprovidesthefollowingdata
CostsperUnit
RawMaterial 52.00
DirectLabout 19.50
Overheads 39.00
TotalCost 110.50
Profit 19.50
SellingPrice 130.00
Thefollowingadditionalinformationisavailable:
a. Averagerawmaterialinstock:Onemonth
b. Averagematerialsinprocess:Halfamonth
c. CreditallowedbySuppliers:Onemonth
d. Creditallowedtodebtors:Twomonths
e. Timelaginpaymentofwages:oneandahalfweeks
f. Timelaginpaymentofoverheadsonemonth
g. Onefourthofsalesoncashbasis
h. CashbalanceexpectedtobemaintainedisRs.1,20,000
Youarerequiredtoprepareastatementshowingtheworkingcapitalrequiredtofinancealevelof
activity of 70,000 units ofoutput. You may assume that productionis carriedon evenly through
185
out the year and wages and overheads occur similarly. Assume 360 days in a year (MBA
adapted)
Solution:
EstimationofWorkingCapital
a. Investmentininventory
1. Rawmaterial
RMC = 70000x52
360360
2. Workinprocessinventory
COP = 70000x110.5
360 360
3. Finishedgoodsinventory
COS = 70000x110.5x30644583.33
3603601270208.33
b. Investmentindebtors
CostofCreditSales 52500x110.5
360 360
c. Cashbalance 120000
d. TotalcurrentAsset(A+B+C) 2357083.33
e. CurrentLiabilities
1. Creditors
PurchaseofrawmaterialsxPDP
360
70000x52x30=303333.33
360
2. Wages
70000x19.5x10=37916.67
360
3. Overheads
70000x39x30=227500.00
360
XRMCP
X30=303333.33
XWIPCP
X15=322291.67
XFGCP =
XDCP
X60=966875.00
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f. TotalCurrentLiabilities568750.00
g. NetworkingCapital(DF)1788958.33
Examples2:ThefollowingannualfiguresrelatetoXYZ:
Sales(attwomonthscredit) 3600000
Materialsconsumed
(Suppliersextendtwomonthscredit) 900000
WagesPaid(monthlyinarrears) 720000
Manufacturingexpensesoutstanding
attheendoftheyear 80000
(Cashexpensesarepaidone
monthinarrears)
Totaladministrativeexpenses
paid,asabove 240000
Salespromotionexpenses,
Paidquarterlyinadvance 120000
Thecompanysellsitsproductsongrossprofitof25%countingdepreciationaspartofthecostof
production. It keeps one months stock each of raw materials and finished goods, and a cash
balanceofRs.100000.
Assumea20percentsafetymargin.Calculatetheworkingcapitalrequirementsofthecompany
oncashcostbasis.Ignoreworkinprocess.
[CAFinalAdapted]
Solution
WorkingNotes:
Computationofmanufacturingexpenses
Sales 3600000
Less:grossprofitat25% 900000
Totalmanufacturingcost 2700000
Less:Materials900000
Wages720000 1620000
Manufacturingexpenses 1080000
187
Cashmanufacturingexpenses 960000
Depreciation:
Totalmanufacturingexpenses Cashmanufacturingexpenses
1080000960000=Rs.120000
Totalcashcost
Totalmanufacturingcost 2700000
Less:Depreciation 120000
Cashmanufacturingcost 2580000
Totalmanufacturingexpenses 240000
SalesPromotionexpenses 120000
Totalcashcost 2940000
Statementofworkingcapitalrequiredcurrentassets:
RawMaterialsstock
MaterialCost 90000x1=75000
12 12
Finishedgoodsstock
Cashmanufacturingcost x 1
12
2580000x=215000
Debtors:
Totalcashcostofsalesx2/12
=2940000x2/12= 490000
Salespromotionexpenses 30000
=120000x1/4
Cashrequired 100000
(A)TotalAssets 910000
CurrentLiabilities
SundryCreditors
MaterialCost 90000x2=150000
12 12
X1
X2
188
Wagesoutstanding=720000x1/12=60000
Manufacturingexpensesoutstanding=80000
Totaladministrativeexpenses
Outstanding 240000/12= 20000
(B)TotalcurrentLiabilities 310000
WorkingCapital
AB 600000
Add20%safetymargin 120000
WorkingCapitalrequired 720000
1. ________________isusedtoestimateworkingcapitalrequirementsofafirm.
2. Operating cycle approach isbased on the assumption that productionand sales occur on a
_____________.
11.9 Summary
Allcompaniesarerequiredtomaintainaminimumlevelofcurrentassetsatallpointoftime.This
leveliscalledcoreorpermanentworking.Capitalofthecompany.Workingcapitalmanagement
isconcernedwiththedeterminationofoptimumlevelofworkingcapitalanditseffectiveutilization.
Toassetstheworkingcapitalrequiredforaformtoconductitsoperationssmoothly,firmuse
operatingcycleconceptandcomputeeachcomponentofworkingcapital.
TerminalQuestions
1. ExaminetheComponentsofworkingcapital.
2. Explaintheconceptsofworkingcapital
3. Whataretheobjectivesofworkingcapitalmanagement?
4. Brieflyexplainthevariouselementsofoperatingcycle.
1. Maintaining,Competitiveness.
2. Currentassets.
3. CurrentLiabilities
4. Adequateworkingcapital
189
1. Grossworkingcapital
2. Plan,utilizationoffundsofafirmworkingcapitalmanagementasapplied.
3. Positive
4. Fixed
1. Liquidity,Profitability.
2. Spontaneousfinance.
3. Spontaneousfinance.
4. Conservative,Largequantum.
1.Operatingcycle
2.Salesofgoodsoncredit,realizationofmoneyfromcustomers.
1. Operatingcycle
2. Inventoryconversionperiod
3. Receivables conversionperiod
4. CashConversioncycle
1. Higher
2. Positivedirectcorrelation.
3. Increased
4. Larger
1. Operatingcycle
2. Continuousbases
1. Refertounit11.2
2. Refertounit11.3
3. Refertounit11.4
4. Refertounit11.6
190
Unit12 CashManagement
Structure
12.1 Introduction
12.1.1MeaningofCash
12.2 Meaningandimportanceofcashmanagement
12.3Motivesforholdingcashbalances
12.4 ObjectivesofCashManagement
12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash
12.5.1 BaumolModel
12.5.2 MillerOrrmodel
12.5.3 CashPlanning
12.5.4 CashForecastingandBudgeting
12.6 Summary
TerminalQuestions
AnswerstoTQsandSAQs.
12.1 Introduction
Cash is the most important current asset for a business operation. It is the energy that drives
business activities and also the ultimate output expected by the owners. The firm should keep
sufficient cash at all times. Excessive cash will not contribute to the firms profits and shortage of
cashwilldisruptitsmanufacturingoperations.
12.1.1 MeaningofCash
Thetermcashcanbeusedintwosensesinanarrowsenseitmeansthecurrencyandothercash
equivalentssuchascheques,draftsanddemanddepositsinbanks.Inabroadersense,itincludes
nearcashassetslikemarketablesecuritiesandtimedepositsinbanks.Thedistinguishingnatureof
thiskindofassetisthattheycanbeconvertedintocashveryquickly.Cashinitsownformisanidle
asset.Unlessemployedinsomeformoranother,itdoesnotearnanyrevenue.
191
LearningObjectives:
1. Meaningofcashandnearcashassets
2. Theimportanceofcashmanagementinafirm
3. Thedifferentmodelsofdeterminingtheoptimalcashbalances
4. Techniquesforforecastingthecashinflowsandoutflows.
12.2 MeaningandimportanceofCashManagement
Cashmanagementisconcernedwith(a)managementofcashflowsintoandoutofthefirm,(b)cash
managementwithinthefirmand(c)managementofcashbalancesheldbythefirmdeficitfinancing
orinvestingsurpluscash.Cashmanagementtriestoaccomplishataminimumcostthevarioustasks
ofcashcollection,paymentofoutstandingsandarrangingfordeficitfundingorsurplusinvestment.It
is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows
and outflows. At some points of time, cash inflows may be lower than outflows because of the
seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes
outflows may be lesser than inflows resulting in surplus cash. There is always an element of
uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage
cashinthebestpossibleway.Thesecanbebroadlysummarizedas:
Cash planning: Cash flows should be appropriately planned to avoid excessive or shortage of
cash.Cashbudgetscanbepreparedtoaidthisactivity
Managing cash flows: Theflowof cash shouldbeproperly managed. Steps to speedup cash
collectionandinflowsshouldbeimplementedwhilecashoutflowsshouldbesloweddown.
Optimumcashlevel:Thefirmshoulddecideontheappropriatelevelofcashbalance.Balance
shouldbestruckbetweenexcesscashandcashdeficientstage.
Investing surplus cash: The surplus cash should be properly invested to earn profits. Many
investmentavenuestoinvestsurpluscashareavailableinthemarketsuchas,bankshortterm
deposits,TBills,intercorporatelendingetc.
192
The ideal cash management system will depend on a number of issues like, firms product,
competition,collectionprogram,delayinpayments,availabilityofcashatlowratesofinterestsand
investmentopportunitiesavailable.
12.3 MotivesofHoldingCash
Therearefourmotivesofholdingcash.Theyare:
Transaction motive: This refers to a firm holding cash to meet its routine expenses which are
incurredintheordinarycourseofbusiness.Afirmwillneedfinancestomeetaplethoraofpayments
likewages,salaries,rent,sellingexpenses,taxes,interests,etc.Thenecessitytoholdcashwillnot
arise if there were a perfect coordination between the inflows and outflows. These two never
coincide. At times, receipts may exceed outflows and at other times, payments outrun inflows. For
suchperiodswhenpaymentsexceedinflowsthefirmshouldmaintainsufficientbalancestobeable
to make the required payments. For transactions motive, a firm may invest its cash in marketable
securities. Generally, they purchase such securities whose maturity will coincide with payment
obligations.
Precautionarymotive:Thisreferstotheneedtoholdcashtomeetsomeexigencieswhichcannot
beforeseen.Suchunexpectedneedsmayariseduetosuddenslowdownincollectionofaccounts
receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and
skilled labour etc. The moneys held to meet such unforeseen fluctuations in cash flows are called
precautionary balances. The amount of precautionary balance also depends on the firms ability to
raise additional money at a short notice. Thegreaterthe creditworthiness of thefirm in the market,
thelesseristheneedforsuchbalances.Generally,suchcashbalancesareinvestedinhighlyliquid
andlowriskmarketablesecurities.
Speculative motive: This relates to holding cash to take advantage of unexpected changes in
business scenario which are not normal in theusual courseoffirms dealings. It mayalso resultin
investinginprofitbackedopportunitiesasthefirmcomesacross.Thefirmmayholdcashtobenefit
fromafallingpricescenarioorgettingaquantitydiscountwhenpaidincashordelaypurchasesof
raw materials in anticipation ofdecline in prices. By and large, businessfirms do not hold cashfor
speculativepurposesandevenifitisdone,itisdoneonlywithsmallamountsofcash.Speculation
maysometimesalsoboomeranginwhichcasethefirmslosealot.
193
Compensatingmotive:Thisisyetanothermotivetoholdcashtocompensatebanksforproviding
certain services and loans. Banks provide a variety of services like cheque collection, transfer of
fundsthroughDD,MT,etc.Toavailallthesepurposes,thecustomersneedtomaintainaminimum
balance in their account at all times. The balance so maintained cannot be utilized for any other
purpose.Suchbalancesarecalledcompensatingbalances.Compensatingbalancescantakeany
ofthefollowingtwoforms(a)maintaininganabsoluteminimum,sayforexample,aminimumofRs.
25000 in current account or (b) maintaining an average minimum balance of Rs. 25000 over the
month.Afirmismoreaffectedbythefirstrestrictionthanthesecondrestriction.
12.4 ObjectivesofCashManagement:
Therearetwomajorobjectivesforcashmanagementinafirm(a)meetingpaymentsscheduleand
(b)minimizingfundsheldintheformofcashbalances.
Meeting payments schedule: In the normal course of functioning, a firm will have to make many
payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash
throughsalesofitsproductsandcollectionofreceivables.Boththesedonothappensimultaneously.
A basic objective of cash management is therefore to meet the payment schedule in time. Timely
payments will help the firm to maintain its creditworthiness in the market and to foster good and
cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are
madeintimeandthefirmcanavailthisdiscountaswell.Tradecreditreferstothecreditextended
bythesupplierofgoodsandservicesinthenormalcourseofbusinesstransactions.Generally,cash
isnotpaidimmediatelyforpurchasesbutafteranagreedperiodoftime.Thereisdeferralofpayment
and is a source of finance. Trade credit does not involve explicit interest charges, but there is an
implicitcostinvolved.Ifthecredittermsare,say,2/10,net30,itmeansthecompanywillgetacash
discountof 2%for prompt payment made within10 days or else the entire payment is to be made
within30days.Sincethenetamountisduewithin30days,notavailingdiscountmeanspayingan
extra2%for20dayperiod.
Theotheradvantageofmeetingthepaymentsintimeisthatitpreventsbankruptcythatarisesoutof
the firms inability to honour its commitments. At the same time, care should be taken not to keep
largecashreservesasitinvolveshighcost.
194
Minimize funds committed to cash balances: Trying to achieve the second objective is very
difficult.Ahighlevelofcashbalanceswillhelpthefirmtomeetitsfirstobjectivediscussedabove,but
keeping excess reserves is also not desirable as funds in its original form is idle cash and a non
earningasset.Itisnotprofitableforfirmstokeephugebalances.Alowlevelofcashbalancesmay
meanfailure to meet the payment schedule. The aim of cash management is therefore to havean
optimal levelof cashbybringingabout apropersynchronization of inflows andoutflowsand check
the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of
mismatchesbetweeninflowsandoutflows.
The efficiency of cash management can be augmented by controlling a few important factors
describedbelow:
Promptbillingandmailing:Thereisatimelagbetweenthedispatchofgoodsandpreparationof
invoice.Reductionofthisgapwillbringinearlyremittances.
Collection of cheques and remittancesof cash: It is generallyfound that there is a delay in the
receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the
processofcollectionanddepositingcashorotherinstrumentsfromcustomers.Theconceptoffloat
helpsfirmstoacertainextentincashmanagement.Floatarisesbecauseofthepracticeofbanksnot
creditingfirmsaccountinitsbookswhenachequeisdepositedbyitandnotdebitfirmsaccountin
its books when a cheque is issued by it until the cheque is cleared and cash is realized or paid
respectively. A firm issues and receives cheques on a regular basis. It can take advantage of the
concept of float. Whenever cheques are deposited with the bank, credit balance increases in the
firms books butnot in banks books until the cheque is clearedand money realized. This refersto
collection float, that is, the amount of cheques deposited into a bank and clearance awaited.
Likewise the firm may take benefit of payment float. The difference between payment float and
collectionfloatiscalledasnetfloat.Whennetfloatispositive,thebalanceinthefirmsbooksis
lessthanthebanksbookswhennetfloatisnegativethefirmsbookbalanceishigherthaninthe
banksbooks.
12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash
One of the prime responsibilities of a Finance Manager is to maintain an appropriate balance
between cash and marketable securities. The amount of cash balance will depend on riskreturn
195
tradeoff.Afirmwithlesscashbalanceshasaweakliquiditypositionbutmaybeearningprofitsby
investingitssurpluscashandontheotherhanditlosesontheprofitsbyholdingtoomuchcash.A
balance has to be maintainedbetweentheseaspects atall times.Sohow much isoptimum cash?
Thissectionexplainsthemodelsfordeterminingtheappropriatebalance.Twoimportantmodelsare
studiedhereBaumolmodelandMillerOrrmodel.
12.5.1 BaumolModel
TheBaumolmodelhelpsindeterminingtheminimumcostamountofcashthatamanagercanobtain
byconvertingsecuritiesintocash.Itisanapproachtoestablishafirmsoptimumcashbalanceunder
certainty.Assuch,firmsattempttominimizethesumofthecostofholdingcashandthecostof
convertingmarketablesecuritiestocash.TheBaumolmodelisbasedonthefollowingassumptions:
Thefirmisabletoforecastitscashrequirementsinanaccurateway.
Thefirmspayoutsareuniformoveraperiodoftime.
Theopportunitycostofholdingcashisknownanddoesnotchangewithtime.
Thefirmwillincurthesametransactioncostforallconversionsofsecuritiesintocash.
A company will sell securities and realizes cash and this cash is used to make payments. As the
cashbalancecomesdownandreachesapoint,theFinanceManagerreplenishesitscashbalance
by selling marketable securities available with it and this pattern continues. Cash balances are
refilledandbroughtbacktonormallevelsbytheactsofsaleofsecurities.Theaveragecashbalance
isC/2.Thefirmbuyssecuritiesasandwhentheyhaveabovenormalcashbalances.Thispatternis
explainedbelow:Error!
BaumolsModel
0 T1 T3 T2
C/2
C
Time
C
a
s
h
b
a
l
a
n
c
e
Average
196
The total cost associated with cash management has two elements(a) cost of conversion of
marketablesecuritiesintocashand(b)theopportunitycost.
The firm incurs a holding cost for keeping cash balance which is the opportunity cost. Opportunity
costisthebenefitforegoneonthenextbestalternativeforthecurrentaction.Holdingcostisk(C/2).
Thefirmalsoincursatransactioncostwheneveritconvertsitsmarketablesecuritiesintocash.Total
number of transactions during the year will be the total funds requirement, T, divided by the cash
balance,C,i.e.T/C.Ifpertransactioncostisc,thenthetotaltransactioncostisc(T/C).
Thetotalannualcostofthedemandforcashisk(C/2)+c(T/C).
Error!
TheoptimumcashbalanceC*isobtainedwhenthetotalcostisminimumwhichisexpressedasC*=
2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash
needed during the year and k is the opportunity cost of holding cash balance. The optimum cash
balancewillincreasewithincreaseinthepertransactioncostandtotalfundsrequiredanddecrease
withtheopportunitycost.
Example:
AfirmsannualcostrequirementisRs.20000000.Theopportunitycostofcapitalis15%perannum.
Rs.150isthepertransactioncostforthefirmwhenitconvertsisshorttermsecuritiestocash.Find
Cashbalance
Transactioncost
Holdingcost
Totalcost
C
o
s
t
C*
BaumolsCutoffModel
197
out the optimum cash balance. What is the annual cost of the demand for the optimum cash
balance?
Solution
C*=2cT/k=[2(150)(20000000)]/0.15=Rs.200000
Theannualcostis150(20000000/200000)+0.15(200000/2)=Rs.30000.
Example:
MysoreLampsLtd.requiresRs.30lakhstomeetitsquarterlycashrequirements.Theannualreturn
on its marketable securities which are of the tune of Rs. 30 lakhs is 20%. The conversion of the
securities into cash necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum
conversionamount.
Solution
C*=2cT/k=[2*3000*3000000]/0.05
@
=Rs.600000
@ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.
12.5.2 MillerOrrmodel
MillerOrr came out with another model due to the limitation of the Baumol model. Baumol model
assumesthatcashflowdoesnotfluctuate.Intherealworld,rarelydowecomeacrossfirmswhich
have their cash needs as constant. Keeping other factors such as expansion, modernization,
diversification constant, firms face situations wherein they need additional cash to maintain their
presentposition because of theeffectof inflationary pressures. Thefirms therefore cannotforecast
theirfundrequirementsaccurately.TheMillerOrrmodelovercomesthisshortcomingandconsiders
dailycashfluctuations.TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweenan
upperbound(uppercontrollimit)andalowerbound(lowercontrollimit).Whencashbalanceshitthe
upper limit, thefirm has too much cash and it istime to buy enough marketable securities to bring
back to the optimalbound.Whencashbalancestouch zero level, the level isbrought upby selling
securities intocash. Returnpoint liesbetween the upperand lower limits.Symbolically, this canbe
expressedasZ=33/4*(c
2
/i)whereZistheoptimalcashbalance,cisthetransactioncost,
2
is
the standarddeviation of thenetcashflowsandi is the interest rate. MO modelalso suggests the
optimumupperboundarybasthreetimestheoptimalcashbalanceandlowerlimit,i.e.upperlimit
b=lowerlimit+3Zandreturnpoint=lowerlimit+Z.Thisisshowngraphicallyasfollows:
198
Error!
MillerOrrModel
Example:
Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The
standard deviation of the companys daily cash flows is Rs. 200000. The interest rate is 14%. The
companyhastospendRs.150pertransaction.Calculatetheupperandlowerlimitsandthereturn
pointasperMOmodel.
Solution
Z=33/4*(c
2
/i)
33/4*(150*200000
2
)/0.14/365=Rs.227226
TheUppercontrollimit=lowerlimit+3Z=500000+3*227226= Rs.1181678
Returnpoint=lowerlimit+Z=500000+227226=Rs.727226
Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968
12.5.3CashPlanning
Cashplanningisatechniquetoplanandcontroltheuseofcash.Ithelpsindevelopingaprojected
cashstatementfromtheexpectedinflowsandoutflowsofcash.Forecastsarebasedonthepast
performanceandfutureanticipationofevents.Cashplanningcanbedoneadaily,weeklyorona
monthlybasis.Generally,monthlyforecastsarecommonlypreparedbyfirms.
Upperlimit
Lowerlimit
Returnpoint
C
a
s
h
b
a
l
a
n
c
e
Time
199
12.5.4 CashForecastingandBudgeting
Cashbudgetisadevicetoplanforandcontrolcashreceiptsandpayments.Itgivesasummaryof
cashflowsoveraperiodoftime.TheFinanceManagercanplanthefuturecashrequirementsofa
firmbasedonthecashbudgets.Thefirstelementofacashbudgetistheselectionofthetimeperiod
whichisreferredtoastheplanninghorizon.Selectingtheappropriatetimeperiodisbasedonthe
factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may
workoutmonthlyestimateswhilesomeothersmaybepreparingquarterlyoryearlybudgets.Firms
should keep in mind that the period selected should be neither too long nor too short. Too long a
period, estimates will not be accurate and too short a period requires periodic changes. Yearly
budgetscanbepreparedbysuchcompanieswhosebusinessisverystableandtheydonotexpect
majorchangesaffectingthecompanysflowofcash.
The second element that has a bearing on cash budget preparation is the selection of factors that
have a bearing on cash flows. Only items of cash nature are to be selected while noncash items
suchasdepreciationandamortizationareexcluded.
Cashbudgetsarepreparedunderthreemethods:
1. ReceiptsandPaymentsmethod
2. IncomeandExpendituremethod
3. BalanceSheetmethod
Weshallbediscussingonlythereceiptsandpaymentsmethodofpreparingcashbudgets.
Example:
GivenbelowisthepreparedacashbudgetofM/s.PandurangaSheetMetalsLtd.forthe6months
ending30
th
June2007.Ithasanopeningcashbalanceof Rs.60000on1
st
Jan2007.
Month Sales Purchases Wages Production
overheads
Selling
overheads
Jan 60000 24000 10000 6000 5000
Feb 70000 27000 11000 6300 5500
March 82000 32000 10000 6400 6200
April 85000 35000 10500 6600 6500
May 96000 38800 11000 6400 7200
June 110000 41600 12500 6500 7500
200
The company has a policy of selling its goods 50% on cash basis and the rest on credit terms.
Debtorsaregivenamonthstimeperiodtopaytheirdues.Purchasesaretobepaidofftwomonths
fromthedateofpurchase.Thecompanyhasatimelaginthepaymentofwagesofamonthand
theoverheadsarepaidafteramonth.Thecompanyisalsoplanningtoinvestinamachinewhichwill
beusefulforpackingpurposes,thecostbeingRs.45000,payablein3equalinstallments
startingbimonthlyfromApril.ItalsoexpectstomakealoanapplicationtoabankforRs.50000and
the loan will be granted in the monthof July. The company has to pay advance income tax of Rs.
20000inthemonthofApril.Salesmenareeligibleforacommissionof4%ontotalsaleseffectedby
themandthisispayableonemonthafterthedateofsale.
Solution
Jan Feb March April May June
Openingcash
balance
60000 85000 126100 153000 118850 150100
Cashreceipts:
Cashsales 30000 35000 41000 42500 48000 55000
Creditsales 30000 35000 41000 42500 48000
Totalcash
available
90000 150000 202100 236500 209350 253100
Cash
payments
Materials 24000 27000 32000 35000
Wages 5000 10500 10500 10250 10750 11750
Production
overheads
6000 6300 6400 6600 6400
Selling
overheads
5000 5500 6200 6500 7200
Sales
commission
2400 2800 3280 3400 3840
Purchase of
asset
15000 15000
Payment of
advanceIT
20000
Total cash
payments
5000 23900 49100 117650 59250 79190
Closing cash
balances
85000 126100 153000 118850 150100 173930
201
Workingnote:
Wagescalculation
Jan Feb Mar Apr May Jun
10000 11000 10000 10500 11000 12500
5000 5500feb 5000mar 5250apr 5500may 6250jun
5000mar 5500feb 5000mar 5250apr 5500may
5000 10500 10500 10250 10750 11750
1. Managementofcashbalancescanbedoneby____________and_________.
2. The four motives for holding cash are ___________, _______________, ____________ and
____________.
3. The greater the creditworthiness of the firm in the market lesser is the need for ___________
balances.
4. __________refers to the credit extended by the supplier of goods and services in the normal
courseofbusinesstransactions.
5. When cheques are deposited in a bank, credit balance increases in the firms books but not in
banks books until the cheque is cleared and money realized. This is called as
________________.
6. AccordingtoBaumolmodel,thetotalcostassociatedwithcashmanagementhastwoelements
______________and____________.
7. TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweena____________anda
__________________.
12.6 Summary
Allcompaniesarerequiredtomaintainaminimumlevelofcurrentassetsatallpointsoftime. Cash
management is concerned with determination of relevant levels of cash balances and near cash
assetsandtheirefficientuse.
The need for holding cash arises due to a variety of motives transaction motive, speculation
motive, precautionary motive and compensating motive. The objective of cash management is to
makeshorttermforecastsofcashinflowsandoutflows,investingsurpluscashandfindingmeansto
arrangeforcashdeficits.CashbudgetshelpFinanceManagertoforecastthecashrequirements.
202
TerminalQuestions
1. MirajEngineeringCo.hasforecastitssalesforthe3monthsendingDec.asfollows:
Oct.Rs.500000NovRs.600000Dec.Rs.650000
The goods are sold on cash and credit basis 50% each. Credit salesare realized in the month
followingthesale.Purchasesamountto50%ofthemonthssalesandarepaidinthefollowing
month. Wages and administrative expenses per month amount to Rs. 150000 and Rs. 80000
respectively and are paid in the following month. On 1
st
Dec. the company has purchased a
testingequipmentworthRs.20000payableon15
th
Nov.On31
st
Dec.acashdepositwithabank
will mature for Rs. 150000. The opening cash balance on 1
st
Nov. is Rs. 100000. What is the
closingbalanceinNov.andDec.?
2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period
endingDec.2007.
Rs.inlakhs
Particulars May June July Aug Sep Oct Nov Dec Jan
Sales 15 20 22 3 34 25 25 15 15
Materials 7 20 22 29 15 15 8 8 Nil
Rent 0.50 0.5 0.5 0.50 0.5 0.5
Salaries 1.5 2 2.5 1.5 1 1
Misc
charges
0.15 0.2. 0.2 0.4. 0.3. 0.2
Taxes 4
Purchase
ofasset
10
Creditterms:Customersareallowed1monthtime.
Suppliersofmaterialsarepaidafter2months.
Thecompanypayssalariesafteragapof15days.
Rentispaidafteragapof1month.
ThecompanyhasanopeningbalanceofRs.200000on1
st
June.
Prepareacashbudgetandfindoutwhatistheclosingcashbalanceon31
st
Dec.
203
1. Deficitfinancingorinvestingsurpluscash
2. Transaction,speculative,precautionaryandcompensating
3. Precautionary
4. Tradecredit
5. Collectionfloat
6. Costofconversionofmarketablesecuritiesintocashandopportunitycost.
7. Upperbound(uppercontrollimit)andlowerbound(lowercontrollimit).
AnswertoTerminalQuestions
1.PrepareaCashBudgetforNovemberandDecember.RefertotheExample12.5.4
2.PrepareacashbudgetasshowninExample12.5.4.
204
Unit13 InventoryManagement
Structure
13.1 Introduction
13.2 Costsassociatedwithinventoriesare
13.3 InventorymanagementTechniques
13.3.1 DeterminationofStockLevels
13.3.2 Pricingofinventories
13.4 Summary
TerminalQuestions
AnswertoSAQsandTQs
13.1 Introduction
InventoriesarethemostsignificantpartofcurrentaspectsofmostofthefirmsinIndia.Since
theyconstituteanimportantelementoftotalcurrentassetsheldbyafirmtheneedtomanage
inventoriesefficiently andeffectivelyforensuringoptimalinvestmentininventorycannotbe
ignored.Anylapseonthepartofmanagementofafirminmanaginginventoriesmaycausethe
failureofthefirm.Themajorobjectivesofinventorymanagementare:
a. Maximumsatisfactiontocustomer.
b. Minimuminvestmentininventory.
c. Achievinglowcostplantoperation.
Theseobjectivesconflicteachother.Therefore,ascientificapproachisrequiredtoarriveatan
optimalsolutionforearningmaximumprofitoninvestmentininventories.
Decisionsoninventoriesinvolvemanydepartments:
a. Rawmaterialpoliciesaredecidedbypurchasingandproductiondepartments
b. Productiondepartmentplaysanimportantroleinworkinprocessinventory,policyand
c. Finishedgoodsinventorypolicyisshapedbyproductionandmarketingdepartments.
Butthedecisionsofthesedepartmentshavefinancialimplications.Therefore,asanexecutive
entrustedwiththeresponsibilityofmanagingfinanceofthecompany,thefinancialmanagerofthe
firmhastoensurethatmonitoringandcontrollinginventoriesofthefirmareexecutedina
scientificmannerforattainingthegoalofwealthmaximizationofthefirm.
205
LearningObjectives:
1. Explainthemeaningofinventorymanagement.
2. Statetheobjectivesofinventorymanagement.
3. Bringouttheimportanceofinventorymanagement.
4. Statethepurposeofinventory.
5. Discussthetechniquesofinventorycontrol.
RoleofinventoryinworkingCapital:
Inventoriesconstituteanimportantcomponentofafirmsworkingcapital.Thefollowingfeatures
ofinventoryhighlightthesignificanceofinventoryinworkingcapitalmanagement.
1. Characteristicsofinventoryascurrentassets.
Currentassetsarethoseassetswhichareexpectedtoberealizedincashorsoldorconsumed
duringthenormaloperatingcycleofthebusiness.Variousformsofinventoryinany
manufacturingunitare:
a. Rawmaterialstobeconvertedintofinishedgoodsthroughtheprocessofproduction.
b. Workinprocessinventoriesaresemifinishedproductsintheprocessofbeingconverted
intofinishedgood.
c. Finishedgoodsinventoriesarecompletelymanufacturedproductsthatcanbesold
immediately.
Thefirsttwoareinventoriesconcernedwithproductionandthethirdismeantforsmooth
performanceofmarketingfunctionofthefirm.
Natureofbusinessinfluencesthelevelsofinventorythatafirmhastomaintaininthesethree
kinds.Amanufacturingunitwillhavetomaintainhighlevelsofinventoryinallthethreeforms.A
retailfirmwillbemaintainingveryhighleveloffinishedgoodsinventoryonly.
Thethreekindsofinventorieslistedabovearedirectinventories.Thereisananotherformof
indirectinventories.Theseindirectinventoriesarethoseitemwhicharenecessaryfor
manufacturingbutdonotbecomepartofthefinishedgoods.Theyarelubricants,grease,oil,
petrol,officematerialmaintenancematerialetc.
TheInventoriesareheldforthefollowingreasons.
1. Smoothproduction:toensuresmoothproductionaspertherequirementsofmarketing
department,inventoriesareprocuredandsold.
206
2. ToachieveCompetitiveedge:Mostofthe retailandindustrialorganizationscarryinventory
toensurepromptdeliverytocustomers.Nofirmlikestolosecustomersonaccountofthe
itembeingoutofstock.
3. Toreapthebenefitsofbuyinginlargevolume.Sometimesbuyinginlargevolumesmaygive
thefirmquantitydiscounts.Thisquantitydiscountsmaybesubstantialthatthefirmwilltake
benefitofit.
4. Hedgeagainstuncertainleadtimes:Leadtimeisthetimerequiredtoprocurefreshsupplies
ofinventory.Uncertaintyduetosuppliertakingmorethanthenormalleadtimewillaffectthe
productionscheduleandtheexecutionoftheordersofcustomersaspertheordersreceived
fromcustomers.Toavoidalltheseproblemsarisingfromuncertaintyinprocurementoffresh
suppliesofinventories,thefirmsmaintainhigherlevelsofinventoriesforcertainitemsof
inventory.
2. Levelofliquidity:Inventoriesaremeantforconsumptionorsale.Bothexcessandshortage
ofinventoryaffectofthefirms.Profitability.
Thoughinventoriesarecalledcurrentassets,incalculatingabsoluteliquidityofafirminventories
areexcludedbecauseitmayhaveslowmovingordormantitemsofinventorywhichcannotbe
easilydisposedof.Thereforelevelandcompositionofinventorysignificantlyinfluencethe
quantumofworkingcapitalandhenceprofitability ofthefirm.
3. LiquidityLags:Inventorieshavethreetypesoflags.
a. Creationlag: Rawmaterialsarepurchasedoncreditandconsumedtoproduce
finishedgoods.Thereisalwaysalaginpaymenttosuppliers fromwhomraw
materialsareprocured. Thisiscalledspontaneousfinance.Theamountof
spontaneousfinancethatafirmiscapableofenjoyinginfluencesthequantumof
workingcapitalofafirm.
b. Storagelag: Thegoodsmanufacturedorheldforsalecannotbeconvertedinto
cashimmediately.Beforedispatchingthegoodstocustomersonsale,thereis
alwaysatimelag.Duringthistimelaggoodsarestoredinwarehouse.Many
expensesofstoragewillberecurringinnatureandcannotbeavoided.Thelevel
ofexpenditurethatafirmincursonthisaccountisinfluencedbytheinventory
levelsofthefirm.Thisinfluencestheworkingcapitalmanagementofafirm.
c. SaleLag:Firmsselltheirproductsoncredit.Thereissometimelagbetweensale
offinishedgoodsandcollectionofdues fromcustomers.Firmswhichare
aggressiveincapturingmarketsfortheirproductsmaintainhighlevelsofinventory
andallowitscustomersliberalcreditperiod.Thiswillincreaseitsinvestmentin
207
receivables.Thisincreaseininvestmentinreceivableswillhaveitseffecton
workingcapitalofthefirm.
Purposeofinventory:
Thepurposeofholdinginventoryisachievingefficiencythroughcostreductionandincreased
salesvolume.Thefollowingarethepurposeofholdinginventories.
1. Sales:Customers placeordersforgoodsonlywhentheyneedit.Butwhencustomers
approachthefirmwithordersthefirmsmusthaveadequateinventoryoffinishedgoodsto
executeit.Thisispossibleonlywhenfirmsmaintainreadystockoffinishedgoodsin
anticipation ofordersfromcustomers.Ifafirmsuffersfromcomplaintsfromcustomersof
constantlytheproductbeingoutofstock,customersmaymigratetootherproducers.It
willaffectthefirmscustomersbase,customerloyaltyandmarketshare.
2. Toavailquantitydiscounts: Suppliersgivediscountsforbulkpurchases.Such
discountsdecreasethecostperunitofinventorypurchased.Suchcostreduction
increasefirmsprofits.Firmsmaygoinforordersoflargequantitytoavailthemselvesof
thebenefitofquantitydiscounts.
3. ReducingorderingCostsandtime
Everytimeafirmplacesanorderitincurscostofprocuringit.Italsoinvolvesaleadtime
inprocurement.Insomecasestheuncertaintyinsupplyduetocertainadministrative
problemsofthesupplieroftheproductwillaffecttheproductionschedulesofthe
organization.Therefore,firmsmaintainhigherlevelsofinventorytoavoidtherisksof
lengtheningtheleadtimeinprocurement.Therefore,tosaveontimeandcostsfirmsmay
placeordersforlargequantities.
4. Reduceriskofproductionstoppages
Manufacturingfirmsrequirealotofrawmaterialsandsparesandtoolsforproductionand
maintenanceofmachines.Nonavailabilityofanyvitalitemcanstoptheproduction
process.Productionstoppagehasseriousconsequences.Lossofcustomersonaccount
ofthefailuretoexecutetheirorderswillaffectthefirmsprofitability.Toavoidsuch
situations,firmsmaintaininventoriesashedgeagainstproductionstoppages.
Therefore,itcanbeconcludedthatthemotivesforholdinginventoriesare
1. Transactionmotive:formakingavailableinventoriestofacilitatesmooth
productionandsales.
2. Precautionarymotive:Forguardingagainsttheriskofunexpectedchangesin
demandandsupply.
208
3. Speculativemotive:Totakebenefitoutofthechangesinpricesfirmsincrease
ordecreasetheinventorylevels.
13.2 Costsassociatedwithinventoriesare:
1. Materialcosts:Thesearethecostsofpurchasingthegoodsandrelatedcostssuchas
transportationandhandlingcostsassociatedwithit.
2. OrderingCost:Theexpensesincurredtoplaceorderswithsuppliersandreplenish
theinventoryofrawmaterialarecalledorderingcosts.Theyincludecostsofthe
following.
a. Requisitioning
b. Purchaseordering orsetup
c. Transportation
d. Receiving,inspectingandreceivingatthewarehouse.Thesecostsincrease
inproportiontothenumberofordersplaced.Firmsmaintaininglargeinventory
levels,placeafewordersandincurlessorderingcosts.
3. CarryingCosts:costsincurredformaintainingtheinventoryinwarehousearecalled
carryingcosts.Theyincludeinterestoncapitallockedupininventory,storage,
insurance,taxes,obsolescence,deteriorationspoilage,salariesofwarehousestaff
andexpensesonmaintenanceofwarehousebuilding.Thegreatertheinventoryheld
thehigherthecarryingcosts.
4. Shortagecostsorstockoutcosts:Thesearethecostsassociatedwitheitheradelay
inmeetingthedemandorinabilitytomeetthedemandatallduetoshortageofstock.
Thesecostsinclude.
a. Lossofprofitonaccountsaleslostcausedbythestockout.
b. Lossoffuturesalescustomersmigratetootherdealers.
c. Lossofcustomergoodwilland
d. Extracostsassociatedwithurgentreplenishmentpurchases.
Measurementofshortagecostattributabletothefirmsfailuretomeetcustomersdemandis
difficultbecauseitisintangibleinnatureanditaffectstheoperationofthefirmnowandinfuture.
1.Leadtimeisthetimerequiredto_______________.
2.Bothexcessandshortageofinventoryaffectthefirms____________.
3.Precautionarymotiveofholdinginventoryisforguardingagainsttheriskof
_____________________andsupply.
4.Costsincurredformaintainingtheinventory inwarehousearecalled______.
209
13.3 InventorymanagementTechniques
Therearemanytechniquesofmanagementofinventory.Someofthemare:
EconomicOrderQuantity:
EOQreferstotheoptimalordersizethatwillresultinthelowestorderingandcarryingcostsfor
anitemofinventorybasedonitsexpectedusage.
EOQmodelanswersthefollowingkeyquantumofinventorymanagement.
a. Whatshouldbethequantityorderedforeachreplenishmentofstock?
b. HowmanyordersaretobepacedinayeartoensureeffectiveinventoryManagement?
EOQisdefinedastheorderquantitythatminimizesthetotalcostassociatedwithinventory
management.
Itisbasedonthefollowingassumptions:
1. Constantoruniformdemand.Thedemandorusageiseventhroughouttheperiod.
2. Knowndemandorusage:Demandorusageforagivenperiodisknowni.edeterministic.
3. ConstantUnitprice:Perunitpriceofmaterialdoesnotchangeandisconstantirrespectiveof
theordersize.
4. ConstantCarryingCosts
Thecostofcarryingisafixedpercentageoftheaveragevalueofinventory.
5. Constantorderingcost
Costperorderisconstantwhateverbethesizeoftheorder.
6. Inventoriescanbereplenishedimmediatelyasthestocklevelreachesexactlyequaltozero.
Consequentlythereisnoshortageofinventory.
7.
CarryingCosts
OrderingCosts
Cost
TotalCost
Q
x
210
EconomicorderQuantity
2DK
K
c
D=Annualusageordemand
Q
x
=EconomicorderQuantity
K=orderingcostperorder
k
c
=p
c
=priceperunitxpercentcarryingcost=carryingcostofinventoryperunitperannum.
Example:
Annualconsumptionofrawmaterialsis40,000units.CostperunitRs16
Carryingcostis15%perannum.
Costofplacinganorder=Rs480
Solution:
2x40000x480
16x0.15
Example:
Acompanyhasgatheredthefollowinginformation:
Annualdemand30,000units
Orderingcostperorder=Rs20(Fixed)
Carryingcost=Rs10perunitperannum
Purchasecostperuniti.epriceperunit=Rs32perunit
DetermineEOQ,totalnumberofordersinayearandthetimegapbetweentwoorders.
Solution:
2DK 2x30000x20
K
c
10
=346units
K=Rs.20
K
c
=Rs.10
D=30000
Thetotalnumberofordersinayear=30,000
346
=87orders
Q
x
=
EOQ=
=4000units
Q
x
= =
211
Timegapbetweentwoorders=365=4days
87
1. ABCSystem:theinventoryofanindustrialfirmgenerallycomprisesofthousandsofitems
withdiverseprices,largeleadtimeandprocurementproblems.Itisnotpossibletoexercise
thesamedegreeofcontroloveralltheseitems.Itemsofhighvaluerequiremaximum
attentionwhileitemsoflowvaluedonotrequiresamedegreeofcontrol.Thefirmhastobe
selectiveinitsapproachtocontrolitsinvestmentinvariousitemsofinventory.Suchan
approachisknownasselectiveinventorycontrol.ABCsystembelongstoselectiveinventory
control.
ABCanalysisclassifiesalltheinventoryitemsinanorganizationintothreecategories.
A: Itemsareofhighvaluebutsmallinnumber.Aitemsrequirestrictcontrol.
B: Itemsofmoderatevalueandsizewhichrequirereasonableattentionofthe
management..
C: Itemsrepresentrelativelysmall valueitemsandrequiresimplecontrol.
Sincethismethodconcentratesattentiononthebasisoftherelativeimportanceofvarious
itemsofinventoryitisalsoknownascontrolbyimportanceandexception.Astheitems
areclassifiedinorderoftheirrelativeimportanceintermsofvalue,itisalsoknownas
proportionalvalueAnalysis.
AdvantagesofABCanalysis:
2. Itensuresclosercontrolsoncostlyelementsinwhichfirmsgreaterpartofresourcesare
invested.
3. Bymaintainingstocksatoptimumlevel itreducestheclericalcostsofinventorycontrol.
4. Facilitatesinventorycontrolandcontroloverusageofmaterials,leadingtoeffectivecost
control.
Limitations:
1. Aneverendingproblemininventorymanagementisadequatelyhandlingthousandsoflow
valueofcitems.ABCanalysisfailstoanswerthisproblem.
2. IfABCanalysisisnotperiodicallyreviewedandupdated,itdefeatsthebasicpurposeofABC
approach.
212
13.3.1DeterminationofStockLevels
Mostoftheindustriesaresubjecttoseasonalfluctuationsandsalesduringdifferentmonthsofthe
yearareusuallydifferent.If,however,productionduringeverymonthisgearedtosalesdemand
ofthemonth,facilitieshavetoinstalledtocatertofortheproductionrequiredtomeetthe
maximumdemand.Duringtheslackseason,alargeportionoftheinstalledfacilitieswillremain
idlewithconsequentuneconomicproductioncost.Toremovethisdisadvantage,attempthasto
bemadetoobtainastabilizedproductionprogrammethroughouttheyear.Duringtheslack
season,therewillbeaccumulationoffinishedproductswhichwillbegraduallyclearedassales
progressivelyincrease.Dependinguponvariousfactorsofproduction,storingandcost,anormal
capacitywillbedetermined.Tomeetthepressureofsalesduringthepeakseason,however,
highercapacitymayhavetobesuedfortemporaryperiods.Similarly,duringtheslackseason,to
avoidlossduetoexcessiveaccumulation,capacityusagemayhavetobescaleddown.
Accordingly,therewillbeamaximumcapacityandminimumcapacity,onlyconsumptionofraw
materialwillaccordinglyvarydependinguponthecapacity usage.
Again,thedeliveryperiodorleadtimeforprocuringthematerialsmayfluctuate.Accordingly,
therewillbemaximumandminimumdeliveryperiodandtheaverageofthesetwoistakenasthe
normaldeliveryperiod.
MaximumLevel:
Maximumlevelisthatlevelabovewhichstockofinventoryshouldneverrise.Maximumlevelis
fixedaftertakingintoaccountthefollowingfactors:
1. Requirementandavailabilityofcapital
2. Availabilityofstoragespaceandcostofstoring.
3. Keepingthequalityofinventory intact
4. Pricefluctuations
5. Riskofobsolescence,and
6. Restrictions,ifany,imposedbythegovernment.
MaximumLevel = Orderinglevel(MRCxMDP)+standardorderingquantity.
Where, MRC=minimumrateofconsumption
MDP=minimumleadtime.
MinimumLevel:
Minimumlevelisthatlevelbelowwhichstockofinventoryshouldnotnormallyfall.
Minimumlevel=OL(NRCxNLT)
213
Where,
OL=orderinglevel
NRC=Normalrateofconsumption
NLT=NormalLeadTime.
OrderingLevel:
Orderinglevelisthatlevelatwhichactionforreplenishmentofinventoryisinitiated.
OL=MRCXMLT
Where,
MRC=Maximumrateofconsumption
MLT=Maximumleadtime.
3. Averagestocklevel
Averagestocklevelcanbecomputedintwoways
1. minimumlevel+maximumlevel
2
2. Minimumlevel+1/2ofreorderquantity.
Averagestocklevelindicatestheaverageinvestmentinthatitemofinventory.Itinofquite
relevantfromthepointofviewofworkingcapitalmanagement.
ManagerialsignificanceoffixationofInventorylevel:
1. Itensurethesmoothproductionsofthefinishedgoodsbymakingavailabletherawmaterial
ofrightqualityinrightquantityattherighttime.
2. Itoptimizestheinvestmentininventories.Inthisprocess,managementcanavoidboth
overstockingandshortageofeachandeveryessentialandvitalitemofinventory.
3. Itcanhelpthemanagementinidentifyingthedormantandslowmovingitemsofinventory.
Thisbringsaboutbettercoordinationbetweenmaterialsmanagementandproduction
managementontheonehandandbetweenstoresmanagerandmarketingmanageronthe
other.
ReorderPoint:
Whentoorderisanotheraspectofinventorymanagement.Thisisansweredbyreorder
point.Thereorderpointisthatinventorylevelatwhichanordershouldbeplacedtoreplenish
theinventory.
214
Toarriveatthereorderpointundercertaintythetwokeyrequireddetailsare:
1. Leadtime
2. Averageusage
leadtimereferstotheaveragetimerequiredtoreplenishtheinventoryafterplacingorders
forinventory
Reorderpoint=leadtimexAverageusage
Undercertainty,reorderpointreferstothatinventorylevelwhichwillmeettheconsumption
needsduringtheleadtime.
SafetyStock:Sinceitisdifficulttopredictinadvanceusageandleadtimeaccurately,provision
ismadeforhandlingtheuncertaintyinconsumptionduetochangesinusagerateandleadtime.
Thefirmmaintainsasafetystocktomanagethestockoutarisingoutofthisuncertainty.
Whensafetystockismaintained,(WhenVariationisonlyinusagerate)
Reorderpoint=leadtimexAverageusage+Safetystock
Safetystock= [(maximumusagerate)(Averageusagerate)]xleadtime.
Or
Safetystockwhenthevariationinbothleadtimeandusageratearetobeincorporated.
Safetystock=(Maximumpossibleusage)(Normalusage)
Maximumpossibleusage=MaximumdailyusagexMaximumleadtime
Normalusage=AveragedailyusagexAverageleadtime
Example:Amanufacturingcompanyhasanexpectedusageof50,000unitsofcertainproduct
duringthenextyear.RecostofprocessinganorderisRs20andthecarryingcostperunitper
annumisRs0.50.Leadtimeforanorderisfivedaysandthecompanywillkeepareserveoftwo
daysusage.Calculate1.EOQ2.Reorderpoint.Assume250daysinayear
Solution:
2DK 2x50000x20
K
c
0.50
=2000units
Reorderpoint
Dailyusage= 50000=200units
250
Safetystock=2x200400units.
EOQ= =
215
Reorderpoint(leadtimexAverageusage)+safetystock
(5x200)+400=1,400units
13.3.2 Pricingofinventories
Therearedifferentwaysofpricinginventoriesusedinproduction.Iftheitemsininventoryare
homogenous(identicalexceptforinsignificantdifferences)itisnotnecessarytousespecific
identificationmethod.Theconvenientpriceisusingacostflowassumptionreferredtoasaflow
assumption.
Whenflowassumptionisuseditmeansthatthefirmmakesanassumptionastothesequencein
whichunitsarereleasedfromthestorestotheproductiondepartment.
Theflowassumptionsselectedbyacompanyneednotcorrespondtotheactualphysical
movementofrawmaterials.Whenunitsofrawmaterialareidentical,itdoesnotmatterwhich
unitsareissuedfromthestorestotheproductiondepartment.
Themethodselectedshouldmatchthecostswiththerevenuetoensurethattheprofitsare
uncertaininamannerthatreflectstheconditionsactuallyprevalent.
1. Firstin,firstout(FIFO):Itassumesthattherawmaterials(goods)receivedfirstareusedfirst.
Thesamesequenceisfollowedinpricingthematerialrequisitions.
2. LIFO(lastin,firstout):Theconsignmentlastreceivedisfirstusedandifthisisnotsufficient
fortherequisitionsreceivedfromproductiondepartmentthentheuseismadefromthe
immediatepreviousconsignmentandsoon.Therequisitionsarepricedaccordingly.This
methodisconsideredtobesuitableunderinflationaryconditions.Underthismethodthecost
ofproductionreflectsthecurrentmarkettrend.Theclosinginventoryofrawmaterialwillbe
valuedonaconservativebasisundertheinflationaryconditions.
3. Weightedaverage:Materialissuesarepriced,attheweightedaveragecostofmaterialsin
stock.Thismethodconsidersvariousconsignmentsinstockalongwiththeirunitspricesfor
pricingthematerialissuesfromstores.
4. othermethodsare:
a. Replacementpricemethod:Thismethodpricestheissuesatthevalueatwhichitcanbe
procuredfromthemarket.
b. Standardpricemethod:underthismethodthematerialsarepricedatstandardprice.
Standardpriceisdecidedbasedonmarketconditionsandefficiencyparameters.The
differencebetweenthepurchasepriceandthestandardpriceisanalyzedthroughvariance
analysis.
216
1. ABCsystembelongsto______.
2. ______________areofhighvaluebutsmallinnumber.
3. ABCsystemisknownas_____________becausetheitemsareclassifiedinorderoftheir
relativeimportanceintermsofvalue.
4. _________isdefinedastheorderquantitythatminimizesthetotalcostofinventory
management.
13.4Summary
Inventoriesformpartofcurrentassetsoffirm.Objectivesofinventorymanagementare.
a. Maximumcustomersatisfaction
b. Optimuminvestmentininventoryand
c. Operationoftheplantattheleastcoststructure.Inventoriescouldbegroupedintodirect
inventoriesarerawmaterials,workinprocessinventoriesandfinishedgoodsinventory.
Indirectinventoriesarethoseitemswhicharenecessaryforproductionprocessbutdonot
becomepartofthefinishedgoods.Therearemanyreasonsattributabletoholdingof
inventorybythemanagements.
TerminalQuestions
1. Examinethereasonsforholdinginventoriesbyafirm.
2. Discussthetechniquesofinventorycontrol.
3. Discusstherelevanceandfactorsthatinfluencethedeterminationofstocklevel.
4. Explainthevariouscostofinventorydecision.
1. Obtainfreshsuppliesofinventory
2. Profitability
3. Unexpectedchangesindemand,supply
4. Carryingcosts
1. Selectiveinventorycontrol.
2. Aitems
3. Proportionalvalueanalysis
217
4. EOQ.
1. Refertounit13.1
2. Referto13.3
3. Referto13.3.3
4. Referto13.2
218
Unit14 ReceivablesManagement
Structure
14.1 Introduction
14.2 Costsassociatedwithmaintainingreceivables
14.3 Creditpolicyvariables
14.4 Evaluationofcreditpolicy
14.5 Summary
TerminalQuestions
14.6 AnswertoSAQsandTQs
14.1Introduction:
Firmssellgoodsoncredittoincreasethevolumeofsales.Inthepresenteraofintense
competition, business firms, to improve their sales, offer to their customers relaxed
conditionsofpayment.Whengoodsaresoldoncredit,finishedgoodsgetconvertedinto
receivables.Tradecreditisamarketingtoolthatfunctionsasabridgeforthemovement
ofgoodsfromthefirmswearhousetoitscustomers.Whenafirmsellsgoodsoncredit
receivablesarecreated.Thereceivablesarisingoutoftradecredithavethreefeatures.
1. Itinvolvesanelementofrisk.Therefore,beforesanctioningcredit,carefulanalysisof
theriskinvolvedneedstobedone
2. It is based on economic value. Buyer gets economic value in goods immediately on
sale,whilethesellerwillreceiveanequivalentvaluelateronand
3. Ithasanelementoffuturity.Thebuyermakespaymentinafutureperiod.
Amounts duefrom customers,whengoods aresoldoncredit,arecalledtradedebitsor
receivables. Receivables form part of current assets. They constitute a significant
portionofthetotalcurrentassetsofthebuyersnexttoinventories.
Receivables are assetaccountsrepresentingamounts owingtothefirm as aresultof
saleofgoods/servicesintheordinarycourseofbusiness.
Objectives: The main objective of selling goods on credit is to promote sales for
increasingtheprofitsofthefirm.Customerswillalwaysprefertobuyoncredittobuying
219
oncashbasis. They always gotoasupplier whogivescredit. All firms therefore grant
credittotheircustomerstoincreasesales,profitsandtomeetcompetition.
LearningObjectives:
1.Understandthemeaningofreceivablesmanagement.
2.Whatarethecostsassociatedwithmaintainingreceivable?
3.Understandthecreditpolicyvariables.
4.Understandtheprocessofevaluationofcreditpolicy.
MeaningofReceivablesManagement:
Receivables are a direct result of credit sales are resorted to, by a firm to push up its
sales which ultimately result in pushing up the profits earned by the firm. At the same
time, selling goods on credit results in blocking of funds in accounts receivables.
Additional funds are, therefore, required for the operating needs of the business which
involveextracostsintermsofinterest.Moreover,increaseinreceivablesalsoincreases
thechancesofbaddebts.Thus,creationofaccountsreceivablesisbeneficialaswellas
dangeroustothefirm.
The financial manager needs to follow a policy of usingcash funds economically to the
extent possible in extending receivables without adversely affecting the chances of
increasing sales and making more profits. Management of accounts receivables may,
therefore, be defined as, the process of making decision relating to the investment of
fundsinreceivableswhichwillresultinmaximisingtheoverallreturnontheinvestmentof
thefirm.
Thus,theobjectiveofreceivablesmanagementistopromotesalesandprojectsuntilthe
levelwherethereturnoninvestmentinfurtherfindingofreceivablesislessthenthecost
offundsraisedtofinancethatadditionalcredit.
14.2Costsassociatedwithmaintainingreceivables:
Costsofmaintainingreceivablesare:
1) Capital costs: A firm when sells goods credit achieves higher sales. Selling goods
oncredithasconsequencesofblockingthefirmsresourcesinreceivablesasthereis
220
atimelagbetweenacreditsaleandcashreceiptfromcustomers.Totheextentthe
fundsareheldupinreceivables,thefirmhastoarrangeforadditionalfundstomeet
itsownobligationof monthlyas wellasdaily recurringexpenditure.Additionalfunds
mayhavetoberaisedeitheroutofprofitsorfromoutside.Inboththecases,thefirm
incursacost.Intheformercasethereistheopportunitycostoftheincomethefirm
could have earnedhadthesame beeninvested insameother profitableavenue. In
thelattercaseofobtainingfundsfromoutside,thefirmhastopayinterestontheloan
taken. Therefore, sanctioning credit to customers on sale of goods on credit has a
capitalcost.
2) AdministrationCost: Whenafirmsellsgoodsoncreditithastoincurtwotypesof
administrationcostviz
a. Creditinvestigationandsupervisioncostsand
b. CollectionCosts.
Before sanctioning credit to any customer the firm has toinvestigate the creditrating of
thecustomertoensurethatcreditgivenwillrecoveredontime.Therefore,administration
costshavetobeincurredinthisprocess.
Costs incurred in collecting receivables are administrative in nature. These include
additional expenses on staff for administering the process of collection of receivables
fromcustomers.
3. Delinquency Costs: The firm incurs this cost when the customer fails to pay the
amount to it on the expiry of credit period. These costs take the form of sending
remaindersandlegalcharges.
BadDebtsorDefaultcost:
Whenthefirm is unabletorecover the amount duefromits customers,itresults inbad
debts.Whenafirmrelaxesitscreditpolicy,sellingtocustomerswithrelativelylowcredit
ratingoccurs.Inthisprocessafirm may makecreditsales toitscustomerswhodonot
payatall.
Therefore, the assessing the effect of a change in credit policy of a firm involves
examinationof
a. OpportunityCostoflostcontribution
b. CreditadministrationCost
221
c. CollectionCosts
d. DelinquencyCost
e. Baddebtloses
1. Costs of maintaining receivables are ________________, _________ cost and
_______.
2.AperiodofNet30 meansthatitallowstoitscustomers30daysofcreditwith____
for___________.
3. Selling goods on credit has consequences of blocking the firms resources in
receivablesasthereisatimelagbetween___________________and____________.
4.When a firmsells goods on credit it has to incur two types of administrationcostviz
_____and_________________.
14.3CreditpolicyVariables
1. Creditstandards.
2. Creditperiod.
3. Cashdiscountsand
4. Collectionprogramme.
1.Creditstandards: Thetermcreditstandardsrefertothecriteriaforextendingcreditto
customers.Thebasesforsettingcreditstandardsare.
a. Creditrating.
b. References
c. Averagepaymentperiod
d. Ratioanalysis
Thereisalwaysabenefittothecompanywiththeextensionofcredittoitscustomersbut
with the associated risks of delayed payments or non payment, funds blocked in
receivablesetc.Thefirmmayhavelightcreditstandards.Itmayselloncashbasisand
extend credit only to financial strong customers. Such strict credit standards will bring
down bad debt losses and reduce thecost of credit administration. But the firm may
not be able to increase its sales. The profit on lost sales may be more than the costs
222
savedby thefirm. Thefirm shouldevaluatethetradeoffbetweencostand benefitof
anycreditstandards.
2. Creditperiod: creditperiodreferstothelengthoftimeallowedtoitscustomersbya
firm to make payment for the purchases made by customers of the firm. It is generally
expressed in days like 15 days or 20 days. Generally, firms give cash discount if
paymentsaremadewithinthespecifiedperiod.
Ifafirmfollowsacreditperiodofnet20itmeansthatitallowstoitscustomers20days
ofcreditwithnoinducementforearlypayments.Increasingthecreditperiodwillbringin
additionalsales from existingcustomers andnew sales from new customers. Reducing
the credit period will lower sales, decrease investments in receivables and reduce the
bad debt loss. Increasing the credit period increases sales increases investment in
receivablesandincreasestheincidenceofbaddebtloss.
The effects of increasing the credit period on profits of the firm are similar to that of
relaxingthecreditstandards.
3.CashdiscountFirms offercashdiscounts toinducetheircustomerstomake prompt
payments.Cashdiscountshaveimplicationsonsalesvolume,averagecollectionperiod,
investmentinreceivables,incidenceofbaddebtsandprofits.Acashdiscountof2/10net
20meansthatacashdiscountof2%isofferedifthepaymentismadebythetenthday
otherwisefullpaymentwillhavetomadeby20
th
day.
4Collectionprogramme
Thesuccessofacollectionprogrammedependsonthecollectionpolicypursuedbythe
firm. The objective of acollection policy is to achieve. Timely collection of receivables,
therebyreleasingfundslockedinreceivablesandminimizestheincidenceofbaddebts.
Thecollectionprogrammesconsistsofthefollowing.
1. Monitoringthereceivables
2. Remindingcustomersaboutduedateofpayment
3. On line interaction through electronic media to customers about the payments due
aroundtheduedate.
4. Initiatinglegalactiontorecovertheamountfromoverduecustomersasthelastresort
torecovertheduesfromdefaultedcustomers.
223
Collectionpolicyformulatedshallnotleadtobadrelationshipwithcustomers
1.Creditperiodisa______________.
2._______refertothecriteriaforextendingcredittocustomers.
3. _________ refers to the length of time allowed to its customers by a firm to make
paymentforpurchasemadebycustomersofthefirm.
4.Acashdiscountof2/10net20meansthata____________isofferedifthepayment
ismade__________________
14.4Evaluation of Credit Policy: Optimum credit policy is onewhich wouldmaximize
thevalueofthefirm.Valueofafirmismaximizedwhentheincrementalrateofreturnon
an investment is equal to the incremental cost of funds used to finance the investment.
Therefore,creditpolicyofafirmcanberegardedasatradeoffbetweenhigherprofits
fromincreasedsalesandtheincrementalcostofhavinglargeinvestmentinreceivables.
The credit policy to be adopted by a firm is influenced by the strategies pursued by its
competitors.Ifcompetitorsaregranting15dayscreditandifthefirmdecidestoextend
the credit period to 30 days, the firm will be flooded with customers demand for
companysproducts.
Creditpolicyvariablesofafirmare
1. CreditStandard
Theeffectofrelaxingthecreditstandardsonprofitcanbeestimatedasunder:
Changeinprofit=P
Increaseinsales=S
Contribution=c=1V
WhereV=Variablecosttosales
BadDebtsonnewsales=Sxb
n
K=posttaxcostofcapital
Increaseinreceivablesinvestment=I
Therefore
224
Change in profit = (Additional contribution on increase in sales Bad Debts on new
sales) (1 tax rate) cost of incremental investment. (1 tax rate) cost of capital x
Incrementalinvestmentinreceivables.
Increase in profit i.e change in profit = [Incremental contribution Bad debts on new
sales]
Example: Followingdetailsareavailableinrespectofxltd:
Currentsales=Rs100million
The company is considering relaxation of its credit policy. Such relaxation would
increase the sales by Rs 15 million on which bad debt losses would be 10%. The
contributionmarginratioforthefirmis20%.Averagecollectionperiodis40days.Post
taxcostoffundsis10%.Taxrateapplicabletothefirmis30%.Assume360daysina
year.
Examine the effect of relaxing the credit policy on the profitability of the organization.
(MBA)adopted.
Solution:
Incrementalcontribution=1,50,00,000x0.20=Rs30,00,000
Baddebtsonnewsales=1,50,00,000x0.10=Rs15,00,000
Costofcapitalis10%
Incrementalinvestmentinreceivables=
Investmentinsales
No.ofdaysintheyear
15000000
360
CostofIncrementalInvestment
10
100
Thereforechangeinprofitiscalculatedasunder
IncrementalContribution= 3000000
Less:Baddebtsonnewsales= 1500000
= XAverageCollectionPeriodXVariableCosttoSalesratio
= X40X0.8=Rs.13,33,333
= x 13,33,333
225
Less:Incometaxat30%= 450000
1050000
Less:Opportunitycostof
Incrementalinvestmentin
Receivables 13,33,333
Increaseinprofit 916667
Since the impact ofchange incredit standards on profit is positive the change in credit
standardsmaybeconsidered.
2.Creditperiod
Theeffectofchangingthecreditperiodonprofitsofthefirmcanbecomputedasunder:
Change in profit = (Incremental contribution Bad debts on new sales) (1 tax rate)
costofincrementalinvestmentinreceivables.
Example:
Acompanyiscurrentlyallowingitscustomers,30daysofcredit.ItspresentsalesareRs
100 million. The firms cost of capital is 10% and the ratio of variables cost to sales is
0.80. The company is considering extending its credit period to 60 days. Such an
extensionwill increasethesales ofthefirm by Rs 100 million. Baddebts onadditional
saleswouldbe8%.Taxrateis30%.Assume360daysinayear.
(MBA)adopted.
Solution:
Incrementalcontribution=10,000,000x0.2=Rs2,000,000
Baddebtsonnewsales=10,000,000x0.8=Rs8,000,000
Existinginvestmentinreceivables=
30
360
Expectedinvestmentinreceivablesafterincreasingthecreditperiodto60days:
Expectedinvestmentinreceivablesoncurrentsales=
100000000
360
100000000x
Rs.8333333
= X60=Rs.16666667
226
Additionalinvestmentinreceivableonnewsales
60
360
Expectedtotalinvestmentinreceivablesonincreasingtheperiodofcredit=18000000
Incrementalinvestmentinreceivables=180000008333333=Rs.9666667
OpportunitycostofIncrementalinvestmentinreceivables=
0.10x9666667=Rs.966667
Statementshowingtheeffectofincreasingthecreditperiodfrom30daysto60daysas
firmsproject
IncrementalContribution 200000
Less:Baddebtsonnewsales 800000
1200000
Less:Incometaxat30% 360000
840000
Less:Opportunitycostofincremental
Investmentinreceivables 966667
Changeinprofit (126667)negative
Since the impact of increasing the credit period on profits of the firm is negative, the
proposedchangeincreditperiodisnotdesirable.
2. CashDiscount
Forassessingtheeffectofcashdiscountthefollowingformulacanbeused.
Change in profit = (Incremental contribution increase in discount cost) (1 t) +
opportunitycostofsavingsinreceivablesinvestment.
Example
Presentcredittermsofacompanyare1/10net30.ItssalesareRs100million,average
collectionperiodis20days,variablecosttosalesratiois0.8,andcostofcapitalis10%.
Theproportionofsalesonwhichcustomerscurrentlytakediscountis0.5.
100000000x
X0.80=Rs.1333333
227
Thecompanyisconsideringrelaxingitsdiscounttermsto2/10,net30
Such a relaxation is expected to increase sales by Rs 10 million, reduce Average
collectionperiodto14days,increasediscountsalesto0.8.Taxrateis0.30.
Examinetheeffectofrelaxingthediscountpolicyonprofitsoftheorganisation
Assume360daysinayear(MBAadopted).
Solution
IncrementalContribution=10000000x0.2=Rs.2000000
Increaseindiscount
Discountcostbeforeliberalisingdiscountterms=
0.5x100000000x0.01=Rs.500000
Discountcostafterliberalisationofdiscountterms=
0.8x110000000x0.002=Rs.1760000
Increaseindiscountcost=Rs.1260000
Computationofsavingsinreceivablesinvestment
10000000010000000
360 360
100000000
60
=1666667311111=Rs.1355556
Opportunitycost(savingsofreductionininvestmentinreceivables
=0.1x135556=Rs.135556
Statementshowingtheeffectofchangeindiscountpolicyasprofitofthecompany
IncreaseinContribution 2000000
Less:increaseindiscountcost 1260000
740000
Less:Taxat30% 222000
518000
Add:Benefitofsavingsdueto
Reductionininvestmentin
=
20 14 0.8x X14
= 311111
228
Receivablesprofit 135556
653556
Itisdesirabletochangethediscountpolicyasitwillimprovetheprofitabilityofthefirm.
4.Collectionpolicy
Forcomputationoftheeffectofnewcollectionprogrammecanbeevaluatedwiththehelp
offollowingformula .
Changeinprofit=(IncrementalcontributionIncreaseinbaddebts)(1taxrate)cost
ofincreaseininvestmentinreceivables.
Example
Acompanyisconsideringrelaxingitscollectioneffort.ItspresentsalesareRs50million,
ACP=20days,variablecosttosalesratio=0.8,costofcapital10%.Itsbaddebtratiois
0.05.
The relaxation in collection programme is expected to increase sales by Rs 5 million,
increaseACPto40daysandbaddebtsratioto0.56.Taxrateis30%.
Examine the effect of change in collection programme on firms profits. Assume 360
daysinayear.(MBAadoptedandalsoACS)
Solution
IncreaseinContribution=5000000x0.2=Rs.1000000
Increaseinbaddebts
Baddebtsonexistingsales=50000000x0.05=2500000
Baddebtsontotalsalesafterincreaseinsales=
55000000x0.56=3300000
Increaseinbaddebts=Rs.800000
Incrementalinvestmentinreceivables
50000000(4020) 5000000x40x0.8
360360
=2777778+444444=Rs.3222222
Opportunitycostofincrementalinvestmentinreceivables=
0.1 x3222222=Rs.322222
=
+
229
Statementshowingtheimpactofnewcollectionprogrammeonprofitsoftheorganisation
IncrementalContribution 1000000
Less:Increaseinbaddebts 800000
200000
Less:Incometaxat30% 60000
1,40,000
Less:Opportunitycostofincrease
Ininvestmentinreceivables 3,22,222
Profit (182222)loss
Sincethechangewillleadtodecreaseinprofit(i,ealossofRs.182222)itisnotdesirable
torelaxthecollectionprogrammeofthefirm
1. Credit policy of a firm can be regarded as a tradeoff between ___________ and
_______.
2.Optimumcreditpolicymaximisesthe__________.
3. Value of a firm is maximised when the incremental rate of return on investment in
receivable is ________________ to the incremental cost of funds used to finance that
investment.
4. Credit policy to be adopted by a firm is influenced by strategies pursued by its
competitions.
14.5Summary
Receivables are a direct result of credit sales. Management of accounts receivables is
the process of making decision relating to investment of funds in receivable which will
resultinmaximisingtheoverallreturnonthe investmentofthefirm.Cost ofmaintaining
receivables are capital costs, administration costs and delinquency costs. Credit policy
variables are credit standards, credit period, cash discounts and collection programme.
OptimumcreditpolicyisthatwhichMaximisesthevalueofthefirm.
230
TerminalQuestions
1. Examinethemeaningofreceivablemanagement.
2. Examinethecostsofmaintainingreceivables.
3. Examinethevariablesofcreditpolicy.
4. Whatarethefeaturesofoptimumcreditpolicy
AnswerforselfAssessmentQuestions
1. Capitalcosts,administration,Delinquencycosts.
2. Noinducementforearlypayments
3. Creditsale,Cashreceiptfromcustomers.
4. Creditinvestigationandsupervisioncost,collectioncosts
1. Creditpolicyvariable.
2. Creditstandards
3. Creditperiod
4. Cashdiscountof2%,onthetenthday.
1. Higher profits from increased sales, incremental cost of having large investment in
receivable.
2. Valueofthefirm.
3. Equal
1. Refertounit14.1
2. Refertounit14.2
3. Refertounit14.3
4. Refertounit14.4
Unit15 DividendDecision
Structure
15.1 Introduction
15.2 TraditionalApproach
15.3 DividendRelevanceModel
15.3.1 WalterModel
15.3.2 GordonsDividendCapitalizationModel
15.4 DividendIrrelevanceTheory: MillerandModiglianiModel
15.5 StabilityofDividends
15.6 FormsofDividends
15.7 StockSplit
15.8 Summary
TerminalQuestions
AnswerstoSAQsandTQs
15.1Introduction
Dividendsarethatportionofafirmsnetearningspaidtotheshareholders.Preferenceshareholders
are entitled to a fixed rate of dividend irrespective of the firms earnings. Equity holders dividends
fluctuateyearafteryear.Itdependsonwhatportionofearningsistoberetainedbythefirmandwhat
portionistobepaidoff.Asdividendsaredistributedoutofnetprofits,thefirmsdecisionsonretained
earningshaveabearingontheamounttobedistributed.Retainedearningsconstituteanimportant
source of financing investment requirements of a firm. However, such opportunities should have
enough growth potential and sufficient profitability. There is an inverse relationship between these
two larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are
alwayscompetitiveandconflicting.
Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturndividendsand
capitalgains.Alowpayoutandhighretentionmayhavetheeffectofacceleratingearningsgrowth.
Investorsofgrowthcompaniesrealizetheirmoneyintheformofcapitalgains. Dividend yield will
be lowfor such companies. The influenceofdividendpolicy onfuture capitalgains is tohappen in
distant future and therefore by all means uncertain. Share prices are a reflection of many factors
including dividends. Some investors prefer current dividends to future gains as prophesied by an
English saying A bird in hand is worth two in the bush. Given all these constraints, it is a major
decisionoffinancialmanagement.
Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient
investmentopportunitieswillretaintheentireearningstofunditsgrowthavenues.Conversely,ifno
suchavenuesareforthcoming,thefirmwillpayoutitsentireearnings.Sothereexistsarelationship
betweenreturnoninvestmentsrandthecostofcapitalk.Solongasrexceedsk,afirmshallhave
goodinvestmentopportunities.Thatis,ifthefirmcanearnareturnrhigherthanitscostofcapitalk,
itwillretainitsentireearningsandifthissourceisnotsufficient,itwillgoinforadditionalsourcesin
theformofadditionalfinancing like equity issue,debenture issueor term loans. Thus, the dividend
decisionisatradeoffbetweenretainedearningsandfinancingdecisions.
Different theories have been given by various people on dividend policy. We have the traditional
theory and new sets of theories based on the relationship between dividend policy and firm value.
Themoderntheoriescanbegroupedas(a)theoriesthatconsiderdividenddecisionasanactive
variableindeterminingthevalueofthefirmand(b)theoriesthatdonotconsiderdividenddecisionas
anactivevariableindeterminingthevalueofthefirm.
LearningObjectives:
1. Explaintheimportanceofdividendstoinvestors.
2. Discusstheeffectofdeclaringdividendsonshareprices.
3. Mentiontheadvantagesofastabledividendpolicy.
4. Listoutthevariousformsofdividend.
5. Givereasonsforstocksplit.
15.2TraditionalApproach
This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship
betweenthedividendsandthestockmarket.Accordingtothem,thestockvaluerespondspositively
tohighdividendsandnegativelytolowdividends,thatis,thesharevaluesofthosecompaniesrises
considerablywhichpayhighdividendsandthepricesfallintheeventoflowdividendspaid.
Symbolically,P=[m(D+E/3)]
WherePisthemarketprice,
Misthemultiplier,
Disdividendpershare,
EisEarningspershare.
Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship
betweenP/Eratiosanddividendpayoutratio.HighdividendpayoutratiowillincreasetheP/Eratio
andlowdividendpayoutratiowilldecreasetheP/Eratio.Thismaynotalwaysbetrue.Acompanys
sharepricesmayriseinspiteoflowdividendsduetootherfactors.
15.3DividendRelevanceModel
Underthissectionweexaminetwotheories WalterModelandGordonModel.
15.3.1WalterModel
Prof. James E. Walter considers dividend payouts are relevant and have a bearing on the share
prices of the firm. He further states, investment policies of a firm cannot be separated from its
dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the
value of thefirm. His model clearlyestablishesa relationship between thefirms rate of return r, its
costofcapitalk,togiveadividendpolicythatmaximizesshareholderswealth.Thefirmwouldhave
the optimum dividend policy that will enhance the value of the firm. This can be studied with the
relationship between r and k. If r>k, the firms earnings can be retained as thefirm has better and
profitableinvestmentopportunitiesandthefirmcanearnmorethanwhattheshareholderscouldby
reinvesting,ifearningsaredistributed.Firmswhichhaver>karecalledgrowthfirmsandsuchfirms
shouldhaveazeropayoutratio.
Ifreturnoninvestmentrislessthancostofcapitalk,thefirmshouldhavea100%payoutratioas
theinvestorshavebetterinvestmentopportunitiesthanthefirm.Suchapolicywillmaximizethefirm
value.
IfafirmhasaROIrequaltoitscostofcapitalk,thefirmsdividendpolicywillhavenoimpactonthe
firmsvalue.Thedividendpayoutscanrangebetweenzeroand100%andthefirmvaluewillremain
constantinallcases.Suchfirmsarecallednormalfirms.
WaltersModelisbasedoncertainassumptions:
Financing:Allfinancingisdonethroughretainedearnings.Retainedearningsistheonlysource
of finance available and the firm does not use any external source of funds like debt or new
equity.
Constant rate of returnandcost of capital: Thefirms r and k remainconstantand itfollows
thatanyadditionalinvestmentmadebythefirmwillnotchangetheriskandreturnprofile.
100% payout or retention: All earningsareeither completely distributedor reinvested entirely
immediately.
Constant EPS and DPS: The earnings and dividends do not change and are assumed to be
constantforever.
Life:Thefirmhasaperpetuallife.
Waltersformulatodeterminethemarketpriceisasfollows:
P=
Ke
] Ke / ) D E ( r [
Ke
D -
+
WherePisthemarketpricepershare,
Disthedividendpershare,
Keisthecostofcapital,
gisthegrowthrateofearnings,
EisEarningspershare,
risIRR.
Example:
ThefollowinginformationrelatestoAlphaLtd.Showtheeffectofthedividendpolicyonthemarket
priceofitssharesusingtheWaltersModel
EquitycapitalizationrateKe11%
Earningspershare Rs.10
ROI(r)maybeassumedasfollows:15%,11%and8%
Showtheeffectofthedividendpoliciesonthesharevalueofthefirmforthreedifferentlevelsofr,
takingtheDPratiosaszero,25%,50%,75%and100%
Solution
Ke11%,EPS10,r15%,DPS=0
P=
Ke
)] D E ( Ke / r [
Ke
D -
+
CaseIr>k(r=15%,K=11%)
a. DP=0
11 . 0
)] 0 10 ( 11 . 0 / 15 . 0 [ 0 - +
=13.64/0.11=Rs.123.97
b. DP=25%
11 . 0
)] 5 . 2 10 ( 11 . 0 / 15 . 0 [ 5 . 2 - +
= 12.73/0.11=Rs.115.73
c. DP=50%
11 . 0
)] 5 10 ( 11 . 0 / 15 . 0 [ 5 - +
=11.82/0.11=Rs.107.44
d. DP=75%
11 . 0
)] 5 . 7 10 ( 11 . 0 / 15 . 0 [ 5 . 7 - +
=10.91/0.11=Rs.99.17
e. DP=100%
11 . 0
)] 10 10 ( 11 . 0 / 15 . 0 [ 10 - +
=10/0.11=Rs.90.91
CaseIIr=k(r=11%,K=11%)
a. DP=0
11 . 0
)] 0 10 ( 11 . 0 / 11 . 0 [ 0 - +
=10/0.11=Rs.90.91
b. DP=25%
11 . 0
)] 5 . 2 10 ( 11 . 0 / 11 . 0 [ 5 . 2 - +
=10/0.11=Rs.90.91
c. DP=50%
11 . 0
)] 5 10 ( 11 . 0 / 11 . 0 [ 5 - +
=10/0.11=Rs.90.91
d. DP=75%
11 . 0
)] 5 . 7 10 ( 11 . 0 / 11 . 0 [ 5 . 7 - +
=10/0.11=Rs.90.91
e. DP=100%
11 . 0
)] 10 10 ( 11 . 0 / 11 . 0 [ 10 - +
=10/0.11=Rs.90.91
CaseIIIr<k(r=11%,K=8%)
f. DP=0
08 . 0
)] 0 10 ( 08 . 0 / 11 . 0 [ 0 - +
=13.75/0.08=Rs.171.88
g. DP=25%
08 . 0
)] 5 . 2 10 ( 08 . 0 / 11 . 0 [ 5 . 2 - +
=12.81/0.08=Rs.160.13
h. DP=50%
08 . 0
)] 5 10 ( 08 . 0 / 11 . 0 [ 5 - +
=11.88/0.08=Rs.107.95
i. DP=75%
08 . 0
)] 5 . 7 10 ( 08 . 0 / 11 . 0 [ 5 . 7 - +
=10.94/0.08=Rs.99.43
j. DP=100%
08 . 0
)] 10 10 ( 08 . 0 / 11 . 0 [ 10 - +
=10/0.08=Rs.90.91
Interpretation:Theaboveworkingscanbesummarizedasfollows:
1. Whenr>k,thatis,ingrowthfirms,thevalueofsharesisinverselyrelatedtoDPratio,astheDP
increases,marketvalueofsharesdecline.MarketvalueofshareishighestwhenDPiszeroand
leastwhenDPis100%.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected
whetherthefirmretainstheprofitsordistributesthem.
3. Inthethirdsituation,whenr<k,indecliningfirms,themarketpriceofashareincreasesastheDP
increases.Thereisapositivecorrelationbetweenthetwo.
Limitations
Walterhasassumedthatinvestmentsareexclusivelyfinancedbyretainedearningsandnoexternal
financing is used. This model is applicable only to allequity firms. Secondly r is assumed to be
constant which again is not a realistic assumption. Finally, Ke is also assumed to be constant and
thisignoresthebusinessriskofthefirmwhichhasadirectimpactonthefirmvalue.
15.3.2GordonsDividendCapitalizationModel
Gordonalsocontendsthatdividendsarerelevanttothesharepricesofafirm.MyronGordonuses
theDividendCapitalizationModeltostudytheeffectofthefirmsdividendpolicyonthestockprice.
Assumptions
Allequityfirm:Thefirmisanallequityfirmwithnodebt.
No external financing is used and only retained earnings are used to finance any expansion
schemes.
Constantreturnr
ConstantcostofcapitalKe
Thelifeofthefirmisindefinite.
Constantretentionratio:Theretentionratiog=brisconstantforever.
Costofcapitalgreaterthanbr,thatisKe>br
Gordons model assumes investors are rational and riskaverse. They prefer certain returns to
uncertain returns and therefore give a premium to the constant returns and discount uncertain
returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they
discount future dividends. Retained earnings are evaluated by the shareholders as risky and
thereforethemarketpriceoftheshareswouldbeadverselyaffected.Gordonexplainshistheorywith
preference for current income. Investors prefer to pay higher price for stocks which fetch them
currentdividendincome.Gordonsmodelcanbesymbolicallyexpressedas:
br Ke
) b 1 ( E
P
-
-
=
WherePisthepriceoftheshare,
EisEarningsPerShare,
bisRetentionraio,
(1b)isdividendpayoutratio,
Keiscostofequitycapital,
brisgrowthrateintherateofreturnoninvestment.
Example:
GivenKeas11%,EisRs.10,calculatethestockvalueofMahindraTech.for(a)r=12%,(b)r=11%
and(c)r=10%forvariouslevelsofDPratiosgivenunder:
DPratio(1b) Retentionratio
A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
E 50% 50%
Solution
CaseIr>k(r=12%,K=11%)
P=E(1b)
Kebr
a. DP10%,b90%
10(10.9) equals1/.002=Rs.500
0.11(0.9*0.12)
b. DP20%,b80%
10(10.8) equals2/.014=Rs.142.86
0.11(0.8*0.12)
c. DP30%,b70%
10(10.7) equals3/.026=Rs.115.38
0.11(0.7*0.12)
d. DP40%,b60%
10(10.6) equals4/.038=Rs.105.26
0.11(0.6*0.12)
e. DP50%,b50%
10(10.5) equals5/.05=Rs.100
0.11(0.5*0.12)
CaseIIr=k(r=11%,K=11%)
P=E(1b)
Kebr
a. DP10%,b90%
10(10.9) equals1/.011=Rs.90.91
0.11(0.9*0.11)
b. DP20%,b80%
10(10.8) equals2/.022=Rs.90.91
0.11(0.8*0.11)
c. DP30%,b70%
10(10.7) equals3/.033=Rs.90.91
0.11(0.7*0.11)
d. DP40%,b60%
10(10.6) equals4/.044=Rs.90.91
0.11(0.6*0.11)
e. DP50%,b50%
10(10.5) equals5/.55=Rs.90.91
0.11(0.5*0.11)
CaseIIIr<k(r=10%,K=11%)
P=E(1b)
Kebr
a. DP10%,b90%
10(10.9) equals1/.02=Rs.50
0.11(0.9*0.1)
b. DP20%,b80%
10(10.8) equals2/.03=Rs.66.67
0.11(0.8*0.1)
c. DP30%,b70%
10(10.7) equals3/.04=Rs.75
0.11(0.7*0.1)
d. DP40%,b60%
10(10.6) equals4/.05=Rs.80
0.11(0.6*0.1)
e. DP50%,b50%
10(10.5) equals5/.06=Rs.83.33
0.11(0.5*0.1)
Interpretation: Gordon is of theopinion thatdividend decision does have a bearing on the market
priceoftheshare.
1. Whenr>k,thefirmsvaluedecreaseswithanincreaseinpayoutratio.Marketvalueofshareis
highestwhenDPisleastandretentionhighest.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected
whetherthefirmretainstheprofitsordistributesthem.
3. Whenr<k,marketvalueofshareincreaseswithanincreaseinDPratio.
15.4MillerandModiglianiModel
The MM hypothesis seeks to explainthatafirms dividendpolicy is irrelevant andhasnoeffecton
thesharepricesofthefirm.Thismodeladvocatesthatitistheinvestmentpolicythroughwhichthe
firmcanincreaseitssharevalueandhencethisshouldbegivenmoreimportance.
Assumptions
Existence of perfect capital markets: All investors are rational and have access to all
information free of cost. There are no floatation or transaction costs, securities are infinitely
divisibleandnosingleinvestorislargeenoughtoinfluencethesharevalue.
No taxes: There are no taxes, implying there is no difference between capital gains and
dividends.
Constant investment policy: The investment policy of the company does not change. The
implicationisthatthereisnochangeinthebusinessriskpositionandtherateofreturn.
No Risk Certainty about future investments, dividends and profits of the firm. This
assumptionwas,however,droppedatalaterstage.
Basedontheaboveassumptions,MillerandModiglianihaveexplainedtheirrelevanceofdividendas
the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two
transactions which are entered into simultaneously. The two transactions are paying out dividends
andraisingexternalfundstofinanceadditionalinvestmentprograms.Ifthefirmpaysoutdividend,it
will have to raise capital by selling new shares for financing activities. The arbitrage process will
neutralizethe increase in share value (due todividends) withthe issue of new shares. This makes
theinvestorindifferenttodividendearningsandcapitalgainsasthesharevalueismoredependent
onthefutureearningsofthefirmthanonitscurrentdividendpolicy.
Symbolically,themodelisgivenas:
StepI:ThemarketpriceofashareinthebeginningisequaltothePVofdividendspaidandmarket
priceattheendoftheperiod.
P0= 1 *(D1+P1)
(1+Ke)
WhereP0isthecurrentmarketprice,
P1ismarketpriceattheendofperiod1,
D1isdividendstobepaidattheendofperiod1,
Keisthecostofequitycapital.
StepII:Assumingthereisnoexternalfinancing,thevalueofthefirmis:
nP0== 1 *(nD1+nP1)
(1+Ke)
Wherenisnumberofsharesoutstanding.
StepIII:Ifthefirmsinternalsourcesoffinancingitsinvestmentopportunitiesfallshortoffunds
required,newsharesareissuedattheendofyear1atpriceP1.Thecapitalizedvalueofthe
dividendstobereceivedduringtheperiodplusthevalueofthenumberofsharesoutstandingisless
thanthevalueofnewshares.
nP0== 1 *(nD1+(n+n1)P1n1p1)
(1+Ke)
Firmswillhavetoraiseadditionalcapitaltofundtheirinvestmentrequirementsafterutilizingtheir
retainedearnings,thatis,
n1P1=I(EnD1)whichcanbewrittenasn1P1=IE+nD1
WhereIistotalinvestmentrequired,
nD1istotaldividendspaid,
Eisearningsduringtheperiod,
(EnD1)isretainedearnings.
StepIV:Thevalueofshareisthus:
nP0== 1 *(nD1+(n+n1)P1I+EnD1)
(1+Ke)
Example:
Acompanyhasacapitalizationrateof10%.Itcurrentlyhasoutstandingsharesworth25000shares
sellingcurrentlyatRs.100each.ThefirmexpectstohaveanetincomeofRs.400000forthecurrent
financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also
requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend
paymentdoesnotaffectthevalueofthefirm.
Solution
CaseI:Whendividendsarepaid:
StepI:P0= 1 *(D1+P1)
(1+Ke)
100=1/(1+0.1)*(4+P1)
P1=Rs.106
StepII:n1P1=I(EnD1),nD1is25000*4
n1P1=600000(400000100000)=Rs.300000
StepIII:Numberofadditionalsharestobeissued
300000/106=2831shares
StepIV:Thefirmvalue
nP0== (n+n1)P1I+E
(1+Ke)
(25000+2831)*106600000+400000 equalsRs.2500000
(1+0.1)
CaseII:Whendividendsarenotpaid:
StepI:P0= 1 *(D1+P1)
(1+Ke)
100=1/(1+0.1)*(0+P1)
P1=Rs.110
StepII:n1P1=I(EnD1),nD1is25000*4
n1P1=600000(4000000)=Rs.200000
StepIII:Numberofadditionalsharestobeissued
200000/110=1819shares
StepIV:Thefirmvalue
nP0== (n+n1)P1I+E
(1+Ke)
(25000+1819)*110600000+400000 equalsRs.2500000
(1+0.1)
Thus,thevalueofthefirmremainsthesameinboththecaseswhetherornotdividendsare
declared.
CriticalAnalysisofMMHypothesis:
Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation
costsrefertothecostinvolvedinraisingcapitalfromthemarket,thatis,thecostsincurredtowards
underwritingcommission,brokerageandothercosts.Thesecostsordinarilyaccounttoaround10%
15%ofthetotalissueandtheycannotbeignoredgiventheenormityofthesecosts.Thepresenceof
these costs affects the balancing nature of retained earnings and external financing. External
financingisdefinitelycostlierthanretainedearnings.Forinstance,ifashareisissuedworthRs.100
andfloatationcostsare12%,thenetproceedsareonlyRs.88.
Transactioncosts:ThisisanotherassumptionmadebyMMthattherearenotransactioncostslike
brokerage involved in capital market. These are the costs associated with sale of securities by
investors. This theory implies that if thecompany does notpay dividends, the investors desirousof
currentincomesellpartoftheirholdingswithoutanycostincurred.Thisisveryunrealisticasthesale
of securities involves cost, investors wishing to get current income should sell higher number of
sharestogettheincometheyaretoreceive.
Underpricingofshares:Ifthecompanyhastoraisefundsfromthemarket,itshouldsellsharesat
apricelesserthantheprevailingmarketpricetoattractnewshareholders.Thisfollowsthatatlower
prices,thefirmshouldsellmoresharestoreplacethedividendamount.
Marketconditions:Ifthemarketconditionsarebadandthefirmhassomelucrativeopportunities,it
is not worthapproaching new investors at this juncture, given the presence of floatation costs. In
such cases, the firms should depend on retained earnings and low payout ratio to fuel such
opportunities.
15.5 StabilityofDividends
Stabilityofdividendsistheconsistencyinthestreamofdividendpayments.Itisthepayment
ofcertainamountofminimumdividendtotheshareholders.Thesteadinessisasignofgoodhealth
of the firm and may take any of the following forms (a) constant dividend per share,
(b)constantDPratioand(c)constantdividendpershareplusextradividend.
Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of
dividendpershareyearafteryear.Forexample,afirmmayhaveapolicyofpaying25%dividendper
share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year
irrespectiveofitsearnings.Generally,afirmfollowingsuchapolicywillcontinuepaymentsevenifit
incurs losses. In such years when there is a loss, the amount accumulated in the dividend
equalizationreserveisutilized.Asandwhenthefirmstartsearningahigheramountofrevenueitwill
considerpaymentofhigherdividendsandinfutureitisexpectedtomaintainthehigherlevel.
ConstantDPratio:WiththistypeofDPpolicy,thefirmpaysaconstantpercentageofnetearnings
totheshareholders.Forexample,ifthefirmfixesitsDPratioas25%ofitsearnings,itimpliesthat
shareholdersget25%ofearningsasdividendyearafteryear.Insuchyearswhereprofitsarehigh,
theygethigheramount.
Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed
dividendordinarily and in years ofgoodprofits, additionalor extradividend is paid over and above
theregulardividend.
Thestabilityofdividendsisdesirablebecauseofthefollowingadvantages:
Build confidence amongst investors: A stable dividend policy helps to build confidence and
remove uncertainty in the minds of investors. A constant dividend policy will not have any
fluctuationssuggestingtotheinvestorsthatthefirmsfutureisbright.Incontrast,shareholdersof
afirmhavinganunstableDPwillnotbecertainabouttheirfutureinsuchafirm.
Investors desire for current income: A firm has different categories of investors old and
retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like
retiredpersonsprefer current income. Their living expensesarefairly stablefrom oneperiod to
another. Sharp changes in current income, that is, dividends, may necessitate sale of shares.
Stabledividendpolicyavoidssaleofsecuritiesandinconveniencetoinvestors.
Informationaboutfirmsprofitability:Investorsusedividendpolicyasameasureofevaluating
thefirmsprofitability.Dividenddecisionisasignoffirmsprosperityandhencefirmshouldhave
astableDP.
Institutional investors requirements: Institutional investors like LIC, GIC and MF prefer to
invest in companies which have a record of stable DP. A company having erratic DP is not
preferred by these institutions. Thus to attract these organizations having large quantities of
investiblefunds,firmsfollowastableDP.
Raise additional finance: Shares of a company with stable and regular dividend payments
appearasqualityinvestmentratherthanaspeculation.Investorsofsuchcompaniesareknown
for their loyalty and whenever the firm comes with new issues, they are more responsive and
receptive.Thusraisingadditionalfundsbecomeseasy.
Stability in market price of shares: The market price of shares varies with the stability in
dividendrates.Suchshareswillnothavewidefluctuationsinthemarketpriceswhichisgoodfor
investors.
SelfAssessmentQuestionsI
1. ____________constituteanimportantsourceoffinancinginvestmentrequirementsofafirm.
2. Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturn__________
and____________.
3. ______________considers dividend payouts are relevant and have a bearing on the share
pricesofthefirm.
4. IfafirmhasaROIrequaltoitscostofcapitalk,itiscalleda___________
5. ________ model explains that consumers prefer certain returns to uncertain returns and
thereforegiveapremiumtotheconstantreturnsanddiscountuncertainreturns.
6. The__________processreferstosettingofforbalancingtwotransactionswhichareenteredinto
simultaneously.
7. __________costsrefertothecostinvolvedinraisingcapitalfromthemarket.
8. ______________arethecostsassociatedwithsaleofsecuritiesbyinvestors.
15.6 FormsofDividends
Dividendsarethatpotionofearningsavailabletoshareholders.Generally,dividendsaredistributed
incash,butsometimestheymayalsodeclaredividendsinotherformswhicharediscussedbelow:
Cash dividends: Most companies paydividends in cash. The investorsalso,especially the old
andretiredinvestorsdependonthisformofpaymentforwantofcurrentincome.
Scripdividend:Inthisformofdividends,equityshareholdersareissuedtransferablepromissory
notes with shorter maturity periods which may or may not have interest bearing. This form is
adopted if the firm has earned profits and it will take some time to convert its assets into cash
(having moreof current salesthancash sales).Payment of dividend in thisform isdoneonly if
thefirmissufferingfromweakliquidityposition.
Bond dividend: Scrip and bond dividend are the same except that they differ in terms of
maturity.Bonddividendscarrylongermaturityperiodandbearinterest,whereasscripdividends
carryshortermaturityandmayormaynotcarryinterest.
Stockdividend(Bonusshares): Stockdividend,asknownisUSAorbonussharesinIndia,is
thedistributionofadditionalsharestotheshareholdersatnoadditionalcost.Thishastheeffect
of increasing the number of outstanding shares of the firm. The reserves and surplus (retained
earnings) are capitalized to give effect to bonus issue. This decision has the effect of
recapitalization, that is, transferfrom reserves toshare capital not changing the total net worth.
Theinvestorsareallottedsharesinproportiontotheirpresentshareholding.Declarationofbonus
shareshasafavourablepsychologicaleffectoninvestors.Theyassociateitwithprosperity.
15.7StockSplit
A stock split isa methodto increasethe number ofoutstanding sharesbyproportionately reducing
thefacevalueofashare.Astocksplitaffectsonlytheparvalueanddoesnothaveanyeffectonthe
totalamountoutstandinginsharecapital.Thereasonsforsplittingsharesare:
Tomakesharesattractive:Theprimereasonforeffectingastocksplitistoreducethemarket
price of a share to make it more attractive to investors. Shares of some companies enter into
highertradingzonemakingitoutofreachtosmallinvestors.Splittingtheshareswillplacethem
inmorepopulartradingrangethusprovidingmarketabilityandmotivatingsmallinvestorstobuy
them.
Indication of higher future profits: Share split is generally considered a method of
managementcommunicationtoinvestorsthatthecompanyisexpectinghighprofitsinfuture.
Higher dividend to shareholders: When shares are split, the company does not resort to
reducing the cash dividends. If the companyfollows a system of stable dividend per share, the
investorswouldsurelygethigherdividendswithstocksplit.
15.8Summary
Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not
mandatory,butmostcompaniesseetoitthatdividendsarepaidonaregularbasistomaintainthe
imageofthe company.Aspayment of dividend is not compulsory, thequestion whicharises in the
minds of policy makers is Should dividends be paid, if yes, what should be the quantum of
payment?Varioustheorieshavecomeoutwithvarioussuggestionsonthepaymentofdividend.B.
GrahamandD.L.Doddareoftheviewthatthereisacloserelationshipbetweenthedividendsand
thestockmarket.Thestockvaluerespondspositivelytohighdividendsandviceversa.
Prof. James E. Walter considers dividend payouts are necessary but if the firms ROI is high,
earningscanberetainedasthefirmhasbetterandprofitableinvestmentopportunities.
Gordon also contends that dividends are significant to determine the share prices of a firm.
Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a
premiumtotheconstantreturnsanddiscountuncertainreturns.
MillerandModiglianiexplainthatafirmsdividendpolicyisirrelevantandhasnoeffectontheshare
prices of the firm. They are of the view that it is the investment policy through which the firm can
increaseitssharevalueandhencethisshouldbegivenmoreimportance.
Dividendscanbepaidoutinvariousformssuchascashdividend,scripdividend,bonddividendand
bonusshares.
TerminalQuestions
1. Writeashortnoteonthedifferenttypesofdividend.
2. Whatisstocksplit?Whatareitsadvantages?
3. Thefollowinginformationisavailableinrespectofacompany.
Equitycapitalization15%
EPSRs.25
Dividendpayoutratio25%
ROI12%
WhatisthepriceoftheshareasperWalterModel?
4. Consideringthefollowinginformation,whatisthepriceoftheshareasperGordonsModel?
Netsales Rs.120lakhs
Netprofitmargin 12.5%
Outstandingpreferenceshares Rs.50lakhs@12%dividend
No.ofequityshares 250000
Costofequityshares 12%
Retentionratio 40%
ROI 16%
5. IftheEPSisRs.5,dividendpayoutratiois50%,costofequityis20%,growthrateintheROIis
15%,whatisthevalueofthestockasperGordonsDividendEqualizationModel?
6. NileLtd.makesthefollowinginformationavailable.WhatisthevalueofthestockasperGordon
Model?
Ke14%,EPSRs.20,D/Pratio35%Retentionratio65%,ROI16%
7. WhatisthestockpriceasperGordonModelifDPratiois60%intheabovecase?
1. Retainedearnings
2. Dividendsandcapitalgains
3. Prof.JamesE.Walter
4. Normalfirm
5. Gordon
6. Arbitrage
7. Floatationcosts
8. Transactioncosts
1. Referto10.6
2. Referto10.7
3.Hint:ApplytheformulaWaltersformulatodeterminethemarketprice
P= D + [r(ED)/Ke]
KeKe
4,5,6,7:Hint:ApplytheGordonformulaofP=E(1b)
Kebr

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